IB Business and
Management
3.5 Depreciation (HL Only)
Learning Objectives
• Understand the causes of depreciation
• Understand the impact of depreciation on the profit
and loss account and balance sheet
• Calculate depreciation using the straight line and
reducing balance methods
• Evaluate the strengths and weaknesses of each
method
Recap
• What can you tell me about Balance Sheets?
• 2 minutes…. Brainstorm all you can remember
Balance Sheet
?
Task
Which section of the Balance Sheet?
• Fixed Asset
• Current Asset
• Current Liability
• Capital Employed
Which section of the Balance
Sheet?
A delivery van
Which section of the Balance
Sheet?
Money invested in the business by
the owner
Which section of the Balance
Sheet?
Shop premises
Which section of the Balance
Sheet?
Money in the Bank
Which section of the Balance
Sheet?
A bank loan taken out
Which section of the Balance
Sheet?
Stocks of goods
Which section of the Balance
Sheet?
Profits retained in the business
Which section of the Balance
Sheet?
Creditors
Which section of the Balance
Sheet?
Cash at premises
What is Depreciation?
• Depreciation is the
reduction of a value of a
fixed asset
• Do all fixed assets
depreciate?
• What causes depreciation?
Depreciation in Practice
Causes of Depreciation
• Usage (Wear and Tear)
• Time
• Obsolescence (due to technology, fashion etc)
Examples?
Depreciation and accounts
• Depreciation has an impact on
both the
balance sheet and profit and loss
account of a business
Depreciation in Accounts
Calculation of
annual
depreciation
Reduce value of asset
in the balance sheet
Include as an expense
on the profit and loss
account
Depreciation and the Balance
Sheet
• The balance sheet
aims to give a true
and fair account of
the value of a
businesses assets
• As the value of fixed
assets depreciates
this needs to be
reflected in the
figure shown
Balance Sheet – Reminder of the
IB structure
Fixed Assets
Less
Depreciation
=
Net Fixed Assets
Depreciation and the Profit and
Loss Account
• Capital expenditure
should be seen as
advanced payment for
the use of an asset
over a period of time
• Although the asset
may have been paid
for all at once, in its
accounts the
businesses spreads
the cost over a number
of years – Why?
• This avoids excessive
costs recorded in the
year of purchase
How do accountants decide how much depreciation to
include in the P&L account each year?
CALCULATING
DEPRECIATION
Calculating annual depreciation
There are 2 methods you need to be able to use to
calculate annual depreciation:
• The straight line method
• The reducing balance method
Before we start…. Some key
terms you need to know.
Residual Value
Useful Life
Initial Cost
Annual
Depreciation
Book
Value
What do you think these terms mean?
Straight Line Method
The Straight line method involves
reducing the value of the asset evenly
over it’s useful life.
• The yearly depreciation is calculated
by:
Annual Provision for Depreciation=
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 −𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒
Example
• A firm buys a delivery van for £15,000 in 2011
• They plan to keep the van for 3 years
• They estimate that they will be able to sell the van at
the end of the 3 years for £8,400
Calculate the yearly depreciation for the van:
£15,000 - £8,400 = £2,200 per year
3
How will this impact on the book value of the van?
Calculating the Book Value
Year
Initial Value
Annual
Depreciation
New Book Value
1
15,000
2,200
12,800
2
12,800
2,200
10,600
3
10,600
2,200
8,400
IB Question Time – 3 mins
Have a go at this question:
Gemel Ltd
‘Peter examined the figures and pointed
out that George had omitted a provision
for depreciation of the firm’s fixed
assets, which were valued at $200 000
on start-up. He suggested that George
worked on the basis of a four-year life
for the assets and estimated a scrap
value of $40 000.’
Calculate the annual depreciation
assuming a straight line method of
depreciation is used.(Show all your
working).
[2 marks]
Mark Scheme:
𝐶𝑜𝑠𝑡 −𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒
$200,000−$40,000
SLD = 𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐
=
= $40 000 p.a.
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐿𝑖𝑓𝑒
4
[2 marks]
The calculation is accurate and the working shown,
although the formula may not be stated.
[1 mark]
The calculation is accurate but no working shown or
inaccurate with appropriate working.
Reducing balance method
• The reducing balance method involves reducing the
value of the asset by a certain percentage each
year
Example
• A firm buys a delivery van for £15,000 in 2011
• They plan to keep the van for 3 years
• They will reduce the value of the asset in the
balance sheet by 17.5% each year
How will this impact on the book value of the van?
Book value of the asset
Year
Initial Value
Annual
Depreciation
New Book Value
1
15,000
2,625
12,375
2
12,375
2,166
10,209
3
10,209
1,787
8,422
IB Question Time – 5 mins
Have a go at this question:
Neat Organization
Neat Organization is a leading provider of
resort-based budget holidays in Spain for
price conscious consumers. As part of its
growth strategy, Neat Organization intends to
purchase some new coaches. The initial cost
of the coaches is $1 000 000. After 7 years
(the predicted useful life of the coaches), the
management hopes that they will have
enough residual value that can then be used
towards purchasing a new fleet.
Calculate the depreciation at 20 % using the
reducing balance method for the first 7 years
of the coaches (Show all your working).
[3 marks]
Year end
Workings
0
Depreciation
–
Value of coaches
1 000 000
1
20 % × 1 000 000
200 000
800 000
2
20 % × 800 000
160 000
640 000
3
20 % × 640 000
128 000
512 000
4
20 % × 512 000
102 400
409 600
5
20 % × 409 600
81 920
327 680
6
20 % × 327 680
65 536
262 144
7
20 % × 262 144
52 428.80
209 715.20
[1 to 2 marks] if the correct procedure has been followed but there is an error(s) in
the calculation(s). Deduct [1 mark] per error, but do not penalize for errors that have
been carried forward. So if two errors have been made and some workings are shown
the mark awarded will be [2 marks].
[3 marks] for the correct final value ($209 715.20) and no errors. Some of the
workings are shown and some of the calculations are well presented.
EVALUATING DEPRECIATION
METHODS
What difference will this make to the P&L Account and
the Balance Sheet in each different year?
Key Questions:
• Which method is more simple to calculate
• Which method is more realistic?
• What difficulties could there be if using the straight
line method?
• Which method will lead to a higher value for fixed
assets in the first years after the purchase?
• Which method will lead to higher profit figures in the
first years after the purchase?
Homework
• Complete exercises c-e from sheet
• Optional Extension Question:
• A firm has bought an asset for £200,000. They
estimate it will have a useful life of 3 years after
which time it will have a residual value of
approximately £100,000. If the reducing balance
method is used what % annual depreciation should
they use?
• Due Date: Monday October 10th