Introduction to Depreciation

Professor Stephen J. Allen

Depreciation is an artificial (non-cash) accounting entry intended to account for the consumption of a capital asset over its economic life Depreciation is an accounting concept that establishes an annual deduction against pre-tax income such that the effect of time and use on an asset's value can be reflected in a firm's financial statements

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Depreciation base or basis is the part of the assets purchase price that is spread over the depreciation period (service life). Depreciation base is purchase cost minus expected salvage value at the end of the service period.

What constitutes a depreciable property?

It must be used in business or held to produce income It must have a determinable useful life and the life must be longer than one year It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes It is not inventory, stock in trade, or investment property

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Depreciation Factors and Process

Depreciation requires the following estimates: 1. Useful life period of time over which the asset is expected to generate cash inflows 2. Salvage value Expected disposal amount for the asset at the end of its useful life 3. Depreciation rate an estimate of how the asset will be used up over its useful life.

Depreciation Rate Assumptions

1. The asset is used up by the same amount each period Or 2. The asset is used up more in the early years of its useful life Or 3. The asset is used up in proportion to its actual usage

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Variance in Depreciation
A company can depreciate different assets using different depreciation rates (and different useful lives). Whatever depreciation rate is chosen, however, it must generally be used throughout the useful life of that asset. Changes to depreciation rates can be made. The using up of an asset generally relates to physical or technological obsolescence. Physical obsolescence relates to an assets diminished capacity to produce output. Technological obsolescence relates to an assets diminished efficiency in producing output in a competitive manner.

Depreciation Methods
All depreciation methods use the general formula:

i)

Straight-line method.

ii) Activity method (units of use or production). iii) Declining-balance method. iv) Double-declining balance method. v) Sum-of-the-years-digits. Accelerated methods

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Straight line method

Under the straight-line (SL) method, depreciation expense is straightrecognized evenly over the estimated useful life of the asset. n = depreciable life of the asset (years) C = Capital cost () di = annual depreciation charge () in year i where 1 i n Bi = Book value () at end of year i S = Scrap or residual salvage value () at end of year n di* = cumulative depreciation charge () up to year i

di =

CS n

di* = id i

B i = C - di*

Straight-line Method

An asset has the following details: (1) capital cost of 100,000 (2) salvage value of 10,000 (3) useful life of 5 years

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For the straight-line method, assign the following amounts to the depreciation formula:

For the assets first year of usage, 18,000 (90,000 * 20%) of depreciation expense is reported in the income statement. At the end of that first year the asset is reported on the balance sheet as follows:

Net book value (NBV) is cost less accumulated depreciation. At the end of year 2, the net book value will be reduced by another 18,000 to 64,000.

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Declining balance method

Under the DB method, the annual depreciation expense is a fixed percentage of the book value at the beginning of the year. The ratio of the depreciation in any one year to the book value at the beginning of the year is constant throughout the life of the asset and is designated by f. Scrap value is not in any of the equations, however, book value cannot fall below scrap value and this will limit di.

d1 = C.f

di = C (1 - f ) (f)
i -1
i

* di = C 1 - (1 - f )i
n

B i = C (1 - f )

B n = C (1 - f )

If i = n then Book value B equals scrap value S. The Matheson formula below can then be used to determine a fraction f which equates B with S.

B n = C (1 - f ) = S
n

S f = 1 C

1 n

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Double Declining balance method

Under the DDB method, the fixed percentage factor f is set at two times two the reciprocal of the service life n. This means that the depreciation rate depreciation is two times the straight line rate. This method permits approximately two-thirds of the depreciable value to twobe written off in the first half of the useful llfe. llfe.

Double-declining-balance method

The asset is reported on the balance sheet as follows:

In the second year, 24,000 (60,000 40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

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Double declining balance depreciation schedule

*The formula value of 5,184 (40% of 12,960) is not reported because it would depreciate the asset below salvage value. Only the 2,960 needed to reach salvage value is reported as depreciated.

Comparison of Depreciation Methods

Comparison of straight line and double declining balance depreciation

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Sum of the years digits method

n = depreciable life of the asset (years) R= remaining years of useful life (years) C = Capital cost () di = annual depreciation charge () in year i where 1 i n Bi = Book value () at end of year i S = Scrap or residual salvage value () at end of year n di* = cumulative depreciation charge () up to year i SD = sum of the years digits or sum of all the numbers from 1 to n

di =

R (C S ) SD

Sum-of-the-Years Digits (an example)

Asset cost = 50,000 Asset life = 5 years Salvage value = 10,000 C-S = 50,000 - 10,000 = 40,000 SD = 1+2+3+4+5=15

di =
Annual Depreciation: Year Year Year Year Year

R (C S ) SD

1, R = 5 and d1 = (40,000) X (5/15) = 13,333.32 2 = (40,000) X (4/15) = 10,666.68 3 = (40,000) X (3/15) = 8,000.00 4 = (40,000) X (2/15) = 5,333.33 5 = (40,000) X (1/15) = 2,666.67

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Corporation purchased a new machine for its assembly process on Septmber 30, 2009. The cost of this machine was 117,900. The company estimated that the machine would have a salvage value of 12,900 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 1,000 hours made up as:
2009 2010 2011 2012 2013 200 hours 150 hours 250 hours 300 hours 100 hours

Exercise (Depreciation Calculations Four Methods) Robert Parish

If the year end accounts are made on 31st December, determine the depreciation expense under the following methods. (a) Straight-line depreciation. (b) Activity method. (c) Sum-of-the-years-digits. (d) Double-declining balance.

Exercise (Straight-line Method)

Depreciable Base 105,000 105,000 105,000 105,000 105,000 105,000 / / / / / / Annual Expense = = = = = = 21,000 21,000 21,000 21,000 21,000 21,000 x 9/12 = x Partial Year 3/12 = Current Year Expense 5,250 21,000 21,000 21,000 21,000 15,750 105,000 Accum. Deprec. 5,250 26,250 47,250 68,250 89,250 105,000

Year 2009 2010 2011 2012 2013 2014

Years 5 5 5 5 5 5

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Exercise (Activity Method)

(105,000 / 1,000 hours = 105 per hour)
Year 2009 2010 2011 2012 2013 (Given) Hours Used 200 150 250 300 100 1,000 Rate per Hours 105 105 105 105 105 Annual Expense 21,000 15,750 26,250 31,500 10,500 Partial Year Current Year Expense 21,000 15,750 26,250 31,500 10,500 105,000 Accum. Deprec. 21,000 36,750 63,000 94,500 105,000

x x x x x

= = = = =

Exercise (Sum-of-the-years-digits Method)

Year 2009 2010 2011 2012 2013 2014 Depreciable Base 105,000 105,000 105,000 105,000 105,000 105,000 Years 5/15 4.75/15 3.75/15 2.75/15 1.75/15 0.75/15 Annual Expense 35,000 33,250 26,250 19,250 12,250 5,250 Partial Year 3/12 Current Year Expense 8,750 33,250 26,250 19,250 12,250 5,250 105,000 Accum. Deprec. 8,750 42,000 68,250 87,500 99,750 105,000

x x x x x x

= = = = = =

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Exercise (Double-Declining Balance Method)

Year 2009 2010 2011 2012 2013 2014 Depreciable Base 117,900 106,110 63,666 38,200 22,920 13,752 Rate per Year 40% 40% 40% 40% 40% 40% Annual Expense 47,160 x 42,444 25,466 15,280 9,168 852 Partial Year 3/12 Current Year Expense 11,790 42,444 25,466 15,280 9,168 852 105,000 Accum. Deprec. 11,790 54,234 79,700 94,980 104,148 105,000

x x x x x x

= = = = = =

9/12

*The formula value of 5,501 (40% 9/12 of 13,752) is not reported because it would depreciate the asset below salvage value. Only the 852 needed to reach salvage value is reported as depreciated.

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