The reason behind depreciating business assets over their economic useful lives is to recognize the fact that the value of the assets are reducing due to wear and tear throughout the whole period of ownership.
Depreciation on fixed assets in accounting term is to write off part of the assets value to the profit and loss account in each year so as to reflect the reduction in value that has taken place in the year. There are two commonly used methods of working out depreciation – The straight line method and the reducing balance method.
It is normally up to the person preparing the accounts as to which method of depreciation is most suitable for an assets or group of assets. Either can be used but once started must maintain consistency.
The straight line method
This method writes off the cost of the assets by equal instalments over its estimated useful life. If the assets have residual value at the end of its economic useful lives and this value is to be subtracted from the cost of the assets when calculating the depreciation value per year.
The reducing balance method
Under this method, a fixed percentage on the diminishing value of the asset is written off to the profit and loss account each year. The percentage used should be such that the depreciation is roughly equal to the loss in the value of the asset over the period of use.
It is important to note that depreciation is not allowed for tax purposes and it must be added back in the tax computation.
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