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