Financial Management Assignment
Dublin Institute of Technology
Faculty of the Engineering and Built Environment
I declare that the work contained in this submission is my own work and
has not been taken from the work of others save to the extent that such
work has been cited within the text of this submission.
Signed: (student)__________________ Date: 28/04/2014
Course Code: DT133 2
Module: Finance – Financial Management 1
Lecturer: Gerald Flynn
Year: 1, 2, 3 ,4
Student ID Number:
- A non-cash expense that reduces the value of an asset as a result of
wear and tear, age or obsolescence. Most assets lose their value
over time ( in other words, they depreciate ), and must be replaced
once the end of their useful life is reached.
- A decline in value of a given currency in comparation with other
For instance, if the US dollar depreciates against the Euro, buyers
would have to pay more dollars in order to obtain the original
amount of euros before depreciation occurred.
Depreciation impact on a firm in the construction industry
Because it is a non-cash expense, depreciation lowers the firms reported
earnings while increasing free cash flow.
Most businesses need to purchase some kind of durable equipment in
order to operate. Equipment that lasts longer than one year is called a
Property such as heavy equipment ( concrete pumps, cranes ), computers,
vehicles, furniture and buildings contribute to the operating capacity of a
firm over many years. Because of this long-term contribution, fixed assets
are treated differently than many other business expanses. The purchase
price of these fixed assets is typically expensed over a period of years,
rather than in the year the purchase was made.
The assets mentioned above are often referred to as fixed assets, plant
assets, depreciable assets, constructed assets, and property, plant and
equipment. It is important to note that the asset land is not depreciated,
because land is assumed to last indefinitely.
Accounting for assets and depreciation
Assets are treated differently to expenses in the firm’s accounts.
In the firm’s accounts, assets are ‘capitalized’ and included in the firms
balance sheet as assets, rather than written off to profit and loss account
Unlike valid expenses, which are 100% tax deductible, depreciation is
treated differently. The firm cannot obtain the tax relive on the
Instead the firm can claim a ‘capital allowance’ on the cost of the
equipment. These capital allowances are set each year in the budget and
vary depending upon the type of equipment.
Effect on the Financial Statement
To get a true picture of the value of Fixed Assets in a firm it would
therefore be necessary to calculate the depreciation every year and reflect
it in the Financial Statement.
The depreciation will affect the value of Fixed Assets which is indicated
in the Balance Statement.
It will also affect the Profit and Loss Statement where the depreciation
will be deducted as an expense.
What to depreciate
If you decide that you have to decrease the value of some of the Fixed
Assets in your company, it must be larger things which represent a
considerable value and which lose value by being used and/or getting old.
Smaller things like hand tools are not depreciated.
The depreciation must be calculated for each machine individually.
How to depreciate
First you have to decide for how long time you can expect the machine to
work for the firm before it will break down totally or you will want to
Secondly you must decide which price you can expect to get for it when
you sell it.
The calculation and reporting of depreciation is based upon two
1. Cost principle. This principle requires that the Depreciation
Expense reported on the income statement, and the asset amount
that is reported on the balance sheet, should be based on the
historical (original) cost of the asset. (The amounts should not be
based on the cost to replace the asset, or on the current market
value of the asset, etc.)
2. Matching principle. This principle requires that the asset's cost be
allocated to Depreciation Expense over the life of the asset. In
effect the cost of the asset is divided up with some of the cost being
reported on each of the income statements issued during the life of
the asset. By assigning a portion of the asset's cost to various
income statements, the accountant is matching a portion of the
asset's cost with each period in which the asset is used. Hopefully
this also means that the asset's cost is being matched with the
revenues earned by using the asset.
As it is not required to use a single depreciation method for all the assets
of the firm, it is on the judgment of the firm to select the method of its
choice. It is also not mandatory to select only one depreciation method for
all the assets, although it is necessary to select a method that will decrease
the value of the asset in the proper manner.
There are several depreciation methods allowed for achieving the
matching principle. The depreciation methods can be grouped into two
Reducing balance depreciation
Straight-line method of depreciation
Straight-line (SL) depreciation is the most commonly used depreciation
method; it's also the simplest. It can be used for both book and tax
depreciation. Under straight-line depreciation, the cost of a fixed asset is
spread in equal amounts over its estimated useful life.
This method assumes the asset provides constant benefits. If an asset is
expected to be used in the business for 10 years, then each year 1/10 of
that asset's depreciable value is expensed. The euro amount of
depreciation remains constant from year to year.
Cost - salvage value
Annual depreciation expense = -----------------------------
Estimated useful life
Cost = how much cost the firm to purchase the item
Salvage value =when firm done with asset, how much can firm get out of
Estimated useful life = assets life expressed in years
Cost price: 60.000 E 60.000 E – 5.000 E
Useful life: 10 years annual depreciation = -------------------------
Salvage value 5.000 E 10 years
= 5.500 E
Net Income = Revenue – Expenses
And so, 5.500 E will be part of expenses for the next 10 years.
Book Value = Assets – Liabilities
And so, since this equipment is part of assets, and is depreciating every
year, assets will decrease every year by 5.500 E and in turn, reduce book
value on the balance sheet.
Reducing balance method of depreciation
Declining balance method of depreciation is a technique of accelerated
depreciation in which the amount of depreciation that is charged to an
asset declines over time. In other words, more depreciation is charged
during the beginning of the life time and less is charged during the end.
Why more depreciation is charged in beginning years? The reason is that
assets are usually more productive when they are new and their
productivity declines gradually. Thus, in the early years of their life time,
assets generate more revenue as compared to the revenue generated in
later years of their life. According to the matching principle of
accounting, we should depreciate more of the asset's cost in early years to
match the depreciation expense with the revenue earned from the use of
It can be advantageous to begin depreciating under DDB and switch to
the straight-line method some years into the asset's useful life.
Declining balance depreciation is calculated using the following formula:
Depreciation = Depreciation Rate × Book Value of Asset
Depreciation rate is given by the following formula:
Depreciation Rate = Accelerator × Straight Line Rate
In the above formula, accelerator is a multiplication factor which
accelerates depreciation. Book value is the difference between cost of an
asset and its accumulated depreciation. During the first accounting period,
accumulated depreciation is zero so book value is equal to cost. Since the
book value decreases after each depreciation charge, depreciation expense
declines in successive charges.
Depreciation is charged according to the above method as long as book
value is less than the salvage value of the asset. No more depreciation is
provided when book value equals salvage value.
Double Declining Balance Depreciation Method
Double declining balance depreciation method is a type of declining
balance depreciation method in which depreciation rate is double the
straight-line depreciation rate. For straight-line depreciation rate of 8%,
double declining balance rate will be 2 × 8% = 16%.
Example 1: An asset costing 20,000E has estimated useful life of 5 years
and salvage value of 4,500E. Calculate the depreciation for the first year
of its life using double declining balance method.
Straight-line Depreciation Rate = 1 ÷ 5 = 0.2 = 20%
Declining Balance Rate = 2 × 20% = 40%
Depreciation = 40% × 20,000E = 8,000E
Example 2: Referring to Example 1, calculate the depreciation of the
asset for the second year of its life.
Declining Balance Rate = 40%
Book Value = Cost − Accumulated Depreciation = 20,000E − 8,000E =
Depreciation = 40% × 12,000E = 4,800E
Example 3: Calculate the depreciation of the asset mentioned in the
above examples for the 3rd
Declining Balance Rate = 40%
Book Value = 20,000E − 8,000E − 4,800E = 7,200E
Depreciation = 40% × 7,200E = 2,880E
The depreciation calculated above will decrease the book value of the
asset below its estimated residual value (7,200E − 2,880E = 4,320E <
4,500E). Therefore depreciation would only be allowed up to the point
where book value = salvage value. Thus,
Depreciation Allowed = 7,200E − 4,500E = 2,700E
When does depreciation ends:
The firm must stop clamming depreciation as soon as:
- the estimated useful life is up.
- Firm stops using the asset in own business.
- Firm sell or dispose of the asset.
- Book value equals salvage value.
Depreciation is when the cost of an asset is spread across its useful life.
Depreciation is a part of expenses and effects net income and also affect
book value by reducing assets values.
Financial Management / An Irish Text /second edition / TP,SW,PO
Ready Ratios / Financial Statements / analysis software
Thomsen Business Information