depreciation methods; units of production and reducing balance
TRANSCRIPT
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Depreciation Methods: Units of Production and
Reducing Balance
from businessbankingcoach.com
in association with
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Last time the topic of the
presentation was the
straight-line method of
calculating depreciation.
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In this presentation
we’ll cover the other
two main methods
that are much less
commonly used.
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Firstly, the units of production method.
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This is especially suited
to the depreciation of
equipment that is used
in a manufacturing
process…….
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…….since the amount of
depreciation that is
charged in an
accounting period is
directly related to the
output of the machinery
or equipment during that
time.
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There are three components to the
calculation;
the cost of the equipment
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its expected total unit
output over its useful
life
any residual value the
equipment may have
at the end of its useful
life
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Let’s use the same equipment that
we used in the straight-line example
to illustrate how the units of
production method works.
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If you recall, the
equipment cost
100,000 and had
an estimated
residual value of
20,000, leaving us
with a depreciable
value of 80,000.
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But with the units of production
method, the useful life is determined
by units produced by the equipment
rather than by time, as was the case
in our straight-line method example.
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So, let’s say that
the directors of the
business estimate
that the equipment
will produce 40,000
units before it has
to be scrapped.
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We can now calculate what the
depreciation amount will be for each unit
produced, using the following formula;
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80,000 = 2
40,000
estimated total units of production
The depreciable value
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This means that each time the equipment
produces one unit, there will be
depreciation of 2 accounted for as an
operating expense.
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At the end of the accounting
period, the total number of units
produced during the year is
multiplied by 2 to arrive at the
total amount of depreciation for
that piece of equipment for that
year.
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Secondly, the other
method of calculating
depreciation is called
the reducing balance
method
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The reducing balance
method is suited to
those assets that
quickly become
technologically
obsolete…….
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…….or which use a
greater proportion of
their productive value
in the early years of
ownership.
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In this method the directors of the
business select a percentage of the
value of the asset that will be applied in
each accounting period to calculate
depreciation.
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The three components of this calculation
are;
the cost of the asset
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its expected useful life
measured by time
a percentage of the
value that will be
applied annually to
depreciate the asset
over its expected useful
life
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Going back again to
our example of a
piece of equipment
costing 100,000 and
with an expected
useful life of 5
years…….
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…..let’s say that the directors decide to
depreciate it at 50% per financial year
and, to keep things simple, let’s also say
that the business acquired the equipment
on the first day of the financial year.
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In the first year, the
amount of depreciation
would be calculated as
follows;
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The initial cost of 100,000
multiplied by 50%, which results in
a depreciation figure for the first
year of 50,000.
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Depreciable
value of asset
Depreciation
percentage
Amount of
depreciation
Depreciated
value of asset
Year 1 100,000 50% 50,000 50,000
So, it looks like this…….
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In the second year,
the initial cost of the
equipment is not used
in the calculation.
Instead the reduced
balance of 50,000 is
used as the base
figure.
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The calculation of
depreciation is then;
The reduced balance
of 50,000 multiplied by
50%, which gives us a
depreciation figure for
the second year of
25,000.
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Depreciable
value of
asset
Depreciation
percentage
Amount of
depreciation
Depreciated
value of
asset
Year 1 100,000 50% 50,000 50,000
Year 2 50,000 50% 25,000 25,000
So now, it looks like this…….
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In the following year, that reduced
balance of 25,000 is used as the base
figure in the calculation.
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That same process
then continues until the
equipment reaches the
end of its useful life or
is disposed of.
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Depreciable
value of
asset
Depreciation
percentage
Amount of
depreciation
Depreciated
value of asset
Year 1 100,000 50% 50,000 50,000
Year 2 50,000 50% 25,000 25,000
Year 3 25,000 50% 12,500 12,500
Year 4 12,500 50% 6,250 6,250
Year 5 6,250 50% 3,125 3,125
Like this…….
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Whatever balance is left at the end of
the useful life is deemed to be the
equipment’s residual value.
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