Question 3.A.13: Assume that the machine used in Example 3.7 was owned by a b...
Assume that the machine used in Example 3.7 was owned by a business that made a profit before depreciation of £40,000 for each of the four years in which the asset was held.
Calculate the profit for the business for each year under each depreciation method, and comment on your findings.
Your answer should be as follows:
| Straight-line method | |||
| (a) Profit before depreciation £ |
(b) Depreciation £ |
(a – b) Profit £ |
|
| Year 1 | 40,000 | 19,031 | 20,969 |
| Year 2 | 40,000 | 19,031 | 20,969 |
| Year 3 | 40,000 | 19,031 | 20,969 |
| Year 4 | 40,000 | 19,031 | 20,969 |
| Reducing-balance method | |||
| (a) Profit before depreciation £ |
(b) Depreciation £ |
(a – b) Profit/(loss) £ |
|
| Year 1 | 40,000 | 46,874 | (6,874) |
| Year 2 | 40,000 | 18,750 | 21,250 |
| Year 3 | 40,000 | 7,500 | 32,500 |
| Year 4 | 40,000 | 3,000 | 37,000 |
The straight-line method of depreciation results in the same profit figure for each year of the four-year period. This is because both the profit before depreciation and the depreciation expense are constant over the period. The reducing-balance method, however, results in very different profit figures for the four years, despite the fact that in this example the predepreciation profit is the same each year. In the first year a loss is reported and, thereafter, a rising profit.
Although the pattern of profit over the four-year period will be quite different, depending on the depreciation method used, the total profit for the period (£83,876) will remain the same. This is because both methods of depreciating will allocate the same amount of total depreciation (£76,124) over the four-year period. It is only the amount allocated between years that will differ.