Methods of Depreciation – SS1 Financial Accounting Lesson Note (Third Term)

Depreciation methods are the ways a business works out how much of a fixed asset’s cost to write off each year.

Behavioural objectives

1. List the methods of providing for depreciation.
2. Explain the straight-line method and state its formula.
3. Explain the reducing balance method and state the formula for its depreciation rate.
4. Explain the revaluation method and name the assets it suits.
5. State the advantages and disadvantages of each of these three methods.
6. Describe briefly the sum of the years’ digits and depletion unit methods.

What are the methods of providing for depreciation?

There are five main methods of providing for depreciation: straight-line, reducing balance, sum of the years’ digits, revaluation and depletion unit.

Main methods

1. Straight-line method: the same amount is charged every year.
2. Reducing balance method: a fixed percentage is charged on the falling balance. It is also called the diminishing balance method.
3. Sum of the years’ digits method: a falling fraction of the depreciable cost is charged each year.
4. Revaluation method: the asset is valued at the start and end of the year.
5. Depletion unit method: the charge depends on the units used or produced in the year.

Other less common methods

• Sinking fund method: money is set aside and invested each year to replace the asset later.
• Insurance policy method: premiums are paid to an insurance company to provide money for replacement.
• Annuity method: the cost of the asset is treated as an investment that earns interest.

What is the straight-line method?

The straight-line method charges an equal amount of depreciation each year throughout the use of the asset.

• Formula: Annual depreciation = (Cost minus Scrap value) ÷ Number of years.
• Suits: assets used evenly over time, such as buildings and office furniture.

Worked example

• Given: cost = ₦500,000, scrap value = ₦50,000, life = 5 years.
• Working: (₦500,000 minus ₦50,000) ÷ 5 = ₦90,000.
• Result: ₦90,000 is charged in each of the 5 years.

Advantages of the straight-line method

• Simple: it is easy to calculate.
• Widely used: many businesses know and accept it.
• Time-oriented: the charge depends on the passing of time.

Disadvantages of the straight-line method

• Not suitable for all assets: it cannot be used for loose tools.
• Not scientific: it ignores the efficiency of the asset.
• Unrealistic: equal depreciation every year is an assumption that rarely holds.

What is the reducing balance method?

The reducing balance method writes off a fixed percentage of the reducing (diminishing) balance of the asset each year.

• Pattern: higher depreciation in the early years and lower depreciation in the later years.
• Reason: the same percentage is applied to a balance that gets smaller each year.
• Suits: assets that lose value fast early on, such as motor vehicles and machinery.

Formula for the depreciation rate

Depreciation rate (%) = [1 minus (S/C)^1/n] × 100

• n: number of years.
• S: scrap value.
• C: cost.

Worked example

• Given: cost = ₦500,000, rate = 20% a year.

Advantages of the diminishing balance method

• Widely used: it is common in practice.
• More scientific: depreciation is provided for more realistically.
• Recognises efficiency: higher charges in the early years and lower charges later.
• Balanced cost: high depreciation with low maintenance early on evens out with low depreciation and high maintenance later.

Disadvantages of the diminishing balance method

• Rate is hard to find: calculating the rate of depreciation may be difficult.
• Not suitable for all assets: it cannot be used for loose tools.

What is the revaluation method?

The revaluation method finds depreciation by valuing the asset at the start and end of the year and charging the difference.

• Values used: the value at the beginning and the end of the year is estimated.
• Charge: the difference is charged to the profit and loss account.
• Suits: assets that cannot easily be depreciated because of their nature.

Assets suited to revaluation

• Loose tools: bolts, nuts, hammers, chisels and screws.
• Livestock: animals kept on a farm.
• Farm crops or plantations: for example a cocoa or oil palm plantation.

Calculation

1. Take the value of the asset at the start of the year.
2. Add any purchases made during the year.
3. Subtract the value of the asset at the end of the year.
4. The result is the depreciation, charged to the profit and loss account.

Worked example

• Given: loose tools valued at ₦40,000 at the start, ₦10,000 bought in the year, ₦35,000 at the end.
• Working: ₦40,000 + ₦10,000 minus ₦35,000 = ₦15,000.
• Result: depreciation of ₦15,000 is charged to the profit and loss account.

Advantages of the revaluation method

• Suitable for hard-to-depreciate assets: it works for loose tools, livestock and similar items.

Disadvantages of the revaluation method

• Limited use: it cannot be used for all classes of assets.
• Cumbersome: revaluing assets every year takes time and effort.

What are the sum of the years’ digits and depletion unit methods?

These two methods charge depreciation by a falling fraction of cost and by units of output.

Sum of the years’ digits

1. Add the digits of the years of life. For 3 years: 1 + 2 + 3 = 6.
2. Use the remaining years of life as the top of the fraction: 3/6 in year 1, 2/6 in year 2, 1/6 in year 3.
3. Multiply each fraction by (Cost minus Scrap value).
4. With cost ₦500,000 and scrap ₦50,000, the charges are ₦225,000, ₦150,000 and ₦75,000.

Depletion unit method

• Formula: (Cost minus Scrap value) ÷ Total estimated units × Units used in the year.
• Suits: wasting assets such as mines and quarries, and assets measured by output.

How do the three main methods compare?

The table compares straight-line, reducing balance and revaluation, each explained in the sections above.

Evaluation

1. List the five main methods of providing for depreciation.
2. State the formula for the straight-line method.
3. Why does the reducing balance method charge more depreciation in the early years?
4. Name two types of asset for which the revaluation method is suitable.
5. Give two disadvantages of the straight-line method.

Assignment

Explain why the reducing balance method is described as more scientific than the straight-line method, and state one disadvantage of the reducing balance method.