Valuation of assets
The only sure way of knowing what an asset is worth to a business is by offering it for sale. Fixed assets such as machinery and vehicles have a limited life span, although at times it can run into decades. So far we have referred to the “life” of a machine as if this was a fixed period of time. The life span of a machine can vary according to the situation in which the business finds itself. Museums contain many examples of working machines that are obviously still in existence but whose usefulness is over. Throughout its life an asset's value is falling. If this change in value is ignored the profit declared by a business can appear low compared with the amount of capital employed. It is usual, therefore, to write off some of the value of the machine each year. This appears as a charge on the profit and loss account before tax is paid. This charge is called depreciation.
By depreciating its fixed assets a business saves on tax and increases profit. However, depreciation itself is not a method of saving up for replacement machinery. That is a decision taken separately by the business when deciding how to use its profit. Depreciation reduces the book value of an asset, i.e. its value after depreciation has been charged. The book value does not reflect the market value of the asset and in itself depends on the method of depreciation used.
The two most common methods of depreciation are straight line depreciation and declining balance depreciation.
1. The straight line method of depreciating assets reduces the book value of the asset by the same amount for each year of its life. An asset which cost £12 000 with an expected life of ten years and a residual value (that is the amount the business expects to sell the machine for at the end of its working life) of £2000 would be depreciated by £1000 per year:
(Cost of asset - Residual value)/ Life of asset
Figure 1 Straight line depreciation Figure 2 Declining balance depreciation
Book value Book value
1
2
12
10 10
8 8
6 6
4 4
2
2
1 Residual value 1 Residual value
0
1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Time (years) Time (years)
Straight line depreciation is a simple and straightforward calculation. It gives a higher level of profit to the business in the first years of the life of the machine and is particularly useful when the business is expecting constant returns over the life of the asset. This is shown in Figure l.
2. The declining balance method of depreciation reduces the book value of the asset by a fixed percentage calculated to apportion the value of the machine after residual value has been subtracted from initial cost over the expected life of the machine. This means that depreciation is highest in the early years of the life of the machine. The use of the declining balance method takes into account that as the machine grows older its running and maintenance costs are likely to increase and its earning power will decrease. As a machine gets older it is more susceptible to obsolescence and may be more difficult to sell. Figure 2 shows declining balance depreciation using the data from Figure 1.
Comprehension check.
Read the text again more carefully. Choose the correct answer from a, b, c.
1. To become aware of an assets value means:
b) to see it
c) to buy it
d) to change it
2. Fixed assets are:
a) petrol and oil
b) machinery and vehicles
c) stock and debtors
3. During a life span an asset’s value:
a) does not change
b) decreases
c) increases
4. Some of value of fixed assets is necessary:
a) to charge each year
b) to write off in a year
c) to write off each year
5. Writing off some of value is:
a) a charge on the profit and loss account after tax is paid
b) a charge on the profit and loss account before tax is paid
c) a charge on the profit and loss account
6. Deprecation of fixed assets means:
a) to economize on tax and increase profit
b) to economize on tax and decrease profit
c) to understate taxes and increase profit
7. To depreciate the book value of an asset is:
a) to reduce the book value of an asset
b) to increase the book value of an asset
c) to control the book value of an asset
8. The book value does not reflect:
a) historical value of an asset
b) cost value of an asset
c) market value of an asset
9. How many methods of depreciation exist?
a) one
b) four
c) two
10. What method of depreciation does not exist?
a) the straight line method
b) the declining balance depreciation
c) the progressive balance depreciation
11. The straight line method of depreciating assets:
a) reduces the book value by the fixed amount for each year of its life
b) reduces the book value by the same amount for each year of its life
c) reduces the book value by the amount increasing each year
12. The declining balance method indicates that:
a) deprecation is lowest in the early years of the life of an asset
b) deprecation is highest in the early years of the life of an asset
c) deprecation is the same each year of the life of an asset
13. The use of the declining balance method takes into account that as an asset grows older:
a) its running and maintenance costs increase
b) its production and distribution costs increase
c) its running and maintenance costs increase
Read the text once again. Find words in the text that mean the opposite of the following.
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Solve the problem. An assets cost £20000. Its residual value is expected to be £2000 and its life span is six years. The business concerned uses the straight line method of depreciation. By how much will it reduce the book value of machine each year?