Depreciation (Junior Cert Business Studies): Revision Notes
📚Revision Notes
Depreciation
What is depreciation?
Depreciation occurs when the value of a fixed asset decreases over time. This reduction in value must be recorded as an expense in the income statement to show the true cost of running the business. Understanding depreciation is essential for accurate financial reporting and helps businesses match the cost of their assets with the revenue they generate over time.
Important
Depreciation is the decrease in value of a fixed asset over time due to usage, wear, and obsolescence.
Why do assets depreciate?
Assets are valuable resources that help businesses generate income, but they don't maintain their value forever. Understanding why assets lose value is crucial for proper financial planning and accurate accounting records.
Note
Assets lose value for several reasons that affect their ability to generate future economic benefits:
- Wear and tear - Assets get damaged or worn out through regular use
- Becoming outdated - New technology makes older assets less efficient or valuable
- Changes in fashion or demand - What customers want may change over time
For example, a delivery truck owned by An Post becomes less valuable each year as it accumulates mileage and wear. Similarly, a laptop used by Aer Lingus becomes outdated when new software requires more advanced hardware. These are real economic costs that businesses must account for to understand their true profitability.
Methods of calculating depreciation
Businesses have flexibility in how they calculate depreciation, but they must choose a method that best reflects how the asset loses value over time. The two main methods each have distinct advantages and are suitable for different types of assets and business situations.
The straight line method
This method spreads the cost of depreciation evenly across the asset's useful life. The same amount is deducted each year, making it simple to calculate and predict future expenses. This approach works well for assets that provide consistent value throughout their useful life.
Formula:
Example
Worked Example: Dunnes Stores Kitchen Equipment
Dunnes Stores purchases kitchen equipment for €60,000 and decides to depreciate it at 10% per year using the straight line method.
Step 1: Calculate annual depreciation Annual depreciation = €60,000 × 10% = €6,000
Step 2: Apply depreciation over three years
| Year | Value at start of year | Depreciation | Balance at end of year |
|---|---|---|---|
| 1 | €60,000 | €6,000 | €54,000 |
| 2 | €54,000 | €6,000 | €48,000 |
| 3 | €48,000 | €6,000 | €42,000 |
Notice how the depreciation amount stays exactly the same (€6,000) each year, but the asset's value steadily decreases.
The reducing balance method
This method calculates depreciation based on the asset's current value each year, not its original cost. This means the depreciation amount gets smaller each year as the asset's value decreases. This approach often provides a more realistic representation of how assets actually lose value in the real world.
Formula:
The net book value (NBV) is simply the current value of the asset after previous years' depreciation has been deducted.
Example
Worked Example: Reducing Balance Method
Using the same €60,000 equipment with 10% depreciation, but applying the reducing balance method:
Step 1: Calculate depreciation for each year based on current value
| Year | Net book value | Depreciation Calculation | Depreciation | Balance at end of year |
|---|---|---|---|---|
| 1 | €60,000 | €60,000 × 10% | €6,000 | €54,000 |
| 2 | €54,000 | €54,000 × 10% | €5,400 | €48,600 |
| 3 | €48,600 | €48,600 × 10% | €4,860 | €43,740 |
Notice how the depreciation amount decreases each year (€6,000, then €5,400, then €4,860) because it's calculated on the reducing value of the asset.
Comparing the methods
Both depreciation methods serve important purposes and the choice between them depends on how the asset actually loses value over time.
Note
Method Comparison:
- Straight line method - Same depreciation amount each year, easier to budget for, suitable for assets that provide consistent value
- Reducing balance method - Higher depreciation in early years, more realistic for assets that lose value quickly when new, better matches actual market value decline
The choice of method significantly impacts the timing of expenses and can affect business profitability reporting, especially in the early years of an asset's life.
Summary
Key Points to Remember:
- Depreciation shows how fixed assets lose value over time due to wear, tear and becoming outdated
- Straight line method deducts the same amount each year based on original cost
- Reducing balance method deducts a decreasing amount each year based on current value
- Both methods help businesses match the cost of assets with the income they generate
- Depreciation appears as an expense in the income statement and reduces reported profits