In this video I'm going to explain what depreciation is and cover two methods
commonly used to calculate it. These are the straight-line method and the reducing
balance method. Both will be covered with clear examples
What is depreciation? Depreciation is how much the value of an asset falls over a
period of time. In order to record this expense to a business on an income
statement it can either use one of two key methods. First is a straight-line
method and secondly the reducing balance method. This is an important expense to
consider for a business as it can be costly if not monitored for example
imagine if a business has a fleet of ten vans that delivers products to its
customers. If each of those vans depreciates by two thousand pounds that
year then this has a cost to the business of twenty thousand pounds. It's
important that the business records this expense, it will provide them with a truer
picture of their overall expenses. The first method a business can use to
calculate the depreciation of its assets is the straight-line method. The
calculation you need to know to do this is the historic value of the asset, minus
the residual value, divided by the expected life of the asset. This itself
means nothing without an example. So, a bakery buys a new asset in the form of a
new van to deliver its products to its customers. They purchase this van brand
new for thirty thousand pounds, this is the vans historic value. The historic
value is the value of the asset when initially purchased. They expect the van
to sell at the end of its use for ten thousand pounds. This is the vans
residual value. Residual value is the value of the asset when it's disposed of
by the business, i.e. sold on. Finally they plan on using the van for four years.
This is the vans expected life. The expected life of an asset is how many
years the business expects to have the asset before it's sold on or disposed
of. These numbers are then put into the calculation above. Thirty thousand
pounds - ten thousand pounds equals twenty thousand pounds divided by four
this equals five thousand pounds. This means that the depreciation of the van
each year for a duration of four years, is five thousand pounds. This figure is a
yearly expense to the business and is recorded as depreciation on a statement
of comprehensive income. In order to apply your knowledge of straight-line
depreciation there is a task sheet to complete in the description of this
video. Why not have a go at a few examples. The next
method of calculating depreciation is the reducing balance method and rather
than calculating the asset will reduce by the same amount each year
this method is calculated by reducing the value of the asset by a set
percentage each year. In order to do this you first take the historic value and
times that by the percentage the asset will fall in value that year. This is then
repeated each year for the duration of the assets life within the business. Let's
take the same scenario as we used for the straight-line method. A bakery has
purchased a van for its deliveries for thirty thousand pounds, this means the
historic value is thirty thousand pounds. They expect the van to depreciate by
twenty percent per year for the duration of its four year expected life within
the business the table shows how this calculation looks over the vans
expected life of four years, we times each starting value by nought point two
as this is the multiplier that gives you a value of 20 percent, for example if we
wanted to reduce the balance by 10 percent we'll multiply the figure by nought point one
in year one the historic value of the van is thirty
thousand pounds. To find the depreciation that year you multiply that by nought point
two which gives you a depreciation for that year of six thousand pounds. We then
find the value of the van at the end of that year by using the value at the
start of the year, which is thirty thousand pounds and subtract the
depreciation just calculated of six thousand pounds. This gives an
end-of-year value of twenty four thousand pounds, this value is then
carried over the start of year two as that is now the vans value at the start of
the second year of its life. You then continue to appreciate the van by
twenty percent each year until the van has reached the end of its expected life.
as you can see the residual value after four years of reducing balance depreciation
is 12,000 288 pounds. The business will record larger expenses in terms of
depreciation in the first year of the vans life, as the name suggests each year
this will reduce until the van is sold or no longer in the business.
Unlike the straight-line method where each year the business will record the
same rate of depreciation. If you would like to have a go at reducing balance
depreciation or straight-line depreciation don't forget to download
the task sheet in the video description. Thank you for watching and if you found this
video useful in terms of helping you understand straight-line and reducing
balance depreciation then give the video a thumbs up and don't forget to
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