MODULE

DEPRECIATION

Learning Objective: At the end of the module, the students will be able to illustrate the
concepts and mechanics of depreciation

Content : 1. Definition of Value

2. Purposes and Types of Depreciation
3. Physical and Economic Life
4. Requirements of a Depreciation Method
5. Straight Line Method
6. Sinking Fund Formula
7. Declining Balance Method
8. Double Declining Balance Method
9. Sum-of-the-Years-Digits (SOYD) Method
10. The Service Output Method
11. Working Hours Method

Depreciation is the decrease in the value of physical property with the passage of time.

DEFINITION OF VALUE
Value, in a commercial sense, is the present worth of all future profits that are to be received
through ownership of a particular property.
The market value of a property is the amount which a willing buyer will pay to a willing seller for
the property where each has equal advantage and is under no compulsion to buy or sell.
The utility or use value of a property is what the property is worth to the owner as an operating
unit.
Fair value is the value which is usually determined by a disinterested third party in order to
establish a price that is fair to both seller and buyer.
Book value, sometimes called depreciated book value, is the worth of a property as shown on
the accounting records of an enterprise.
Salvage, or resale, value is the price that can be obtained from the sale of the property after it
has been used.
Scrap value is the amount the property would sell for if disposed off as junk.

PURPOSES OF DEPRECIATION
1. To provide for the recovery of capital which has been invested in physical property.
2. To enable the cost of depreciation to be charged to the cost of producing products or
services that results from the use of property.
TYPE OF DEPRECIATION
1. Normal depreciation
(a) Physical
(b) Functional
2. Depreciation due to changes in price level
3. Depletion

Physical depreciation is due to the lessening of the physical ability of a property to produce
results. Its common causes are wear and deterioration. Functional depreciation is due to the
lessening in the demand for the function which the property was designed to render. Its common
causes are inadequacy, changes in styles, population centers shift, saturation of markets or more
efficient machines are produced.
Depreciation due to changes in price levels is almost impossible to predict and therefore is not
considered in economy studies.
Depletion refers to the decrease in the value of a property due to the gradual extraction of its
contents.

PHYSICAL AND ECONOMIC LIFE

Physical life of property is the length of time during which it is capable of performing the function
for which it was designed and manufactured.
Economic life is the length of time during which the property may be operated at a profit.

REQUIREMENTS OF A DEPRECIATION METHOD

1. It should be simple.
2. It should recover capital.
3. The book value will be reasonably close to the market value at any time.
4. The method should be accepted by the Bureau of Internal Revenue.

DEPRECIATION METHODS
We shall use the following symbols for the different depreciation methods.
L = useful life of the property in years
FC = the original cost
SV = the value at the end of the life, the scrap value (including gain or loss due to removal)
d = the annual cost of depreciation
BV = the book value at the end of n years
Dn = depreciation up to age n years

THE STRAIGHT LINE METHOD

This method assumes that the loss in values directly proportional to the age of the property.

𝐹𝐶 − 𝑆𝑉
𝑑=
𝐿

𝑛(𝐹𝐶 − 𝑆𝑉)
𝐷 = = 𝑛𝑑
𝐿

𝐵𝑉 = 𝐹𝐶 − 𝐷

(3-1) An electronic balance costs P90,000 and has an estimated salvage value of P8,000 at the end
of its 10 years life time. What would be the book value after three years, using the straight line method
in solving the depreciation? (see video for Solution)

THE SINKING FUND FORMULA

This method assumes that a sinking fund is established in which fund will accumulate for
replacement. The total depreciation that has taken place up to any given time is assumed to be equal
to the accumulated amount in the sinking fund at that time.

𝐹𝐶 − 𝑆𝑉
𝑑=
𝐹
𝐴 , 𝑖%, 𝐿
 𝐹
𝐷 = 𝑑( , 𝑖%, 𝑛)
𝐴

𝐵𝑉 = 𝐹𝐶 − 𝐷

(3-2) A broadcasting corporation purchased an equipment for P53,000 and paid P1,500 for freight
and delivery charges to the job site. The equipment has a normal life of 10 years with a trade-in value
of P5,000 against the purchase of a new equipment at the end of the life.
(a) Determine the annual depreciation cost by the straight line method.
(b) Determine the annual depreciation cost by the sinking fund method. Assume interest at 6-
1/2% compounded annually. (see video for solution)

(3-3) A firm bought an equipment for P56,000. Other expenses including installation amounted for
P4,000. The equipment is expected to have a life of 16 years with a salvage value of 10% of the
original cost. Determine the book value at the end of 12 years by (a) the straight line method and (b)
sinking fund method at 12% interest. (see video for solution)

DECLINING BALANCE METHOD

In this method, sometimes called the constant percentage method or the Matheson Formula,
it is assumed that the annual cost of depreciation is a fixed percentage of the salvage value at the
beginning of the year. The ratio of the depreciation in any year to the book value at the beginning of
that year is constant throughout the life of the property and is designated by k, the rate of depreciation

dn = depreciation during the nth year

Year Book value at the
beginning of year
1 CO
2 CO(1-k)
3 CO(1-k)2
- -
n-1
n CO(1-k)
- -
L CO(1-k)L-1
Depreciation during the Book value at the end of
year year
d1 = kCO C1 = CO – d1 = CO(1-k)
d2 = kC1 C2 = C1 – d2 = CO(1-k)2
d3 = kC2 C3 = C2 – d3 = CO(1-k)3
- -
dn – kCn-1 Cn = Cn-1 – dn = CO(1-k)n
- -
dL = KcL-1 CL = CL-1 – dL = CO(1-k)L

𝑑 = 𝐹𝐶(1 − 𝑘) 𝑘

𝐹𝐶
𝐵𝑉 = 𝐹𝐶(1 − 𝑘) = 𝐹𝐶
𝑆𝑉

𝑆𝑉 = 𝐹𝐶(1 − 𝑘)

𝐶 𝐶
𝑘 =1− =1−
𝐶 𝐶

This method does not apply, if the salvage value is zero, because k will be equal to one and
d1, will be equal to CO.

(3-4) A certain type of machine loses 10% of its value each year. The machine cost P2,000.00
originally. Make out a schedule showing the yearly depreciation, the total depreciation and the book
value at the end of each year for 5 years.(see video for solution)

DOUBLE DECLINING BALANCE (DDB) METHOD

This method is very similar to the declining balance method except that the rate of
depreciation k is replaced by 2/L.

𝑑 = 𝐹𝐶(1 − 𝑘) 𝑘
 𝐹𝐶
𝐵𝑉 = 𝐹𝐶(1 − 𝑘) = 𝐹𝐶
𝑆𝑉

𝑆𝑉 = 𝐹𝐶(1 − 𝑘)

2
𝑘=
𝐿

When the DDB method is used, the salvage value should not be subtracted from the first
cost when calculating the depreciation charge.

(3-5) Determine the rate of depreciation, the total depreciation up to the end of 8th year and the book
value at the end of 8 years for an asset that cost P15,000 new and has an estimated scrap value of
P2,000 at the end of 10 years by (a) the declining balance method and (b) the double declining
balance method. (see video for solution)

(3-6) A plant bought a calciner for P220,000 and used it for 10 years, the life span of equipment.
What is the book value of the calciner after 5 years of use? Assume a scrap value of P20,000 for
straight line method; P22,000 for textbook declining balance method and P20,000 for the double
declining balance method. (see video for solution)

THE SUM-OF-THE-YEARS’-DIGITS (SYD) METHOD

Let dn = depreciation charge during the nth year
dn = (depreciation factor) (total depreciation)
dn = (𝐹𝐶 − 𝑆𝑉)

For example, for a property whose life is 5 years.

Year Year in Reverse Depreciation factor Depreciation during the
Order year
1 5 5/15 (5/15) (CO – CL)
2 4 4/15 (4/15) (CO – CL)
3 3 3/15 (3/15) (CO – CL)
4 2 2/15 (2/15) (CO – CL)
5 1 1/15 (1/15) (CO – CL)
∑ of digits = 15

(3-7) A structure costs P12,000 new. It is estimated to have a life of 5 years with a salvage value at
the end of life of P1,000. Determine the book value at the end of each year of life. (see video for
solution)

(3-8) A consortium of international telecommunication companies contracted for the purchase and
installation of a fiber optic cable linking two major cities at a total cost of US$960 million. This
amount includes freight and installation charges estimated at 10% at the above contract price. If the
cable should be depreciated over the period of 15 years with zero salvage value.
(A) Given the sinking fund deposit factor of 0.0430 at 6% interest where n = 15, what is the
annual depreciation charge?
(B) What is the depreciation charge during the 8th year using the-sum-of-the-years-digits
method?

THE SERVICE OUTPUT METHOD / WORKING HOURS METHOD

This method assumes that the total depreciation that has taken place is directly proportional
to the quantity of output of the property/working hours of a property up to that time. This method has
the advantage of making the unit cost of depreciation constant and giving low depreciation expense
during periods of low production.

Let n = total output/working hours capacity

r = number of units of output/workings hours for year r
 𝐹𝐶 − 𝑆𝑉
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 =
𝑛
𝐹𝐶 − 𝑆𝑉
𝑑𝑟 = ×𝑟
𝑛

(3-9) A Television Company purchased machinery for P100,000 on July 1, 1979. It is estimated that
it will have a useful life of 10 years; scrap value of P4,000, production of 400,000 units and working
hours of 120,000.
The company uses the machinery for 14,000 hours in 1979 and 18,000 hours in 1980. The
machinery produces 36,000 units in 1979 and 44,000 units in 1980. Compute the depreciation for
1980 using each method given below:
(1) Straight line
(2) Working hours
(3) Output method

(3-10) A machine costs P7,000, last 8 years and has a salvage value at the end of life of P350.
Determine the depreciation charge during the 4th year and the book value at the end of 4 years by
the (a) straight line method. (b) declining method, (c) SYD method, and (d) sinking fund method with
interest at 12%. (see video for solution)

(3-11) A machine costs P20,000 and has a salvage value of P2,000 after a useful life of 8 years.
Money is worth 12%. If average inflation is 8% per year during this period, what is the annual cost of
depreciation to replace the machine after 8 years? What is the annual cost of depreciation if inflation
is not considered? (see video for solution)

_________________________________________________________________________

Reference:
Sta. Maria, H.B. (2000). Engineering Economy (3rd Ed). National Book Store
Sullivan, W.G., et al (2015). Understanding Engineering Economy (16th Ed). Pearson Education Inc.