Depreciation

Depreciation is a decrease in value of assets (equipment and building) due

to their deterioration and reduction in usefulness over a period of time.
Types of depreciation
 Factors which cause depreciation may be physical or functional
1) Physical depreciation: decrease in value due to change in the physical
aspects of property. Cause of physical depreciation are wear, tear,
corrosion, and deterioration due to age.
2) Functional depreciation: decrease in serviceability (obsolescence) of asset.
Factors which cause functional depreciation includes;
 Technological advancement
 Insufficient capacity for service required
 Decrease in demand for product and abandonment of enterprise.
 What are Depreciable Assets?

All properties with a limited useful life of (> 1year) that is used in trade, business or
production of income are depreciable.
 Depreciable Assets
 Physical facilities, including such costs as design and engineering, shipping,
and field erection.
 Improvements to the land such as grading, adding utilities services
 Fixed-capital investment, not including land is depreciable.
 Non Depreciable assets
 Working capital and start-up costs
 inventories held for sale ,
 the cost of maintenance and repairs
 land is not depreciable.
 Purpose and benefits of Depreciation

 Helps as a means of distributing the original expense for a physical asset

over the period during which the asset is in use.
 Used as a means to set aside a fund to replace the asset when it is no
longer operable.
 Serves to reduce income tax and allows the company earn greater net
profit
Parameters for determination of depreciation
1. Present (current) value: Represents the value of the asset at the time of
estimation.
2. Book Value of an asset: The difference between the original cost of a
property and the depreciation charges made up to particular point of time.
 Book value Va = –ad
– is original value at start of the service-life period ($)
d – is annual depreciation ($/year)
a – is the number of years the asset is in actual use.
3. Service life (n): The time period during which an asset is in service and
is economically feasible.
4. Salvage value: is the net amount of money obtained from the sale of used
property minus the cost for removal and transportation.
 Salvage value implies that the asset can give some type of further service.
5. Scrap value: money obtained from the sale of used property which have
no further useful service but be sold for material recovery and used as a
manufacturing raw material.
 Methods For Calculating Depreciation
 The commonly used methods of depreciation calculation are;
1) Straight Line Method (SLM)
2) Declining-Balance or Fixed Percentage Method, (DBM)
3) Double Declining Balance Method (DDM)
4) Modified Accelerated Cost Recovery System (MACRS)
5) Sum of the Years Digits Methods (SOYDM)
6) Sinking Fund Method (SFM)
 1) Straight Line Method
 In this method it is assumed that cost of Property is distributed uniformly
throughout its service life and value of property decreases linearly with
time.
 Equal amounts of depreciation is charged each year throughout the entire
service life of the property.
Depreciation (d) is the slope of the straight line
V0
V1 Therefore, = = …..= =d
Value ($)

V2

V3
Where – is the initial price of property at start of
the service life period ($)
VS
–is salvage value at the end of service life
0 1 2 3
n
($)
t =Service life (Years)

n –is service life (year)

d -is depreciation ($/year)
 2) Declining-Balance or Fixed Percentage Method, (DBM)

 The depreciation cost in a particular year is a fixed percentage of the

property value at the beginning of that particular year.
 Meaning that depreciation cost in a particular year is fixed percentage
(depreciation rate) of book value from the previous year or the book value
at the beginning of the particular year.
 The fixed percentage factor is constant throughout the service life of the
property, But since the book value goes on changing the depreciation cost
varies from year to year.
 From the Above definition,
 The present/book value at the beginning of the first year service life is
then, depreciation cost at the end of 1st year service life is; = f,
At the end of the first year, book/asset value Va = V1 is

V1 =- = - f = (1-f)

 Depreciation cost at end of 2nd year = V1f = (1-f)f

book/asset value at the end of 2nd year V2 = V1 – d2 (1-f) -(1-f)f = (1-f)2

 Depreciation cost at end of 3rd year = V2f = (1-f)2 f,

book/asset value at the end of 3rd year V3 = V2 – d3 (1-f) -(1-f)f = (1-f)2

In general, dn = (1-f)n-1 f

=(1-f)n ………..(n)

Solve for f from the above equn (n) then, f =1-

()1/n Matheson formula
 3) Double Declining Balance method (DDBM)
Declining balance method is not applicable if salvage value is zero ( =0),
So, to overcome this disadvantage a double declining method in which the
fixed percentage factor giving the depreciation rate equal to twice (200%
the depreciation rate of the straight-line method is used.
 Under these conditions, the value of f is two times the reciprocal of the
service life n (1/n).
In general dn = (1-f)n-1 f
=(1-f)n
f =2/n
 4) Modified accelerated cost recovery system (MACRS)
In DDBM the value of the asset cannot decrease to zero at the end of the
service life and may possibly be greater or lower than the salvage value.
Double declining balance never gives complete depreciation as its taken
fraction of un depreciated amount each time.
 To lower this difficulty, it is desirable to switch from the declining-
balance to the straight-line method after a portion of the service life has
expired.
 depreciation cost is determined based on statutory annual percentages and
class life periods.
The half-year convention applied for the first year when property was
placed in service and also for the year of disposal. Salvage value was
taken as zero.
 For MACRS, the statutory percentages were based on a 200% declining
balance for class lives of 3, 5, 7, and 10 years
 a 150 % declining balance for class lives of 15 and 20 years with a
switch to straight-line depreciation.
 5) Sum Of Years Digits Method
In this method, depreciation is based on the number of service-life years
remaining and the sum of all of the service life from 1 to n.
 The yearly depreciation factor is the number of useful service-life years
remaining divided by the sum of service life from 1 to n.
 This factor times the total depreciable value at the start of the service life
gives the annual depreciation cost.

SOYD depreciation = - )
SOYD = 1+2+3….+n =n()

Dt =- )

=-)+
 6) Sinking Fund Method
 This method assumes depreciation cost as annual uniform series of
payments deposited into an imaginary sinking fund at a given
interest rate i.
 The amount of the annual deposit is calculated so that the accumulated
sum at the end of the asset life and the interest rate, will just equal the
value of the asset depreciated, that is - ).
The depreciation invested in compound manner is determined using the
following equation
P
1 2 3 n-1 n
S= = - )
R R R R R R =d = …………(a)
S
 The amount accumulated in the fund after a years of useful life let a
year must be equal to the total amount of depreciation up to that time.
 This is the same as the difference between the original value of the
property at the start of the service life and the asset value , at the end
of a years.
 Total amount of depreciation at the end of a years =

= ……..(b)
combine eqn (a) and (b)
=
= - , asset/book value after a years