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Depreciation. All manufactured items decrease in value over time – as they wear out or are replaced by better technology. This is called depreciation. This is regarded as an expense. The loss in value of an item can only be estimated as the real cost is only known when the item is sold.

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## Depreciation

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**All manufactured items decrease in value over time – as**they wear out or are replaced by better technology. • This is called depreciation. • This is regarded as an expense. • The loss in value of an item can only be estimated as the real cost is only known when the item is sold. • There are 2 methods for calculating the depreciation – the straight line method and the reducing balance method.**Straight Line Depreciation**• The formula assumes that the item has no value at the end of its estimated useful life. • In reality this may not be the case**Straight Line – with a Residual Value**• At the end of the useful life of an item, a company can often sell it – even for scrap value. • This way they get some money for it. • If an item has a residual value – it will only decrease down to that value – not to zero.**As an item is depreciated each year – it’s value**decreases and the amount you could sell it for decreases. • The reduced amount is referred to as the Book Value. • The more an item is depreciated the lower it’s book value becomes. • The Book Value represents the original cost of an item take the amount of depreciation.**Reducing Balance Depreciation**• This is more realistic as it takes into account that the older an item gets – the less it is worth – so the less it should be depreciated each year. • The tax department favours this method. • With this method the book value is depreciated by a fixed percentage each year.**When a business prepares a profit and loss statement they**must follow the depreciation rates set by the tax department. • The calculation of depreciation for tax purposes is based on the effective life of an asset. The ATO publishes a list of their estimates of effective life of assets and these must be used when calculating depreciation for tax purposes.**The annual depreciation decreases each year as the book**value drops because the depreciation is calculated as a fixed percentage of the book value. • Add the cumulative depreciation to the book value and you will get the original cost.

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