For this section of the syllabus, students need to understand the straight line method (AO2, AO4) and the appropriateness of this depreciation method (AO3).

The most straightforward way to account for depreciation is the straight line method. This simply spreads the depreciation evenly over the useful life of the non-current asset being depreciated. Hence, the value of the asset falls by equal amounts each year.

For example, if a business bought a new delivery van for $30,000 and expects to use it for 5 years, by which time the vehicle has no market value, then the annual depreciation is: $30,000 ÷ 5 = $6,000 per year. This means the value of the delivery van drops by $6,000 each year for 5 years, until it has no monetary value to the business. This can be shown in the table below:

The book value is the value of the asset that is recorded in the balance sheet.

Diagrammatically, the book value falls by the depreciated value each year (it should become clear now why this method is called the straight line method, as illustrated below).

The formula for calculating depreciation using the straight line method is:

Advantages of the straight line method

Advantages of the straight line method of calculating depreciation include:

• The ease of calculating depreciation, as the same amount is deducted each year.

• It is suitable for depreciating assets that have a known useful shelf-life and can be estimated accurately.

• It is also suitable for assets that have a consistent usage rate over the lifetime of the asset, e.g. furniture or automated machinery.

• It is also easier to depreciate the value of assets until their scrap value is zero.

• As the same amount is charged to the profit and loss account each year, it is easier to make historical comparisons of the data.

 Disadvantages of the straight line method

Disadvantages of the straight line method of calculating depreciation include:

• Many fixed assets, such as motor vehicles and computers, depreciate in value the most during the initial stages of their useful shelf life. Hence, using a uniform depreciation value can be misleading and inaccurate.

• In addition, many assets do not depreciate consistently as they become less efficient over time. For example, machinery, computers and vehicles tend to have higher repair costs over time.

• It is not suitable or useful if the functional life span of the asset cannot be estimated accurately.

• Scrap values are only estimates of the future value of an asset. This makes the provisions for depreciation less accurate.

 Exam-style question

STC recently paid $380,000 for a set of new photocopiers. The machines are expected to be replaced in 5 years’ time, and have an expected residual value of $50,000. Calculate the annual depreciation for STC.  [2 marks]

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Answer

• Annual depreciation = ($380,000 – $50,000) / 5 years

• Annual depreciation = 330,000 / 5 = $66,000 per year

Award [1 mark] for the correct answer, and [1 mark] for the correct working out.

For this section of the syllabus, students need to understand the units of production method (AO2, AO4) and the appropriateness of this depreciation method (AO3).

The units of production method of depreciation apportions an equivalent value of depreciation to a non-current asset based on each physical unit of output. Hence, this method calculates depreciation based on the units of usage rather than time (as used for the straight line method). This means that the depreciation expense will be higher during years when there is a greater usage (due to favourable business activities) and lower during years when the asset is used less.

For example, a taxi vehicle would depreciate more with a higher mileage (the unit of measurement of output or usage). Whilst a taxi would also depreciate with time, it is more realistic to base the fall in the value of the vehicle based on mileage or usage, rather than time. The same would apply to other non-current assets such as delivery vehicles, office printers, photocopiers, coffee machines, and other such equipment and machinery.

There are two steps needed to calculate depreciation using the units of production method:

1.  Calculate the units of production rate (also known as the depreciation per unit):

2.  Calculate the depreciation expense:

  Advantages of units of production depreciation

 The advantages of using the units of production method of depreciating non-current assets include:

• For many businesses, it is more realistic or accurate to use this method to depreciate the value of an asset due to its usage than just the passing of time. In particular, it works well for businesses that use machinery or capital equipment to manufacture a product.

• Similarly, this method is more accurate for non-current assets that depreciate directly due to wear and tear, rather than the passage of time which eventually makes the product obsolete.

• It is useful for manufacturers the experience fluctuation in production, based on changes in consumer demand over time.

 Disadvantages of units of production depreciation

The limitations of using the units of production method of depreciating non-current assets include:

• It is more complicated to calculate than the straight line method of depreciation.

• There is so degree of subjectivity as the salvage value is subject to change and the estimated units of production is exactly that - an estimate only. Over- or under-estimating the figures will make the depreciation expense less accurate.

• Many tax authorities (such as the IRS in the US) do not allow the units of production depreciation method to be used for tax purposes. Hence, this method is primarily used for internal bookkeeping (accounting records).

 Exam Practice Question 1

Use the information in the table below for Firm X to calculate the depreciation expense using the units of production method.  [2 marks]

Asset	Cost ($)	Salvage ($)	Estimated output	Actual output
Printer	10,000	800	200,000	180,000

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Answer

First, calculate the units of production rate:

• ($10,000 – $800) / 200,000

• $9,200 / 200,000 = $0.046

Now calculate depreciation expense:

• $0.046 × 180,000 = $8,280

Award [1 mark] for the correct answer] and a further [1 mark] for showing the working out in a clear way. Apply the own figure rule (error carried forward) as appropriate.

 Exam Practice Question 2

A large publishing company purchases a new industrial printer for $7,500. The publisher estimates the new industrial printer will have a salvage value of $1,200 and a useful life of 500,000 high-quality pages. During the first year of use, the publisher prints 25,000 pages.

Using the units of production method, calculate the depreciation expense of the industrial printer at the end of the first year.  [2 marks]

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Answer

• Depreciation rate = ($7,500 – $1,200) / 500,000 pages = $0.0126 per page

• Units of production deprecation (Year 1) = $0.0126 × 25,000 pages = $315

Award [1 mark] for the correct answer] and a further [1 mark] for showing the working out in a clear way. Apply the own figure rule (error carried forward) as appropriate.

 Exam Practice Question 3

At the beginning of the trading year, Siby Thomas Inc. paid $500,000 for a new management information system (MIS). The company expects to use the new MIS for 5,000 hours, i.e., approximately 1,000 hours per year for 5 years. It expects to be able to sell the MIS for $100,000 thereafter.

Using the units of production method, calculate the depreciation expense for the first year if Siby Thomas Inc. uses the MIS for 1,500 hours.  [2 marks]

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Answer

• Depreciation rate = ($500,000 – $100,000) / 5,000 hours = $80 per hour

• Units of production deprecation (Year 1) = $80 × 1,500 hours = $120,000

Award [1 mark] for the correct answer] and a further [1 mark] for showing the working out in a clear way. Apply the own figure rule (error carried forward) as appropriate.

 Exam Practice Question 4

A business has just purchased a large office photocopier for $3,500. The machine is expected to last for 4 years and produce 1.8 million copies. The expected scrap value is $500.

(a)	Calculate the per unit depreciation rate for the business. Express your answer to 4 decimal places.	[2 marks]
(b)	Calculate the depreciation expense if the business makes 500,000 copies during the year.	[2 marks]

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Answers

(a)  Calculate the per unit depreciation rate for the business (to 4 d.p.)  [2 marks]

Depreciation charge per unit = ($3,500 – $500) / 1,800,000 = $0.0017

Award [1 mark] for the showing appropriate working out and a further [1 mark] for the correct answer.

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(b)  Calculate the depreciation expense if the firm makes 500,000 copies during the year.  [2 marks]

Depreciation charge = $0.00166' × 500,000 = $833.33

Accept answers that show depreciation charge = $0.0017 × 500,000 = $850

Apply the Own Figure Rule (OFR) as appropriate (error carried forward).

Award [1 mark] for the showing appropriate working out and a further [1 mark] for the correct answer.

• Depreciation refers to the fall in the value of a fixed asset. As a fixed asset is used over and over, its value drops due to wear and tear.

• The residual value (also known as salvage value or scrap value) is the monetary value of a non-current asset at the end of its useful life, before it is replaced.

• The straight line method of depreciation spreads the depreciation value evenly over the useful life of the non-current asset being depreciated. Hence, the value of the asset falls by equal amounts each year.

• The units of production method calculates depreciation based on the units of usage rather than time.