Depreciation method? Straight line or reducing balance?
Posted On January 27, 2019
I am often asked should we use straight line or reducing balance to depreciate assets?
Straight Line (SL) is where an assets cost is written off in equal chunks over the life of the asset. This may well apply for example to an alarm system where you say the life is 5 years and so you write off the cost at 20% per year.
You can apply a residual value to the asset and write off the difference in the case where some value will be retained in the long run.
Eg A vending machine costs £5,000 with a value at the end of 5 years of £500. Depreciation would be £5,000 – £500 = £4,500 split equally over 5 years. This would write off £900 per annum.
Reducing Balance (RB) on the other hand applies the 20% to a balance that reduces each period. 20% x £5,000 in year 1 = £1,000, 20% x (£5,000-£1,000) = £800 in year 2, 20% x (£5,000-£1,000-£800) = £640 in year 3 etc.
Here you can see that the amount written off each period reduces throughout the life of the asset, but it is more difficult to calculate.
So which should you use?
The idea of depreciation is to allocate the cost of an asset to the period where you have derived economic benefit for the asset. If you expect an asset to last for 5 years then it is appropriate to write this off straight line over 5 years. This is straightforward and why this method is most widely used in business.
However, where the asset loses a lot of its value in the early years and yet keeps a lower value in the long run, eg a car or production equipment, then reducing balance would be a more appropriate way to depreciate such assets.
Why would you bother using reducing balance if it is more difficult to calculate?
This is because an asset should be carried at a value not greater than its recoverable amount. Reflecting a car at a value of £50,000 when its recoverable amount is only £30,000 understates the depreciation charged to the accounts and is in breach of Accounting Standards as a result!
It is important to note that the rate of depreciation affects only the reported profit and does not affect the level of tax deduction which is calculated using capital allowance rules. The topic of a later article!
If you need help to decide on a depreciation policy then why not get in touch with Finance Interim on 07967 365191?