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  Depreciation Method

Introduction to Depreciation method

Once the amount to be depreciated i.e. the cost, or fair value, of the asset less any residual value has been approximated, the business have to be select a method of allocating this depreciable amount among the accounting periods covering the useful life of asset. Even though there are several ways in which the total depreciation might be allocated and by this, a depreciation charge for each period derived, there are actually only two methods that are generally used in practice.

Deriving the fixed percentage

Deriving the fixed percentage to be applied needs the use of the following formula:

P = (1 √n R/C) × 100%

Where:

 P stands for                the depreciation percentage

N stands for                 the useful life of the asset (in years)

R stands for                 the residual value of the asset

C stands for                 the cost, or fair value, of the asset.

 

We can observe that the pattern of depreciation is quite dissimilar among the two methods. If we plot the carrying amount of the asset that has been derived by using the reducing balance method, against time, the result will be as displayed in Figure.

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Graph of carrying amount against time using the reducing- balance method

DEPRECIATION METHOD

Once the amount to be depreciated i.e. the cost, or fair value, of the asset less any residual value has been approximated, the business have to be select a method of allocating this depreciable amount among the accounting periods covering the useful life of asset.

Selecting a depreciation method

How does a business decide what type depreciation method to use for a specific asset? The reply is the one that best matches the depreciation expense to the pattern of economic advantages that the asset gives. In which these advantage are given evenly over time (buildings, for instance), the straight-line method is generally appropriate. In which assets lose their efficiency (as with specific types of machinery), the advantages provided will decline over time and so the reducing-balance method might be more suitable. In which the pattern of economic benefits given by the asset is uncertain, the straight-line method is normally chosen.

There is an international accounting standard (or international financial reporting standard) to deal with the depreciation of property, plant and equipment. The purpose of accounting standards is to narrow regions of accounting dissimilarity and to try to make sure that information given to users is transparent and comparable. The appropriate standard endorses the view that the depreciation method chosen should reflect the pattern of economic advantages given but does not specify specific methods to be employed. It says that the useful life, depreciation method and residual values of non-current assets have to be reviewed at least yearly and adjustments made where suitable.

 The approach taken to computing depreciation is summarised in Figure below:

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Figure: calculating the annual depreciation charge

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