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In order to calculate depreciation, it is important to be aware that there are differences between revenue and capital costs. Use this simple guide to learn how to do depreciation calculations.
What Are the Methods for Calculating Depreciation?
There are two methods of calculating depreciation:
- the straight line method
- the reducing balance method
The straight line method is the most commonly used in practice and also the easiest to calculate. As a result, this is the method you are likely to need.
How Do I Use the Straight Line Method?
You should follow these three steps:
1. Identify the Cost That is to be Depreciated
This is the net purchase price, less the resale value.
2. Identify the Useful Economic Life of the Asset
To do this you will need to work out the number of years the asset is in use. This might be fairly easy as you know from experience how long assets tend to last before they break or experience so much wear and tear that they need replaced. Your organization should also have a general accounting policy on the useful economic life of particular classifications of assets. It is useful to check this out and not make any assumptions based on your own estimates.
3. Calculate the Depreciation
The annual depreciation can be calculated using the following formula:
Depreciation charge
=
Net purchase price - resale value
Number of years asset is in use
An example:
You buy a filing cabinet for a net price of £100. Your last filing cabinet lasted for 10 years before it started to show signs of serious wear and tear and the lock broke. You couldn’t sell it on to anyone else so it was just disposed of.
Workings (Following the Three Steps):
- The cost that is to be depreciated is the net purchase price of £100 less resale value of £0 (the filing cabinet was not fit for resale so was thrown out). Therefore, the cost to be depreciated is £100.
- The asset is in use for 10 years.
- Calculation outlined below:
Depreciation charge
=
Net purchase - resale value
Number of years asset is in use
=
100 - 0
10 years
=
10
Answer: The depreciation charge is £10 per year.
The annual depreciation charge is recorded as an expense in the profit and loss account. At the same time, the balance sheet shows what is known as the ‘net book value’ (NBV) which is the asset cost less the accumulated depreciation.
In our example, the balance sheet will show £100 less £10 (i.e. NBV = £90) in year one as only £10 worth of benefit has been accumulated by the organization and there is another nine years’ worth of benefit to go before the asset is worthless.
In year two, the balance sheet will show £100 less £20 (i.e. NBV = £80) as two years’ worth of benefit has been accumulated by the organization and the accumulated deprecation is £20.
After 10 years of depreciating the assets, the NBV will be £100 less £100 = £0 which is to be expected as the filing cabinet is so worn that it can’t be resold and has to be thrown out.
You may, however, find that it is worn but still useable. In this instance, it will still have a NBV of £0 as the standard life of such an item is 10 years and it has been fully depreciated. It doesn’t have any accounting value left despite it being of ‘value’ to you. But you don’t have to throw it out. You can keep the filing cabinet in your accounts at a NBV of £0 and continue to use it.
