Depreciation methods (HL only)
Depreciation Methods
This topic is assessed in IBDP Business Management at Higher Level (HL) only.
Most non-current assets lose value over time through wear and tear, obsolescence, or the passage of time. Depreciation is the accounting process of systematically allocating the cost of a non-current asset over its useful economic life. It serves two purposes: it charges the cost of using an asset against the profit of each period that benefits from it (matching principle), and it reduces the book value of the asset on the balance sheet to reflect its declining value. Two methods are required at HL: the straight-line method and the reducing balance method.
Key terms
- Cost price: the original purchase price of the asset, including installation and delivery costs.
- Residual value (scrap value): the estimated value of the asset at the end of its useful life.
- Useful economic life: the estimated number of years the asset will be used productively.
- Net book value (NBV): the value of the asset on the balance sheet — cost price minus accumulated depreciation to date.
Straight-line method
The straight-line method charges an equal amount of depreciation in each year of the asset's useful life. It is the simpler of the two methods and is appropriate when an asset is expected to deliver roughly equal benefit in each year of its use.
[ ext{Annual depreciation} = frac{ ext{Cost price} - ext{Residual value}}{ ext{Useful economic life (years)}} ]Because this formula is not provided on the IB formula sheet, students should learn to construct it from first principles: the depreciable amount (cost minus residual value) is spread equally across the useful life.
Ridgeway Distribution Ltd purchases a delivery lorry for £74,000. The lorry has an estimated residual value of £8,000 after a useful life of 6 years.
[ ext{Annual depreciation} = frac{£74{,}000 - £8{,}000}{6} = frac{£66{,}000}{6} = £11{,}000 ext{ per year} ]| Year | Depreciation charge (£) | Accumulated depreciation (£) | Net book value (£) |
|---|---|---|---|
| 0 (purchase) | — | 0 | 74,000 |
| 1 | 11,000 | 11,000 | 63,000 |
| 2 | 11,000 | 22,000 | 52,000 |
| 3 | 11,000 | 33,000 | 41,000 |
| 4 | 11,000 | 44,000 | 30,000 |
| 5 | 11,000 | 55,000 | 19,000 |
| 6 | 11,000 | 66,000 | 8,000 |
The lorry reaches its residual value of £8,000 at the end of year 6, confirming the calculation is correct. Each year's depreciation charge of £11,000 appears as an expense in the profit and loss account; the net book value falls by £11,000 each year on the balance sheet.
Reducing balance method
The reducing balance method charges a fixed percentage of the asset's remaining book value each year — not of its original cost. Because the book value declines each year, the depreciation charge also declines, producing higher charges in early years and lower charges in later years. This better reflects the pattern of many assets, which lose value rapidly when new and more slowly as they age.
[ ext{Annual depreciation} = ext{Net book value at start of year} imes ext{Depreciation rate (\%)} ]Again, this formula is not on the IB formula sheet and must be applied from understanding.
Ridgeway Distribution Ltd purchases a computer server for £42,000, depreciated at 30% per year on a reducing balance basis.
[ ext{Year 1 depreciation} = £42{,}000 imes 30\% = £12{,}600 quad ext{NBV: } £29{,}400 ] [ ext{Year 2 depreciation} = £29{,}400 imes 30\% = £8{,}820 quad ext{NBV: } £20{,}580 ] [ ext{Year 3 depreciation} = £20{,}580 imes 30\% = £6{,}174 quad ext{NBV: } £14{,}406 ] [ ext{Year 4 depreciation} = £14{,}406 imes 30\% = £4{,}322 quad ext{NBV: } £10{,}084 ]Note how the depreciation charge falls each year as the book value decreases. The asset never reaches zero under this method — the book value approaches zero asymptotically. In practice, the business chooses a rate that reflects the expected rate of economic decline in the asset's value.
Comparing the two methods
| Feature | Straight-line | Reducing balance |
|---|---|---|
| Depreciation charge each year | Equal (constant) | Declining (higher in early years) |
| Calculation basis | Original cost minus residual value, divided by useful life | Fixed percentage of remaining book value each year |
| Best suited to | Assets providing roughly equal benefit each year (e.g. office furniture, buildings) | Assets losing value rapidly when new (e.g. technology, vehicles) |
| Impact on profit and loss account | Equal annual expense — smooths reported profit | Higher early-year expense — reduces reported profit more in early years |
| Reaches residual value? | Yes — exactly at end of useful life | Approaches zero asymptotically — never exactly reaches it |
Key Takeaways
- Depreciation allocates the cost of a non-current asset over its useful life; it appears as an annual expense in the profit and loss account and reduces the asset's book value on the balance sheet.
- Straight-line depreciation charges an equal amount each year: (cost - residual value) ÷ useful life.
- Reducing balance depreciation charges a fixed percentage of the remaining book value each year, producing higher charges in early years and lower charges later.
- Neither formula is on the IB formula sheet — both must be applied from understanding.
- Straight-line is simpler and suits assets providing uniform benefit; reducing balance better reflects rapid early depreciation of technology and vehicles.
- The choice of depreciation method affects reported profit: reducing balance produces lower profits in early years, which may affect ratio analysis and investor perceptions.