Topic 3

Topic 3

Modelling Depreciation Methods

Introduction
The portion of the cost (or other value) of an asset charged to an accounting period is called depreciation
where tangible assets are involved, although the term amortisation is used for intangible assets and
depletion for natural resources. Therefore, this discussion of depreciation is restricted to assets such as
plant, machinery, or buildings - i.e. non-current tangible assets.

Learning Objectives
• Understand the purpose of charging depreciation.
• Define the terms depreciation, amortisation and replacement cost.
• Model the calculation of depreciation for a period.
• Understand the modelling variations depending on the depreciation method chosen.

Key Words
Amortisation
Annuity method
Appraisal method
Declining-balance method
Depreciable cost
Depreciation
Historical cost
Inventory method
Production-units method
Reducing-balance method
Replacement cost
Residual value
Salvage value
Straight-line method
Sum-of-the-year-digits method
Useful life

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 Modelling Depreciation Methods

Prescribed Readings
• Course Notes

Lecture Outline
• Purpose of Charging Depreciation
• Calculation of Depreciation for a Period
• Depreciation Methods
• Summary
• Appendix 3.1
• Self Assessment Questions
• Self Assessment Answers
• Self Assessment Exercises
• Self Assessment Solutions
• Case Study

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Topic 3

Course Notes
Purpose of Charging Depreciation
The purpose of charging depreciation is to allocate the cost, or other value, of plant, (less any salvage
value), over the periods during which it contributes to the organisation's revenue-earning activities. Such
an allocation, therefore, can easily be modelled. The depreciation charge is treated either as an expense
of the period or as part of the cost of products manufactured in a period. A portion of the charge may be
capitalised by being included in the cost of production when a firm manufactures some of its own plant.

The charging of depreciation is a process of allocation of the cost of a non-current tangible asset; it is not
a process of valuation. As plant is used in the activities of a firm, a portion of its cost should be charged
against the revenue for each period. If the plant is more heavily used in the current period than was
expected, for example, by a change from one-shift to three-shift operation, the model developed should
be flexible enough to increase the charge for depreciation, because the service potential is being used up
more rapidly than was originally estimated. Model flexibility of the depreciation charge is also required
in a period in which management recognises that the life of the plant (its service potential) has been
shortened by changes in technology or customer demand; adjustments which are material in amount need
to be reported as an abnormal item in the financial statements.

As the charging of depreciation is the allocation of the cost (or other value) of plant over the periods
which benefit from the use of that plant, it is not considered to be associated with the provision of funds
for replacement of the plant or with the recording of the market value of the plant. In Example 3.1, it is
demonstrated that charging depreciation as an expense results in the retention within the firm of an
amount equal to the capital originally invested in the plant. As it is assumed in the example that all
transactions are for cash, all of the capital originally contributed is available in cash when the plant is
fully depreciated. The original capital is available to the proprietor who must decide whether to purchase
further plant or withdraw the capital. It is pointed out, however, that the transactions of a firm are rarely
as simple as in this example.

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 Modelling Depreciation Methods

Example 3.1

The capital ($3,000) of a firm is invested in plant which has a life of 3 periods; all revenue is received in
cash, expenses (excepting depreciation) are paid in cash, and the profit of each period is withdrawn in full
by the proprietor.

Balance Sheet at Start of First Period

Plant $3,000
Represented by:
Capital $3,000

Statement of Profit and Loss for Period

1 2 3

Cash sales $5,000 $6,000 $7,000

Less Cash expenses (2,000) (4,000) (4,000)
Depreciation (1,000) (1,000) (1,000)

Net Profit 2,000 1,000 2,000

Distribution to proprietor (2,000) (1,000) (2,000)

Balance Sheet at End of Period

1 2 3
Plant $3,000 $3,000 $3,000
Less (1,000) (2,000) (3,000)
2,000 1,000 NIL
Cash at bank 1,000 2,000 3,000
Represented by:
Capital $3,000 $3,000 $3,000

The depreciation expense affects the calculation of net profit and, consequently, the amount available for
distribution to the proprietor. However, unlike the other expenses, depreciation expense does not involve
the expenditure of cash in the current period. Within the assumptions of this example, that is, the only
payments were cash expenses and drawings, at the end of the third period, the cash held by the firm is
equal in amount to that originally invested in the plant and, as the life of the plant has expired, the
proprietor must choose between purchasing a new plant with the cash available and withdrawing his or
her capital from the firm.

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In more complicated situations involving credit transactions and frequent replacement of some assets, the
effects of charging depreciation cannot be seen so clearly. In addition, it must be noted that the
depreciation charge merely reduces the amount that could otherwise have been distributed as profit, it
does not ensure that an equivalent amount of cash will be available to replace the asset. Management has
to take some positive action to ensure that cash will be available.

Depreciation and Replacement Cost

The conventional practice has been to base the depreciation charge on the cost of the asset. However,
some firms revalue at least some of their assets from time to time and base their depreciation charges on
these revalued amounts. Over recent years, it has been advocated that depreciation charges should be
based on the current value of assets, one measure of which is replacement cost. In this way, expenses and
revenues would both be expressed in current terms. It is also argued that the current values of assets
should be disclosed in the balance sheet. Example 3.2 provides a simple illustration of depreciation
based on replacement cost.

Example 3.2

A firm purchased equipment for $6,000 on 1 July 20x1. This cost is to be allocated to the next three
accounting periods. At the end of Period 3 the replacement cost of the equipment is found to be $9,000.

Depreciation charge for Period 3:

• based on historical cost $6,000/3 = $2,000

• based on replacement cost at end of period $9,000/3 = $3,000

Calculation of Depreciation for a Period

Any method of allocating the cost of plant over several periods is based on some assumption about the
pattern of use of the asset over its whole life. In addition, the calculation of periodic depreciation
involves estimates (model variables) of the following:
• The depreciation base or depreciable cost.
• The expected useful life of the plant.
• The residual or salvage value of the plant at the end of its expected useful life.

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 Modelling Depreciation Methods

Depreciable cost: The cost of plant (or its restated value) sometimes differs from the amount that is
expected to be allocated as expense over the life of the plant. This difference may be caused by the
expectation that the plant will have some value as scrap metal or by an intention to sell the plant before
all its service potential has been used up. The depreciation base or depreciable cost is the cost of the
plant less estimated net residual or salvage value.

Useful life: The useful life of plant is often difficult to estimate and any estimate should be modified if
found, later, to be incorrect. Because of this difficulty, as a matter of policy, different lives may be
chosen for different categories of fixed assets.

Residual value: The scrap value represents the estimated net amount to be received when the plant is
sold or scrapped; any estimated costs associated with removing the plant should be deducted from
estimated receipts. Because it is difficult to determine, the residual value (also known as terminal value)
is frequently ignored in calculating the depreciation base.

The Estimation of Expected Useful Life

In estimating the expected useful life of an asset, it is necessary to consider the quantity of service that the
asset is designed to produce and the pattern of its use. The expected pattern of use is an important factor
in the selection of a depreciation method, but it may also affect the expected life of the asset. As a result,
expected useful life may be measured in terms of time or of output. For example, the service life of a fax
machine may be estimated to be four years, that is, the depreciation charge is related to time rather than to
use. On the other hand, a firm may plan to use a motor vehicle for 70,000 kilometres and then to dispose
of it. The planned use then becomes the 'expected life' and the depreciation charge is related to distance
travelled rather than to time. The financial model developed must cater for such variations.

The factors leading to a decrease in value of plant may be physical or functional (economic). Physical
factors which influence the useful life of plant include wear and tear from use, deterioration, damage and
destruction. Functional factors, which are usually more important in societies subject to frequent
technological innovations, arise from obsolescence and inadequacy. Basic and industrial research, and
the improvements resulting from such research, tend to make yesterday's plant obsolete in comparison
with new plant incorporating the fruits of the research. The continuing developments in the field of
electronics such as computers vividly demonstrate the kind of obsolescence that new research can bring
about. Management may fear that newly acquired plant could be made obsolete by future developments
and attempt to counteract this by selecting an expected useful life which is shorter than that suggested by
all the other data. Inadequacy, the other functional factor, occurs when items of plant which once had the
capacity to meet the firm's requirements are no longer capable of so doing, and must be replaced because

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Topic 3

of the firm's growth. Management may have difficulty in quantifying this factor when estimating the
useful life of assets and, again, the number of periods expected to benefit from use of the asset may be
deliberately understated.

Depreciation Methods

The depreciation method chosen to allocate the cost (or other measure of service potential) of an asset
should be the method which best reflects the rate of decline of future service potential. As a result, some
depreciation methods are based on the passage of time and others are based on the output, or use, of the
asset. There are many ways of allocating depreciation but the discussion in this Topic is restricted to
modelling the following:

• Straight-line method.
• Reducing-balance method.
• 'Sum-of-the-years-digits' method.
• Production-units method.
• Appraisal or inventory method.
• Annuity method.
•

Straight-Line Method

Under this method, depreciation is treated as if it were a function of time, with the depreciable cost of the
plant being spread equally over the periods making up its estimated useful life. An assumption is made
that the benefits obtained from the use of the plant are the same in each period. This method is illustrated
in Example 3.3.

Example 3.3

Plant is acquired on 3 January 20x1 at a cost of $8,000. The expected effective life if 5 year and net
salvage value is estimated at $1,000.

The straight-line depreciation per year can be calculated as follows:

Depreciation for the year = (Cost-Residual Value)/Useful life (3-1)

= ($8,000 - $1,000)/5 = $1,400

The depreciation charge is therefore a constant which is easy to calculate using this method, but its
accuracy as a measure of service potential consumed is questionable. However, it is appropriate when the
pattern of use of the asset is expected to be fairly uniform over its life.

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 Modelling Depreciation Methods

Note that the book value is reduced by a constant amount each year, usually (but not always) expressed as
a percentage of the original asset cost. The book value is a linear function of time and is expressed as:

BV = a + bt (3-2)

where a = the original asset cost, and

b = the constant dollar amount (negative) the book value drops each year (i.e. constant
depreciation amount)

Where the value of b is not expressed as a percentage of the original asset cost, it can be calculated as
follows:

b = (Original Asset Cost - Residual Value)/Useful Life (3-1)

The Excel function that calculates the straight-line depreciation amount is:

SLN(Asset Cost, Salvage Value, Useful Life)

Reducing-Balance Method

When the reducing-balance (or declining-balance) method is used, the depreciation charge for each
period is calculated by applying a constant percentage to a continually reducing balance, that is, the book
value of the plant at the beginning of each period. One argument advanced for the use of this method is
that the rate of decline of the service potential is highest in the early years, or, expressed differently, that
most of the revenue is earned in the first few years of the plant's life. It is also argued that this method
offers some protection against uncertainty about the useful life of plant because the depreciation charge is
greatest in the early years, that is, a high proportion of the asset's cost is written off within a few years.
Yet another justification for this method rests on the claim that the depreciation and repair costs should be
considered together. In other words, as plant becomes older, it needs more maintenance so a decreasing
charge for depreciation is likely to result in a more or less uniform expense charge for plant when these
two items are combined.

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The constant percentage (r) may be calculated from the formula:

1
r = 1 - (RV/P) n (3-3)

where n denotes the number of periods, RV the residual value, and P the original outlay.

Example 3.4

Plant is acquired on 3 January 20x1 at a cost of $8,000 and it is estimated that its effective life is 5 years
and that the net salvage value will be $1,000. The calculation of the constant percentage (depreciation
rate) is as follows:
1
r = 1 - (1000/8000) 5
1
r = 1 - (.125) 5

r = 1 - .6598
r = .3402
r = 34.02% (34% approx.)

Again, this depreciation rate is effected by the salvage or residual value.

Note that the book value is reduced by a constant percentage of the current value each year. Book value
is thus an exponential function of time:

BV = a(1-r)t (3-4)
where a = the original asset cost, and
r = the constant percentage factor (0 < r < 1) per year

Where the value of r is not expressed as a percentage of the original asset cost, it can be calculated as
follows:

r = 1 - (Residual Value/Asset Cost)^(1/Useful Life) (3-3)

This formula can only be used when the Residual Value is greater than zero. The Excel function that
calculates the declining balance depreciation amount is:

DB(Asset Cost, Salvage Value, Useful Life, Period #)

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Sum-of-the-Year-Digits Method

The sum-of-the-year-digits method is a variant on the reducing-balance method; it also accelerates the
writing off of the asset. The method involves relating the remaining life of the asset to the sum of the
series of numbers developed from the original estimate of the asset's useful life (the sum-of-the-years).
The relationship can be expressed as:

Depreciation rate = Number of years of remaining life of asset/Sum of the years (3-5)

The data in Example 3.5 illustrates the application of this method. The sum-of-years depreciation method
is based on the mathematical fact that the sum of the digits 1, 2, 3, 4, ... n is equal to:

n(n+1)/2 (3-6)

where n = the useful life of the asset.

The formula for the depreciation amounts for the years 1, 2, 3, ... n is as follows:

Dep (yr 1) = n*(Asset Cost - Residual Value)/(n(n+1)/2)

Dep (yr 2) = (n-1)*(Asset Cost - Residual Value)/(n(n+1)/2)
. .
. .
Dep (yr n) = 1*(Asset Cost - Residual Value)/(n(n+1)/2)

Example 3.5

Plant is acquired on 3 January 20x1 at a cost of $8,000 and it is estimated that its effective life is 5 years
and net salvage value is $1,000.

The depreciation rate is calculated by summing the series developed from 5 (years):

5 + 4 + 3 + 2 + 1 = 15

The remaining life of the asset is then related to this sum:

20x1 - 5 years, therefore, the depreciation rate is 5/15.

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Therefore, the depreciation rate (r) and cost for the remaining years are as follows:

Depreciation Charge Using Sum-of-the-Year-Digits Method

Depreciation Depreciable Depreciation Accumulated Book

Year
Rate Cost Expense Depreciation Value
20x1 5/15 $7,000 $2,333 $2,333 $5,667
20x2 4/15 7,000 1,867 4,200 3,800
20x3 3/15 7,000 1,400 5,600 2,400
20x4 2/15 7,000 933 6,533 1,467
20x5 1/15 7,000 467 7,000 1,000

Note that in the latter years the amount charged for depreciation decreases because the method is based
on the assumption that the plant is more productive in its early years. Under this method all the
depreciable cost of the plant ($7,000) is charged as an expense over the five years.

The Excel function that calculates the sum-of-the-year-digits depreciation amount is:

SYD(Asset Cost, Salvage Value, UsefulLife, Period #)

Production-Units Method

Under the production-units method, depreciation is a function of use and not of time. Examples of the
units in which the use of an asset can be measured are: number of items produced, hours of operation,
kilometres travelled etc. There are two steps in calculating the depreciation charge for the period:

• Depreciation rate per unit = Depreciable cost/Estimated useful life (units) (3-7)
• Depreciation for the period = Rate per unit x Number of units for the period (3-8)

These two steps are illustrated in Example 3.6.

Example 3.6

A firm sells its motor vehicles after they have travelled 200,000 kilometres and depreciation charges are
based on the kilometres travelled. The rate per unit of a truck, which cost $78,000 and has a residual
value of $20,000, is as follows:

Rate per unit (kilometre) = ($78,000 - $20,000)/200,000 km = $0.29 per km

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 Modelling Depreciation Methods

Therefore, if the kilometres travelled is as shown below, the annual depreciation charge on the
Production-Units Method is as follows:

Kilometres Depreciation
Year Rate
Travelled Charge
1 40,000 29¢ per km $11,600
2 60,000 17,400
3 70,000 20,300
4 30,000 8,700
200,000 $58,000

Note that while the depreciation per unit of output (kilometres in Example 3.6) is constant, the
depreciation charge per period varies with the use made of the asset. As it is difficult to estimate the
useful 'life' of an asset, the asset may not be worn out when the end of its estimated useful life is reached
and management may decide to retain it. Thus, an asset may be used after it has been fully depreciated.
When it is discovered that the estimate of useful life is incorrect, the depreciation rate should be altered
so that it is in line with the re-assessed useful life.

Appraisal or Inventory Method

An enterprise owning a large number of assets, each of which has a small value, would find it difficult to
use any of the methods for calculating depreciation that were discussed above. Indeed, the term 'use' is
more appropriate than 'depreciation'. The service potential of assets such as glasses in a hotel, crockery
and cutlery in a restaurant, spanners and gauges in a garage, may be lost at any time through breakage,
theft, spoilage or loss.

The usual method of allocating the cost of these assets to a period is to take a physical inventory at
balance date and to calculate the cost of use (depreciation) by deducting the closing inventory from the
cost of assets available during the period. The following Example 3.7 shows the method:

Example 3.7

Opening value as per previous physical inventory $1,500

Purchases for period 3,000
$4,500
Closing value as per physical inventory using current
period's invoice prices ($2,000)
Depreciation $2,500

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Annuity Method

It was stated earlier that the charging of depreciation involves the retention of funds within the firm.
Those funds ought to be invested so as to earn additional revenue but that revenue should not be viewed
as the result of increased managerial efficiency because it is no more than the necessary result of the
replacement cycle of the depreciable asset. The annuity method is intended to achieve a constant rate of
return over the life of the asset by charging an increasing amount of depreciation which offsets the
increase in revenue flowing from the investment of funds retained as a result of depreciation charges.

The calculation of annuities is discussed later when discussing compounding and discounting. Following
from this, the annuity method of depreciation is illustrated in Example 3.8.

Example 3.8

Plant is acquired on 3 January 2001 for $8,000 and it is estimated that its effective life is 5 years and net
salvage value is $1,000. Assuming an interest rate of 10 percent, the calculations (rounded to $) under
the annuity method are as follows:

Present value of investment $8,000

Less: Present value of net salvage ($1,000 x 0.6209*) (621)
Net present value to be recovered in depreciation charges $7,379

* Present value of $1 to be received at end of year 5 at 10% interest.

Therefore, an annuity for 5 years at 10 percent with net present value of $7,379 is equal to
($7,379/3.7908+, or) $1,947. [+ Present value of an annuity of $1 for 5 years at 10% interest].

Therefore, the annual charges under the annuity method will be as follows:

Interest on Accumulated Book

Year Annuity Depreciation
net book Depreciation Value
value
20x1 - Jan - - - - $8,000
20x1 - Dec $1,947 $800 $1,147 $1,147 6,853
20x2 1,947 685 1,262 2,409 5,591
20x3 1,947 559 1,388 3,797 4,203
20x4 1,947 420 1,527 5,324 2,676
20x5 271* 1,676 7,000 1,000

* Rounding error of $3.

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 Modelling Depreciation Methods

Note that provided that the funds invested as a result of the depreciation charge earn 10 percent per
annum and that the services yielded by the depreciable asset are constant over time, the firm will show a
constant rate of return over the life of the asset.

Summary

In most of the above examples a single asset was used to illustrate the various depreciation methods.
However, firms can and do have several categories of asset which have different life-spans and patterns
of use, so that different rates and methods are normally used in the calculation of depreciation. In many
firms, the depreciation charge is significant in relation to the other expenses, so that the depreciation
policy formulated by management may be important in the determination of operating profit. The policy
selected from the alternatives available to management influences the calculation of profit and of the
book values of the assets and, consequently, affects the various ratios which can be used to analyse the
accounting reports of a firm (as will be discussed in Topic 6).

For example, the use of the straight-line method of depreciation may result in the appearance of
increasing returns on the book value of plant. The method is based on the assumption that the
consumption of future service potential is a function of time or, expressed differently, that there will be a
constant amount of revenue per period. If revenue and the depreciation charge per period are both
assumed to be constant, the difference between them must be constant. When this constant difference is
related to a diminishing investment (cost less accumulated depreciation) the apparent rate of return must
rise.

On the other hand, the production-units method, by charging depreciation on the basis of use, takes
account of the fluctuations in revenue from period to period.

Further, management may wish to depreciate an asset quickly even though it has a fairly long useful life.
This wish can be satisfied by the adoption of an accelerated method of depreciation such as reducing
balance or sum-of-the-year-digits. Both of these methods write off a high proportion of the asset's cost in
the early years of its life.

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Topic 3

Appendix 3.1
A B C D E F
1 Topic 3
2
3 Modelling Depreciation
4
5
6 Data Input Section
7
8 Cost of asset $8,000
9 Salvage value $1,000
10 Discount rate 10%
11 Serviceable life (Fixed at five years) 5
12
13 Output Section
14
15 Caution: Do not make any entries below this line.
16
17 Depreciation Charge Using Sum-of-the-Years-Digits Method
18
19 Year Depreciation Depreciable Depreciation Accumulated Book
20 Rate Cost Expense Depreciation Value
21
22 1 33.33% $7,000 $2,333 $2,333 $5,667
23 2 26.67% 7,000 1,867 4,200 3,800
24 3 20.00% 7,000 1,400 5,600 2,400
25 4 13.33% 7,000 933 6,533 1,467
26 5 6.67% 7,000 467 7,000 1,000
27 15
28
29
30 Annuity Method
31
32 Asset Cost $8,000
33 Salvage value $1,000
34 Life years (fixed at 5) 5
35 Discount rate 10%

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 Modelling Depreciation Methods

36
37 PV of cost $8,000
38 PV of salvage value ($621)
39 NPV of depreciation charges $7,379
40
41 Annuity equivalent $1,947
42
43 Year Annuity Interest Depreciation Accumulated Book
44 0 Depreciation $8,000
45 1 $1,947 $800 $1,147 $1,147 $6,853
46 2 $1,947 $685 $1,261 $2,408 $5,592
47 3 $1,947 $559 $1,387 $3,795 $4,205
48 4 $1,947 $420 $1,526 $5,321 $2,679
49 5 $1,947 $268 $1,679 $7,000 $1,000
50
51
52 Note:
53 In the above model only the following data may be changed:
54
55 Asset Cost
56 Salvage value
57 Discount rate
58
59 The life of the asset cannot be changed.

Appendix 3.1 (Formulae)

A B C D E F
1 Topic 8
2
3 Modelling Depreciation
4
5
6 Data Input Section
7
8 Cost of asset 8000
9 Salvage value 1000
10 Discount rate 0.1
11 Serviceable life (Fixed at five years) 5
12
13 Output Section
14
15 Caution:
16 Do not make any entries below
17 this line.

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Topic 3
18
19 Depreciation Charge Using
20 Sum-of-the-Years-Digits Method
21
22 Year Depreciation Depreciable Depreciation Accumulated Book
23 Rate Cost Expense Depreciation Value
24
25 1 =A29/A30 =B8-B9 =B25*C25 =D25 =$B$8-E25
26 2 =A28/A30 =C25 =B26*C26 =E25+D26 =$B$8-E26
27 3 =A27/A30 =C26 =B27*C27 =E26+D27 =$B$8-E27
28 4 =A26/A30 =C27 =B28*C28 =E27+D28 =$B$8-E28
29 5 =A25/A30 =C28 =B29*C29 =E28+D29 =$B$8-E29
30 =SUM(A25:A29)
31
32
33 Annuity Method
34
35 Asset Cost =B8
36 Salvage value =B9
37 Life years (fixed at 5) =B11
38 Discount rate =B10
39
40 PV of cost =B35
41 PV of salvage value =(B36/(1+B38)^B37)*-1
42 NPV of depreciation charges =B40+B41
43
44 Annuity equivalent =PMT($B$38,B37,B42,0)*-1
45
46 Year Annuity Interest Depreciation Accumulate Book Value
d
47 0 Depreciatio =B35
n
48 =IF(B37>0,1,"") =$B$44 =F47*$B$38 =B48-C48 =D48 =$F$47-E48
49 =IF($B$37>A48,A48+1,"") =$B$44 =F48*$B$38 =B49-C49 =E48+D49 =$F$47-E49
50 =IF($B$37>A49,A49+1,"") =$B$44 =F49*$B$38 =B50-C50 =E49+D50 =$F$47-E50
51 =IF($B$37>A50,A50+1,"") =$B$44 =F50*$B$38 =B51-C51 =E50+D51 =$F$47-E51
52 =IF($B$37>A51,A51+1,"") =$B$44 =F51*$B$38 =B52-C52 =E51+D52 =$F$47-E52
53
54
55 Note:
56 In the above model only the
57 following data may be changed:
58 Asset Cost
59 Salvage value

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 Modelling Depreciation Methods
60 Discount rate
61
62 The life of the asset cannot be
63 changed.

Self Assessment Questions

Q3.1 What is the purpose of charging Depreciation?

Q3.2 What is the difference between amortisation and depreciation?

Q3.3 Depreciation is associated with the provision of funds for replacement of an asset and the market
value of an asset. Discuss.

Q3.4 Depreciation is always based on the initial purchase cost of the asset. Discuss.

Q3.5 What are the factors used in the estimation of Expected useful life?

Q3.6 List the various depreciation methods and discuss as to which methods depreciate an asset faster
than others.

Q3.7. Why is depreciation expenses called “notional expenses”?

Self Assessment Answers

Q3.1 The purpose of charging depreciation is to allocate the cost, or other value, of plant, (less any
salvage value), over the periods during which it contributes to the organisation's revenue-earning
activities. The depreciation charge is treated either as an expense of the period or as part of the
cost of products manufactured in a period. A portion of the charge may be capitalised by being
included in the cost of production when a firm manufactures some of its own plant.

Q3.2 The portion of the cost (or other value) of an asset charged to an accounting period is called
depreciation where tangible assets are involved, although the term amortisation is used for
intangible assets and depletion for natural resources. Therefore, this discussion of depreciation
is restricted to assets such as plant, machinery, or buildings - i.e. non-current tangible assets.

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Q3.3 As the charging of depreciation is the allocation of the cost (or other value) of plant over the
periods which benefit from the use of that plant, it is not considered to be associated with the
provision of funds for replacement of the plant or with the recording of the market value of the
plant.

Q3.4 The conventional practice has been to base the depreciation charge on the cost of the asset.
However, some firms revalue at least some of their assets from time to time and base their
depreciation charges on these revalued amounts. Over recent years, it has been advocated that
depreciation charges should be based on the current value of assets, one measure of which is
replacement cost. In this way, expenses and revenues would both be expressed in current terms.
It is also argued that the current values of assets should be disclosed in the balance sheet.

Q3.5 The factors taken into consideration in the estimation of expected useful life are those leading to
a decrease in value of plant over its life, and may be physical or functional (economic).
Physical factors which influence the useful life of plant include wear and tear from use,
deterioration, damage and destruction. Functional factors, which are usually more important in
societies subject to frequent technological innovations, arise from obsolescence and inadequacy.

Q3.6 The depreciation method chosen to allocate the cost (or other measure of service potential) of an
asset should be the method which best reflects the rate of decline of future service potential. As
a result, some depreciation methods are based on the passage of time and others are based on the
output, or use, of the asset. There are many ways of allocating depreciation including the
following:

• Straight-line method.
• Reducing-balance method.
• 'Sum-of-the-years-digits' method.
• Production-units method.
• Appraisal or inventory method.
• Annuity method.

As to which methods depreciate an asset faster than others, the Reducing-balance method, 'Sum-
of-the-years-digits' method and the Annuity method would depreciate assets faster over the
earlier years of its useful life, whilst the Production-units method and the appraisal or inventory
method depends on the usage patterns of the assets.

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Q3.7. Depreciation expenses are called “notional expenses” as there is no cash involved in the period
the expense is charged against revenue. The cash actually went out of the business on the day
the asset was purchased. Of course, if one depreciated the asset fully (100%) in the first year of
its purchase, then the depreciation expense for that year and the cash outflow would be equal.

Self Assessment Exercises

E3.1 The Clift Company purchased an Steam Activation plant for its Activated Carbon factory for
$100,000. Its useful life was estimated 5 years., at the end of which the plant would be worth
only for scrap metal at $5,000.

Required:
Calculate depreciation under the following methods:

• Straight-line method.
• Reducing-balance method.
• 'Sum-of-the-years-digits' method.

E3.2 The Clift Company in the above example can elect to use either the Straight-line method or
Reducing-balance method by the Tax authorities. It is very interested in reducing its tax
payments.

Required:
Calculate which depreciation method it should elect.

E3.3 Retrieve the template TUTEX3. You will notice that the spreadsheet is divided into three
sections - a data section, a calculation section (logic section) and a report section. When the
formulas in the report section have been correctly completed you will be able to change any
value in the data section and automatically have the depreciation schedule in the report section
recalculated with the correct annual charges and the written down amount.

You are required to enter the nine formulas for cells C27, E27, G27, B28, C28, D28, E28, F28,
G28 in order to reproduce the numbers as shown in Tutorial Figure 3.1. The formulas for the
cells in the calculation section are already in the template. Study them closely and make sure
you understand what they are doing. The first three formulas are not difficult and should be
constructed by using the 'point' mode and moving to the cell in the data section corresponding to
the asset cost.

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Formulas four through nine are more complicated. In particular, the formulas for cells B28, D28
and F28 must be constructed so that the schedule will work for different estimated useful lives.
To do this you must use the IF function (see Topic 7). It is to be used here to check whether the
useful life of the asset has expired, and if so to enter the value zero rather than the value
calculated by the formula.

There are two ways you can construct the formulas for cells B28, D28 and F28. The first is to
use the formulas as detailed in this Topic (Formulas 3.1, 3.3 and 3.5). Alternatively, you could
use the inbuilt Excel functions for straight-line, declining-balance and sum-of-the-year-digits
methods of depreciation. These are respectively:

SLN(Asset Cost, Salvage Value, Useful Life)

DB(Asset Cost, Salvage Value, Useful Life, Period #)
SYD(Asset Cost, Salvage Value, Useful Life, Period #)

When you have correctly completed the formulas in the report section of the spreadsheet, your
answers should agree with those in Tutorial Figure 3.1. If your answers do not agree, check that
you have entered the data values correctly; i.e. Asset Cost - $200,000, Residual (or Salvage)
Value - $10,000 and Useful Life - 6 years.

Once your answers agree with those below you could now change the values in the data section
and notice how the depreciation amounts and the book values automatically change.

The difference between the three depreciation methods is best appreciated when we view the
depreciation amounts and book values by graph (see Tutorial Figure 3.2). You are required to
reproduce this graph using Excel in the sheet labelled “Graph”. Notice there is little difference
between the reducing balance method and the sum-of-years'-digits method. Change the values
in the data section and then check how the graphs have changed.

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Tutorial Figure 3.1

A B C D E F G
1 TUTORIAL EXERCISE #3 NAME:
2 FILENAME: TUTEX3 TUTE:
3 DEPRECIATION METHODS
4 ********************** ********** ********** ********* ******** ********* ********
5 DATA SECTION:
6
7 COST OF ASSET $200,000
8 ESTIMATED SALVAGE VALUE $10,000
9 ESTIMATED USEFUL LIFE (1 < n > 10) 6 YEARS
10 RED BAL % (where salvage = $0)
11
12 ********************** ********** ********** ********* ******** ********* ********
13 CALCULATION SECTION:
14
15 EQUIVALENT STRAIGHT LINE DEPRECIATION % 15.83%
16 SUM OF YEARS CONSTANT AMOUNT $9,048
17 EQUIVALENT REDUCING BALANCE % 39.30%
18
19
20 ********************** ********** ********** ********* ******** ********* ********
21 REPORT SECTION:
22
23 STRAIGHT-LINE REDUCING-BALANCE SUM-OF-YRS’-DIGITS
24 YEAR DEPREC'N BOOK DEPREC'N BOOK DEPREC'N BOOK
25 AMOUNT VALUE AMOUNT VALUE AMOUNT VALUE
26
27 0 200,000 200,000 200,000
28 1 31,667 168,333 78,608 121,392 54,286 145,714
29 2 31,667 136,667 47,712 73,681 45,238 100,476
30 3 31,667 105,000 28,959 44,721 36,190 64,286
31 4 31,667 73,333 17,577 27,144 27,143 37,143
32 5 31,667 41,667 10,669 16,475 18,095 19,048
33 6 31,667 10,000 6,475 10,000 9,048 10,000
34 7 0 10,000 0 10,000 0 10,000
35 8 0 10,000 0 10,000 0 10,000
36 9 0 10,000 0 10,000 0 10,000
37 10 0 10,000 0 10,000 0 10,000
38 ---------- --------- ---------
39 TOTAL: $190,000 $190,000 $190,000
40 ========== ========= =========

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Tutorial Figure 3.2

Depreciation Methods

200,000
180,000
160,000
140,000
Book Value ($)

120,000 Straight Line

100,000 Reducing Balance
80,000 Sum-of-years
60,000
40,000
20,000
0
0 1 2 3 4 5 6 7 8 9 10
Years

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 Modelling Depreciation Methods

Self Assessment Solutions

E3.1 Clift Company

Cost $ 100,000
Residual Value -$ 5,000
Depreciable Value $ 95,000
Useful Life (Years) 5

Straight-Line ($) =$95,000/5 = $ 19,000 per year

per year on
Straight-Line (%) =19/95 = 20% Cost

per year on
Reducing Balance b(%) =1-(5/100)^(1/5) = 45% WDV
Reducing Balance ($) =$100,000*45%= $ 45,072 In first Year

Sum of Digits (rate) =5+4+3+2+1=15 5/15 In first Year

Sum of Digits ($) =100,000*(5/15)= $ 33,333 In first Year

E3.2 The company should choose the Reducing Balance Method as it gets the largest tax deduction in
the first year, and although over the 5 years the tax deductions using all three methods will be equal, tax
cash flows saved earlier are more valuable in terms of purchasing power of money than those saved later.

E3.3 [Do Exercise using Excel Template]

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Case Study in Asset Accounting

Working Hill Proprietary Limited
The accountant of Working Hill Proprietary Ltd (WHP) is considering the following asset purchases:

• On 1 July 20x7 WHP Ltd purchased a disused quarry and filling rights for $1,200,000. It was
anticipated that the quarry would be filled in nine years’ time. The present cost of the quarry,
exclusive of filling rights, at the time of purchase was $500,000.

• WHP Ltd has also purchased plant that could be used to convert certain types of household refuse to
acceptable landfill material at a cost of $46,200, including installation at the quarry site. It is
estimated that the plant has a useful life of 6 years and a productive capacity of 56,000 tonnes of
converted material.

After the quarry had been purchase the company incurred the following costs defending
an appeal by a group of environmentalists:

Legal expenses and payments to consultants $70,000

Estimate of costs of top management engaged
In preparation of defence against appeal $25,000

The company was successful at the appeal and the resultant costs of additional beautification, tree
screening, and construction of roads was $160,000. The managing director states that these costs
should be capitalised and that they should not be allocated over the useful life of the quarry.

The following information has been estimated by the company regarding the plant:

Year Tonnes Converted

1 10,600
2 10,100
3 9,000
4 9,400
5 7,600
6 7,000
7 (Plant Scrapped) ----
53,700

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Required:

1. Write a report to the board of directors indicating your views on the capitalisation of costs
relating to the quarry purchase and the charging of depreciation on the quarry and the filling
rights.

2. Calculate the depreciation of the new plant rate under:

(a) The production-units method (assume a residual value of zero);
(b) The reducing-balance method (assume a residual value of $1,800); and
(c) The sum-of-the-years-digits method (assume a residual value of zero).

Sensitivity Analysis:

Recalculate the depreciation rates for each of the methods assuming a residual value of $2,500 and a
useful life of 5 years, and a productive capacity of 50,000 tonnes.

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