Depreciation:

Depreciation is the reduction in the value of assets owned by a corporation. “Depreciation

methods are based upon legally approved rules which do not necessarily reflect actual usage
patterns of assets during ownership.” Annual depreciation changes are tax deductible and
indicated in corporate accounts.

Capital recovery:
The process of depreciating an asset is referred to as capital recovery.

Book value:
Book value represents the remaining undepreciated investment on corporate books after the total
amount of annual depreciation charges (to date) has been subtracted from the initial value. Book
value is usually determined at the end of each year.

It is ordinarily taken to the mean the original cost of property less the amount that has been
charged as depreciation expenses.

Market value:
“Market value is the actual amount that could be realized if an asset were sold on the open
market”. Due to structure of tax laws, book value and market value may have substantially
different values.

For example: A commercial building tends to increase in market value, but the book value will
decrease as depreciation charges are taken. However, the computer may have market value much
lower than its book value due to rapid changing technology of information system.

Basis/First cost:
Basis or first cost of the asset including purchase price, delivery and installation fees and other
depreciable direct costs incurred to ready the asset for use. The term unadjusted basis is used
when asset is new and adjusted basis may be used in years after depreciation has been charged.

Recovery Period:
Recovery period (also called depreciable life or class life) is the life of the asset for depreciation
and tax purposes.

Depreciation rate or recovery rate:

Depreciation rate or recovery rate is the fraction of the basis or first cost removed through
depreciation from corporate books each year or the rate at which asset depreciates.

Salvage value:
Salvage value is the expected market value at the end of the useful life of the asset.
Methods of depreciation:
Following are the methods of depreciation.
 Straight line (SL) Depreciation method
 Double Declining Balance Method
 Sum of Year Digits Methods

1. Straight line (SL) Depreciation method

The straight-line depreciation method of depreciation is most popular method and is used as the
standard of comparison for most other methods. It derives its name from the fact book value
decreases linearly with time because the recovery or depreciation rate is same each year. The
annual depreciation is determined by dividing the first cost or unadjusted basis minus the salvage
value by the recovery period of the asset. In formula, we use “B” for unadjusted basis because it
may be different for depreciation purposes then the first cost. In equation,

𝐵 − 𝑆𝑣
𝐷𝑡 =
𝑛
Where,
t = year (t=1,2,3………..)
Dt = Annual depreciation charge
B = First cost or unadjusted basis
SV = salvage value
n = expected depreciable life or recovery period.

The book value can be calculated as follow

𝐵𝑉𝑡 = 𝐵 − 𝑡𝐷𝑡
Where, BV= Book value.

The recovery rate”𝑑𝑡 ”is same for each year t.

1
𝑑𝑡 =
𝑛
Example:
If an asset has a first cost of 50,000 with a $10,000 salvage value after 5 years
• Calculate the annual depreciation and
• Calculate the book value of the asset after each year using SL depreciation.
Sol:
The depreciation charged each year can be found as follows.

50,000 − 10,000
𝐷1 = = 8000
5
50,000 − 10,000
𝐷2 = = 8000
5
50,000 − 10,000
𝐷3 = = 8000
5
50,000 − 10,000
𝐷4 = = 8000
5
50,000 − 10,000
𝐷5 = = 8000
5
The book value of the asset after each year can be found by using

𝐵𝑉𝑡 = 𝐵 − 𝑡𝐷𝑡
𝐵𝑉1 = 50,000 − 1(8000) = 42,000
𝐵𝑉2 = 50,000 − 2(8000) = 34,000
𝐵𝑉3 = 50,000 − 3(8000) = 26,000
𝐵𝑉4 = 50,000 − 4(8000) = 18,000
𝐵𝑉5 = 50,000 − 5(8000) = 10,000

2. Declining balance and double Declining balance(DDB) Depreciation:

It is also known as uniform or fixed percentage method. In this method the depreciation charge
for any year is determined by multiplying a uniform percentage by the book value at the
beginning of that year.

The maximum percentage depreciation that is permitted is 200% (double) the straight-line rate.
When this rate is used the method is known as double Declining balance method. Thus, if an
1 1
asset had a useful life of 10 years, the straight-line depreciation rate would be = 10 . The
𝑛
1 2
uniform rate of 2 ∗ 𝑛 = 10 therefore could be used in the DDB method. The general formula to
1
calculate DB rate 𝑑𝑚 is two times the straight-line recovery rate (2 ∗ 𝑛).

The actual depreciation rate, relative to the unadjusted basis ”B” for year ”t” is computed as

𝑑𝑡 = 𝑑(1 − 𝑑)𝑡−1
The depreciation 𝐷𝑡 for year ”t” is the uniform rate 𝑑 times the book value at the end of the
previous year; that is

𝐷𝑡 = (𝑑) 𝐵𝑉𝑡−1
If 𝐵𝑉𝑡−1 is not known, the depreciation charge is can be calculated as;

𝐷𝑡 = (𝑑)𝐵(1 − 𝑑)𝑡−1
The book value in year ”t” is

𝐵𝑉𝑡 = 𝐵(1 − 𝑑)𝑡

Since the salvage value in declining balance method does not go to zero, an implied SV after 𝑛
years may be computed as

𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑆𝑉 = 𝐵𝑉𝑛 = 𝐵(1 − 𝑑)𝑛

If the 𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑆𝑉 is less than the 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑆𝑉, the asset will be totally depreciated before the
end of its useful life 𝑛 and vice versa.

Example: Assume that an asset has a first cost of $25000 and an expected $4000 salvage after
12 years. Calculate its depreciation and book value for

a) year 1
b) year 4
c) the implied salvage value after 12 years using DDB method.

Solution: First compute the DDB uniform rate.

1 2
𝑑𝑚 = 2 ∗ = = 0.1667 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝑛 12
(a) For the first year, the depreciation and book value can be calculated as
𝐷1 = (𝑑)𝐵(1 − 𝑑)𝑡−1 = (0.1667) ∗ 25000 ∗ (1 − 0.1667)1−1 = 4167.50
𝐵𝑉1 = 𝐵(1 − 𝑑)𝑡 = 25000(1 − 0.1667)1 = 20832.50

(b) For year 4, again depreciation and book value can be calculated by using same
formula
𝐷4 = (𝑑)𝐵(1 − 𝑑)𝑡−1 = (0.1667) ∗ 25000 ∗ (1 − 0.1667)4−1 = 2411.46
𝐵𝑉4 = 𝐵(1 − 𝑑)𝑡 = 25000(1 − 0.1667)4 = 12054.40
(c) Implied SV can be calculated as following

𝐼𝑚𝑝𝑙𝑖𝑒𝑑 𝑆𝑉 = 𝐵𝑉𝑛 = 𝐵(1 − 𝑑)𝑛 = 25000(1 − 0.1667)12 = 2802.57

Since the stated salvage value is anticipated to be $ 4000. The asset will be completely
depreciated before its expected 12 year life is over. Therefore, after the BV reaches $4000 no
further depreciation charges would be allowed.

3. Sum of year digits (SYD) depreciation Method

The SYD method is a classical accelerated depreciation technique which removes much of he
basis in the first one third of the recovery period. However, write-off (depreciation rate in
percentage) is not as rapid as in DDB method. The technique is often utilized in economics
analysis for rapid depreciation of invested capital and in the actual deprecation of multiple asset
accounts.

The mechanics of the method involve initially finding the sum of the year digits “1” through “n”.
The number obtained represents the sum of year digits. The depreciation charge for any given
year is obtained by multiplying the basis of the asset less the salvage value (B-SV) by the ratio of
the number of year remaining in the recovery period to the sum of year digits.

𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑦𝑒𝑎𝑟 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔

𝐷𝑡 = ∗ (𝐵𝑎𝑠𝑖𝑠 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒)
𝑆𝑢𝑚 𝑜𝑓 𝑦𝑒𝑎𝑟 𝑑𝑖𝑔𝑖𝑡𝑠

𝑛−𝑡+1
𝐷𝑡 = ∗ (𝐵 − 𝑆𝑉)
𝑆
Where,
S = sum of year digits 1 to 𝑛
𝑛
𝑛 (𝑛 + 1)
𝑆 = ∑𝑗 =
2
𝑗=1
Note that the depreciable year remaining must include the year which the depreciation charge is
desired. That is why the “1” has been included in the numerator of depreciation equation

The book value can be calculated as follow

𝑡 (𝑛 − 𝑡/2 + 0.5)
𝐵𝑉𝑡 = 𝐵 − [ ] (𝐵 − 𝑆𝑉)
𝑆

The rate of depreciation 𝑑𝑡 , which decreases each year for SYD method, is
𝑛−𝑡+1
𝑑𝑡 =
𝑆
Example:

Calculate the depreciation charges for year 1,2 and 3 for electrooptic equipment with 𝐵 =
25000, 𝑆𝑉 = 4000 and an 8 𝑦𝑒𝑎𝑟 recovery period.
Sol :

The sum of year digits is 𝑆 = 36

𝑛
𝑛 (𝑛 + 1) 8 (8 + 1)
𝑆 = ∑𝑗 = = = 36
2 2
𝑗=1

and the depreciation amounts for the first 3 years can be calculated by using

𝑛−𝑡+1
𝐷𝑡 = ∗ (𝐵 − 𝑆𝑉)
𝑆
8−1+1
𝐷1 = ∗ (25000 − 4000) = 4667
36
8−2+1
𝐷2 = ∗ (25000 − 4000) = 4083
36
8−3+1
𝐷3 = ∗ (25000 − 4000) = 3500
36