Depreciation -definitions

A decline in the value of a property due to general wear and tear or obsolescence Method of writing off wear and tear on assets that are used to produce income. Amount of value that a possession loses over time. Depreciation basis is that part of the assets purchase price that is spread over the depreciation period (service life).

Depreciation
The cost is spread out over its estimated useful life in the form of an expense given various depreciation methods.

Causes of Depreciation

Question: What are the causes of depreciation?

Answers: Fixed assets are those assets bought by the company for the intention to be used for a long period of time. Fixed assets are said to depreciate over a period of time due to the following factors:

Causes of Depreciation
1) Physical deterioration i) Wear and tear When a motor vehicle or machinery or fixtures and fittings are used, they eventually wear out. Some last many years, others last only a few year.

ii) Erosion, rust, rot and decay Land may be eroded or wasted away by the action of wind, rain, sun and other elements of nature. Similarly, the metals in motor

vehicles or machinery will rust away.

Causes of Depreciation
2) Economic factors i) Obsolescence This is the process of becoming out of date. For instance, replacing a computer with old operating system with a new computer with XP system. ii) Inadequacy This arises when an asset is no longer used because of the growth and changes in the size of the firm. For instance, a small ferryboat that is operated by a firm at a coastal resort will become entirely inadequate when the resort becomes more popular, to be more efficient and economical, the firm may replace it with a large ferryboat.

Causes of Depreciation
3) The time factor (the effluxion of time) Some assets might have a legal life fixed in terms of years. For example, the patents, and leasehold. You may agree to rent some buildings for 10 years. This is

normally called a lease. When the years are finished, the lease is worth nothing to you, as it has finished. Whatever you paid for the lease is now of no value.

Causes of Depreciation

4) Depletion Other assets are of wasting character, perhaps due to the extraction of raw materials from them. These materials are then either used by the firm to make something else, or are sold in their raw state to other firms. Natural

resources such as mines, quarries and oil wells come under this heading.

Factors that affect the calculation of Depreciation

Question: What are the factors that affect the calculation of depreciation? Answers: 1) Cost of asset (include expenses and capital expenditure incurred eg. The installation fees, the legal fees) 2) Estimated useful life of asset
This is the number of years that the asset is expected to be used)

3) Residual or scrap value of the asset This is the value of the asset at the end of its life. 4) Method of calculating depreciation

4 factors required for depreciation calculations

1.

Cost

Net purchase price. All reasonable and necessary expenditures to get the asset in place and ready for use.

2.

Residual Value (Salvage or Scrap Value)

Asset value at the end of its expected useful life.

3.

Depreciable Cost

Cost less residual value. Depreciable cost is allocated over the useful life of an asset. useful life period of the asset

4.

Life

Depreciation Methods

Straight-line Method Accelerated Methods

Declining balance method Sum-of-the-years digits

Production or Use Methods

Straight Line Method

This method spreads the depreciable costs evenly over the assets estimated useful life. Annual depreciation is computed as follows: Cost - Residual Value Estimated Useful Life
=

$10,000 - $1000 = $1800 / year 5 years

Check the help for SLN function in Excel for more details

The straight line formula

I S N

DA

AI S N

SA I

AI S N

Where: N = life of the structure in years I = the original cost S = the values at the end of the life of structure d = the annual cost of depreciation DA = depreciation up to age A years SA = the value of the end of A years

B 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Depreciation Schedule
Straight Line Method - SLN function Scrap Value Years 1000 5

pe rio d

yrs

C o st

A nnua l A c c um ula t e d C a rrying V a lue D e pre c ia t io n D e pre c ia t io n

DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5

0 1 2 3 4 5

10000 10000 10000 10000 10000 10000 Same each year

0 1800 1800 1800 1800 1800

0 1800 3600 5400 7200 9000

10000 8200 6400 4600 2800 1000

=D10-F10

Increases Decreases Uniformly Uniformly

Stop at Residual Value

=SLN(D11,$D$5,$D$6) Carrying Value(CV) = Cost Accumulated Depreciation

Book Value
The book value of a plant asset is the net cost of the asset after accumulated depreciation (the contra account) has been subtracted.
$50,000 Beg. Book Value -12,000 Accum. Depre. $38,000 End. Book Value

Example

Straight-Line Depreciation Schedule

An equal amount of depreciation is recorded each fiscal year.

Straight-line method (Examples)

Example 1: ABC Ltd. Bought a machine at a cost of 80,000. The machine has an expected useful life of 5 years and at the end of the 5th year, it can be sold for 10,000. calculate depreciation per annum?
Depreciation for 5 years would be:
Cost Date of purchase End of 1st year End of 2cd year End of 3rd year End of 4th year End of 5th year 80,000 80,000 80,000 80,000 80,000 80,000 14,000 14,000 14,000 14,000 14,000 14,000 28,000 42,000 56,000 70,000 Annual Depreciation Provision for Depreciation NBV 80,000 66,000 52,000 38,000 24,000 10,000

Straight-line method (Examples)

Example 2: ABC Ltd. Bought a machine at a cost of 80,000. The depreciation is to be charged at a 20% per annum on cost. Solution:Depreciation per annum = 80,000 x 20% = 16,000 per year

Accelerated Depreciation
Decling-Balance (DB) Method -Type
1. 2. 3.

Fixed DB method
computes depreciation at a fixed rate. computes depreciation at an accelerated rate. Also computes depreciation at an accelerated rate. switches to straight-line depreciation when depreciation is greater than the declining balance calculation

Double DB method Variable DB method

Check the help for DB, DDB and VDB functions in Excel for more details

Accelerated Depreciation
Declining balance method Depreciation is calculated on a fixed percentage on the Diminishing Balance of the Asset (the NBV). This results in a higher depreciation charge in the earlier years of the assets estimated useful life.

Example 3: A machine costs 50,000 is to be depreciated at 15% on Reducing Balance Method.

Accelerated Depreciation
Declining balance method

Cost Date of purchase End of 1st year End of 2cd year End of 3rd year End of 4th year End of 5th year 50,000 50,000 50,000 50,000 50,000 50,000

Annual Depreciation 0 50,000 x 15% = 7,500 42,500 x 15% = 6,375 36,125 x 15% = 5,419 30,706 x 15% = 4,606 26,100 x 15% = 3,915

Provision for Depreciation 7,500 13,875 19,294 23,900 27,815

NBV 50,000 42,500 36,125 30,706 26,100 22,185

The Matheson formula or declining balance method

The ratio of the depreciation in any one year to the salvage value at the beginning of that year is constant throughout the life of the structure and is designated by X.

X = the annual fixed ratio of depreciation Deprecation during the first year (d1) = I X Depreciation value (Book value) at the end of the
1st year = I I X = I (1 X)

Depreciation value (Book Value) at the end of n

years (S) = I (1 X)n S/I = (1 X)n X = 1 (S/I)(1/n)

Accelerated Depreciation
Double-declining-balance method, it would Multiply the straight-line rate by two, e.g. 2/1 x = 2/4
2 x straight-line Expected useful life

Double-declining-balance = Book Value x depreciation expense

$25,000 = $50,000 x

2 4

Double-Declining Balance Depreciation Schedule

A B C D E

Year 2004 2005 2006 2007

Double(A xB) ($50k - D) Declining- Beginning Debit Credit Ending Balance Book Depreciation Accumulated Book Rate Value Expense Depreciation Value 2/4 $50,000 $25,000 $25,000 $25,000 2/4 25,000 12,500 37,500 12,500 2/4 12,500 6,250 43,750 6,250 2/4 6,250 4,250 48,000 2,000

$6,250 $2,000 (residual value) Accelerated Depreciation

Reasons for Using Accelerated Depreciation

1. An asset is more useful earlier in its life than later, and the useful life may be difficult to estimate. 2. Depreciation expense is deductible in computing taxable income and income taxes.

The second reason is the most common reason for using accelerated depreciation.

Comparison of Straight-Line and Accelerated Depreciation Methods in 2004

Straight-Line Accelerated Income before depreciation and taxes $100,000 $100,000 Depreciation expense 12,000 25,000 Pretax income 88,000 75,000 Income taxes (35%) 30,800 26,250 Net income $ 57,200 $ 48,750

B 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Depreciation Schedule
Fixed Decling Method - DB function Scrap Value Years 1000 5

pe rio d

yrs

C o st

A nnua l A c c um ula t e d C a rrying V a lue D e pre c ia t io n D e pre c ia t io n

DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5

0 1 2 3 4 5

10000 10000 10000 10000 10000 10000

0 3690 2328 1469 927 585

0 3690 6018 7488 8415 9000

10000 6310 3982 2512 1585 1000

=D10-F10

Increases Decreases Quickly Quickly

Can't go below scrap Value

=DB(D11,$D$5,$D$6,C11) Carrying Value(CV) = Cost Accumulated Depreciation

B 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Depreciation Schedule
Accelerated Double Decling Method - DDB function Scrap Value Years 1000 5

pe rio d

yrs

C o st

A nnua l A c c um ula t e d C a rrying V a lue D e pre c ia t io n D e pre c ia t io n

DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5

0 1 2 3 4 5

10000 10000 10000 10000 10000 10000

0 4000 2400 1440 864 296

0 4000 6400 7840 8704 9000

10000 6000 3600 2160 1296 1000

=D10-F10

Increases Decreases Quickly Quickly

Can't go below scrap Value

=DDB(D11,$D$5,$D$6,C11)

Carrying Value(CV) = Cost Accumulated Depreciation

Summary - depreciation

VDB

Variable-decling balance

10

B 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

F
Formulae

Depreciation Schedule
Asset Cost Scrap Value Years Depreciation Amt.
Years SLN DB DDB VDB

Equipment 100,000 2000 5

C12 =SLN($D$5,$D$6,$D$7) D12=DB($D$5,$D$6,$D$7,B12) E12=DDB($D$5,$D$6,$D$7,B12) F12=VDB($D$5,$D$6,$D$7,B11,B12) D20=D19-C11

1 2 3 4 5 Value of Asset
period yrs

19,600 19,600 19,600 19,600 19,600

54,300 24,815 11,341 5,183 2,368

40,000 24,000 14,400 8,640 5,184

40,000 24,000 14,400 9,800 9,800

SLN

DB

DDB

VD B

DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5

0 1 2 3 4 5

100,000 80,400 60,800 41,200 21,600 2,000

100,000 45,700 20,885 9,544 4,362 1,993

100,000 60,000 36,000 21,600 12,960 7,776

100,000 60,000 36,000 21,600 11,800 2,000

Comparison of Depreciation Methods

Depreciation Vs Period
60,000 50,000
Depreciation Amt

40,000 30,000 20,000

SLN DB DDB VDB

Asset value vs Life time

10,000
120,000

0 1 2 3 4 5 6
100,000

Period (years)
80,000
Asset Value

SLN DB DDB VDB

60,000

40,000

20,000

0 0 1 2 3 4 5 6

Period (years)

Sum of digits plan

To obtain the depreciation charge in any year of
life by the sum-of-the designated year by digits the method digits (commonly SYD),

corresponding to the number of each year of life are listed in reverse order.

The sum of the digits is then determined. The depreciation factor for any year is the reverse
digit for that year divided by the sum of the digits.

For example, for a property having a life of five

years,

11

Sum of digits plan

year Number of the year in reverse order (digits) 5 4 3 2 1 15 Depreciation

1 2 3 4 5 Sum of the digits

5/15 4/15 3/15 2/15 1/15

Sum of digits plan

The depreciation for any year is the product of the SYD depreciation factor for that year and the depreciable value, I S. The general expression for the annual cost of depreciation for any year, A, when the total life is N, is

DA =

2( N A 1) (I S ) N ( N 1)

Activity Depreciation
At the beginning of 2005, Moms Cookie Company purchased a truck for $30,000. Management expects the useful life of the truck to be 100,000 miles, at which time it will be sold for $10,000.

Cost Residual Value $30,000 $10,000

$0.20 per mile

Expectedmiles 100,000 Units

Units-of-Production Depreciation

12

Activity Depreciation
If the truck were driven 12,000 miles in 2005, Hydro would record depreciation expense of $2,400 (12,000 x $0.20).
Units-of-Production Depreciation

13