When a business buys equipment, a vehicle or a building, the cost is not charged to profit all at once. Depreciation spreads it over the years the asset is expected to be useful. Two methods are used most often: straight-line and reducing balance (also called declining balance).
Terms you need
- Cost: what you paid to buy the asset and get it ready for use.
- Residual value: what you expect it to be worth at the end of its useful life.
- Useful life: how long you expect to use it.
- Depreciable amount: cost minus residual value.
- Carrying amount: cost minus the depreciation recorded so far, also called net book value.
Straight-line
The same charge is made every year: (cost − residual value) ÷ useful life. It is simple and gives a steady charge, which suits assets that give about the same benefit every year.
Reducing balance
A fixed percentage is applied to the carrying amount at the start of each year, so the charge is highest in the early years and falls over time. It suits assets that lose most of their usefulness early, or need more repairs as they age.
The same asset, both methods
An asset costs 10,000, has a residual value of 1,000 and a useful life of five years. The reducing-balance rate is 30%. The figures are illustrative.
| Year | Straight-line charge | Straight-line carrying amount | Reducing-balance charge | Reducing-balance carrying amount |
|---|---|---|---|---|
| 1 | 1,800 | 8,200 | 3,000.00 | 7,000.00 |
| 2 | 1,800 | 6,400 | 2,100.00 | 4,900.00 |
| 3 | 1,800 | 4,600 | 1,470.00 | 3,430.00 |
| 4 | 1,800 | 2,800 | 1,029.00 | 2,401.00 |
| 5 | 1,800 | 1,000 | 720.30 | 1,680.70 |
Straight-line charges (10,000 − 1,000) ÷ 5 = 1,800 every year and ends exactly at the residual value of 1,000. Reducing balance charges 30% of the opening carrying amount, so the first year is 3,000 and the fifth is only 720.30. The carrying amount should never be depreciated below the residual value.
Choosing a method
- Follow the pattern of use. The method should reflect how the asset's benefits are consumed. Accounting standards such as IAS 16 expect this and expect the method, useful life and residual value to be reviewed at least once a year.
- Be consistent for similar assets, and change a method only when the pattern of use really changes.
- Remember that tax rules differ. Tax depreciation often follows its own rates and rules, separate from the accounting charge.
- Decide how to treat the first year. Many businesses charge a part-year in proportion to the months the asset was in use.
When you dispose of an asset
Remove the asset's cost and its accumulated depreciation from the books, and compare the proceeds with the carrying amount. If the asset is sold at the end of year 3 under straight-line, the carrying amount is 4,600. Proceeds of 5,000 give a gain of 400. Proceeds of 4,000 would give a loss of 600. The gain or loss is recorded in profit or loss.
Fox Pro Accounting's Fixed Assets module supports straight-line or declining-balance depreciation, depreciation journals and disposals with gain or loss treatment.