DEPRECIATION

LEARNING OBJECTIVES

• Describe depreciation, deterioration, and obsolescence.

• Distinguish various types of depreciable property and
differentiate between depreciation expenses and other business
expenses.
●Use historical depreciation methods to calculate the annual
depreciation charge and book value over the asset’s life.
• Explain the differences between the historical depreciation
methods and the modified accelerated cost recovery system
(MACRS).
LEARNING OBJECTIVES

• Use MACRS to calculate allowable annual depreciation

charge and book value over the asset’s life for various cost
bases, property classes, and recovery periods.
• Fully account for capital gains/losses, ordinary losses, and
depreciation recapture due to the disposal of a depreciated
business asset.
• Use the units of production and depletion depreciation
methods as needed in engineering economic analysis
problems.
BASIC ASPECTS OF DEPRECIATION

The word depreciation is defined as a “decrease

in value.”
This is somewhat ambiguous because value has
several meanings.
In economic analysis, value may refer to either
market value or value to the owner.
DETERIORATION AND OBSOLENSCENCE

A machine may depreciate because it is deteriorating, or

wearing out and no longer performing its function as well as
when it was new.
Depreciation is also caused by obsolescence.
A machine that is in excellent working condition, and serving a
needed purpose, may still be obsolete.
DETERIORATION AND OBSOLENSCENCE

The accounting profession defines depreciation in yet another

way, as allocating an asset’s cost over its useful or depreciable
life. Thus, we now have three distinct definitions of
depreciation:
1. Decline in market value of an asset.
2. Decline in value of an asset to its owner.
3. Systematic allocation of an asset’s cost over its depreciable
life.
DEPRECIATION AND EXPENSES

It is the third (accountant’s) definition that is used to compute

depreciation for business assets.
Business costs are generally either expensed or depreciated.
Expensed items, such as labor, utilities, materials, and
insurance, are part of regular business operations and are
“consumed” over short periods of time (sometimes recurring).
These costs do not lose value gradually over time
DEPRECIATION AND EXPENSES

In contrast, business costs due to capital assets (buildings,

forklifts, chemical plants, etc.) are not fully written off when
they occur.
Capital assets lose value gradually and must be written off or
depreciated over an extended period.
Depreciable life is determined by the depreciation method used
to spread out the cost—depreciated assets of many types
operate well beyond their depreciable life.
DEPRECIATION AND EXPENSES

Depreciation is a noncash cost that requires no exchange of

dollars. Companies do not write a check to someone to pay
their depreciation expenses.
Rather, these are business expenses that are allowed by the
government to offset the loss in value of business assets.
Remember, the company has paid for assets up front;
depreciation is simply a way to claim these “business
expenses” over time.
DEPRECIATION AND EXPENSES

In general, business assets can be depreciated only if they meet

the following basic requirements:
1.The property must be used for business purposes to produce
income.
2.The property must have a useful life that can be determined,
and this life must be longer than one year.
3.The property must be an asset that decays, gets used up,
wears out, becomes obsolete, or loses value to the owner
from natural causes.
SAMPLE PROBLEM
Consider the costs that are incurred by a local pizza business. Identify each cost as
either expensed or depreciated and describe why that term applies.
• Cost for pizza dough and toppings
• Cost to pay wages for janitor
• Cost of a new baking oven
• Cost of new delivery van
• Cost of furnishings in dining room
• Utility costs for soda refrigerator
TYPES OF PROPERTY
The rules for depreciation are linked to the classification of business property as
either tangible or intangible. Tangible property is further classified as either real or
personal.
Tangible property can be seen, touched, and felt.
Real property includes land, buildings, and all things growing on, built upon,
constructed on, or attached to the land.
Personal property includes equipment, furnishings, vehicles, office machinery, and
anything that is tangible excluding assets defined as real property.
TYPES OF PROPERTY

Intangible property is all property that has value to the owner

but cannot be directly seen or touched. Examples include
patents, copyrights, trademarks, trade names, and franchises.
One important and notable exception is land, which is never
depreciated. Land does not wear out, lose value, or have a
determinable useful life and thus does not qualify as a
depreciable property.
Definition of Terms
Adjusted (cost) basis The original cost basis of the asset, adjusted by allowable
increases or decreases, is used to compute depreciation deductions. For example, the
cost of any improvement to a capital asset with a useful life greater than one year
increases the original cost basis, and a casualty or theft loss decreases it. If the basis
is altered, the depreciation deduction may need to be adjusted.
Basis or cost basis The initial cost of acquiring an asset (purchase price plus any
sales taxes), including transportation expenses and other normal costs of making the
asset serviceable for its intended use; this amount is also called the unadjusted cost
basis.
Definition of Terms
 
Definition of Terms
Market value (MV) The amount that will be paid by a willing buyer to a willing
seller for a property, where each has equal advantage and is under no compulsion to
buy or sell. The MV approximates the present value of what will be received
through ownership of the property, including the time value of money (or profit).
Recovery period The number of years over which the basis of a property is
recovered through the accounting process. For the classical methods of depreciation,
this period is normally the useful life. Under MACRS, this period is the property
class for the General Depreciation System (GDS), and it is the class life for the
Alternative Depreciation System (ADS)
Recovery rate A percentage (expressed in decimal form) for each year of the
MACRS recovery period that is utilized to compute an annual depreciation
deduction.
Definition of Terms
Salvage value (SV) The estimated value of a property at the end of its useful life.∗
It is the expected selling price of a property when the asset can no longer be used
productively by its owner. The term net salvage value is used when the owner will
incur expenses in disposing of the property, and these cash outflows must be
deducted from the cash inflows to obtain a final net SV. Under MACRS, the SV of a
depreciable property is defined to be zero.
Useful life The expected (estimated) period that a property will be used in a trade or
business to produce income. It is not how long the property will last but how long
the owner expects to productively use it.
DEPRECIATION CALCULATION
FUNDAMENTALS
Figure 11-1 illustrates the general
depreciation problem of allocating the
total depreciation charges over the
asset’s depreciable life. The vertical axis
is labeled book value. At time zero the
curve of book value starts at the cost
basis (= the first cost plus installation
cost). Over time, the book value
declines to the salvage value. Thus, at
any point in time:
Book value = Asset cost −
Depreciation charges made to date
Depreciation Methods: Book and Tax
Depreciation
One important distinction regarding the general definition of
accounting depreciation must be introduced.
Most firms calculate depreciation in two different ways,
depending on whether the calculation is
(I)intended for financial reports (book depreciation method),
such as for the balance sheet or income statement, or
(II)intended for the Internal Revenue Service (IRS) for the
purpose of calculating taxes (tax depreciation method)
Depreciation Methods: Book and Tax
Depreciation
Calculating depreciation differently for financial reports and for tax purposes allows
for the following benefits:
The book depreciation enables firms to report depreciation to stockholders and other
significant outsiders on the basis of the matching concept. Therefore, the actual loss
in value of the assets is generally reflected.
The tax depreciation method allows firms to benefit from the tax advantages of
depreciating assets more quickly than would be possible under the matching
concept. In many cases, tax depreciation allows firms to defer paying income taxes.
This deferral does not mean that they pay less tax overall because the total
depreciation expense accounted for over time is the same in either case.
STRAIGHT LINE DEPRECIATION
 
Sample Problem
Consider the following (in $1000):
Cost of the asset, B $900
Depreciable life, in years, N 5
Salvage value, S $70
Compute the straight-line depreciation schedule.
Sample Problem
A compressor was purchased at a cost of $16,000
with an estimated salvage value of $2,000 and an
estimated useful life of 7 years. Determine the
depreciation allowance for each year and the book
value at the end of each year, using straight-line
depreciation.
Sample Problem
A laser surgical tool has a cost basis of $200,000 and a five-
year depreciable life. The estimated SV of the laser is $20,000
at the end of five years. Determine the annual depreciation
amounts using the SL method. Tabulate the annual
depreciation amounts and the book value of the laser at the end
of each year.
SINKING FUND FORMULA
 
Sample Problem

A civil engineer bought a gantry crane for erecting tall

building. It was invoiced from Japan CIF (cost, insurance,
freight) Manila at ₱250,000. Brokerage, bank, arrester fees,
customs’ duties, permits etc. total ₱120,000. At the end of 10
years, he expects to sell it for ₱50,000. Using sinking fund
depreciation at 12%, what would be its book value at the end
of 5 years?
ACCELERATED DEPRECIATION METHOD
Several other methods of depreciation are known as accelerated depreciation
methods.
Under an accelerated depreciation method, the depreciation allowance for an asset
will be greater in the earlier years of its life and less in the later years of its life than
under the straight-line method.
The total depreciation allowance would be the same under the accelerated method
as under the straight-line method, and, hence, total taxable income would be the
same for the whole period; however, greater allowances in the earlier years also
mean less tax in the earlier years.
SUM OF THE YEARS’ DIGIT DEPRECIATION
SAMPLE PROBLEM
Compute the SOYD depreciation schedule for the situation
Cost of the asset, B = $900
Depreciable life, in years, N= 5
Salvage value, S = $70
DECLINING BALANCE DEPRECIATION
 
Sample Problem
Compute the DDB depreciation schedule for the situations
Cost of the asset, B = $900
Depreciable life, in years, N = 5
Salvage value, S = $70
DECLINING BALANCE METHOD

Declining-balance depreciation (also known as reducing-

balance depreciation) models the loss in value of an asset over
a period as a constant fraction of the asset’s current book
value. In other words, the depreciation charge in a particular
period is a constant proportion (called the depreciation rate) of
its closing book value from the previous period
DECLINING BALANCE METHOD
DECLINING BALANCE METHOD
DECLINING BALANCE METHOD
Sample Problem

Paquita wants to estimate the scrap value of a smokehouse 20

years after purchase. She feels that the depreciation is best
represented using the declining-balance method, but she
doesn’t know what depreciation rate to use. She observes that
the purchase price of the smokehouse was $245 000 three
years ago, and an estimate of its current salvage value is $180
000. What is a good estimate of the value of the smokehouse
after 20 years?
Sample Problem

Sherbrooke Data Services has purchased a new mass storage

system for $250 000. It is expected to last six years, with a $10
000 salvage value. Using both the straight-line and declining-
balance methods, determine the following:
(a) The depreciation charge in year 1
(b) The depreciation charge in year 6
(c) The book value at the end of year 4
(d) The accumulated depreciation at the end of year 4