Depreciation

Introduction:
An analysis of costs and profits for any
business operation requires recognition of
the fact that physical assets decrease in
value with age. This decrease in value may
be due to physical deterioration,
technological advances, economic changes,
or other factors which ultimately will cause
retirement of the property. The reduction in
value due to any of these causes is a
measure of the depreciation
Depreciation:

Depreciation refers to two very

different but related concepts:
The decrease in value of assets (fair
value depreciation), and
The allocation of the cost of assets to
periods in which the assets are used
(depreciation with the matching
principle).
Meaning of Value:
The total cost due to depreciation is the
original or new value of a property
minus the value of the same property
at the end of the depreciation period.
The original value is usually taken as
the total cost of the property at the
time it is ready for initial use.
 it is necessary to estimate the final
value of the property as well as its
useful life.
In estimating property life, the
various factors which may affect the
useful-life period, such as wear and
tear, economic changes, or possible
technological advances, should be
taken into consideration.
Appraised Depreciation
The difference between the
estimated cost of new equivalent
property and the appraised value of
the present asset is known as the
appraised depreciation.
Purpose of Depreciation as a
Cost
Consideration of depreciation as a cost
permits realistic evaluation of profits
earned by a company and, therefore,
provides a basis for determination of
Federal income taxes.
Types of Depreciation:

Physical depreciation

Functional depreciation
Physical Depreciation:
The measure of the decrease in value
due to changes in the physical aspects
of the property.
Wear and tear, corrosion, accidents,
and deterioration due to age or the
elements are all causes of physical
depreciation.
With this type of depreciation, the
serviceability of the property is
reduced because of physical
Functional Depreciation:
A loss in value of an improvement due
to functional inadequacies, often
caused by age or poor design.
Obsolescence:
This is caused by
technological advances or
developments which make an existing
property obsolete.
 Continue.
Even though the property has suffered
no physical change, its economic
serviceability is reduced because it is
inferior to improved types of similar
assets that have been made available
through advancements in technology.
Other causes of functional
depreciation:
1. Change in demand for the service rendered
by the property, such as a decrease in the
demand for the product involved because of
saturation of the market
2. Shift of population center
3. Changes in requirements of public authority
4. Inadequacy or insufficient capacity for the
service required for termination of the need
for the type of service rendered, and
5. Abandonment of the enterprise.
 Depletion
Capacity loss due to materials
actually consumed is measured as
depletion. Depletion cost equals the
initial cost times the ratio of amount
of material used to original amount
of material purchased.
 Costs for Maintenance and
Repairs
The term maintenance conveys the idea
of constantly keeping a property in good
condition, repairs connotes the replacing
or mending of broken or worn parts of a
property.

The costs for maintenance and repairs are

direct operating expenses which must be
paid from income, and these costs should
not be confused with depreciation costs.
 Continue..
The extent of maintenance and
repairs may have an effect on
depreciation cost, because the useful
life of any property ought to be
increased if it is kept in good
condition.
 Service Life
The period during which the use of a property is
economically feasible is known as the service life of
the property.

Both physical and functional depreciation are taken

into consideration in determining service life,
and, as used in this book, the term is synonymous
with economic or useful life.

In estimating the probable service life, it is assumed

that a reasonable amount of maintenance and
repairs will be carried out at the expense of the
property owner
 Salvage Value
Salvage value is the net amount of money
obtainable from the sale of used property
over and above any charges involved in
removal and sale.

The term salvage value implies that the

asset can give some type of further
service and is worth more than merely its
scrap or junk value.
 Scrap/Junk value

If the property cannot be disposed of as a

useful unit, it can often be dismantled and
sold as junk to be used again as a
manufacturing raw material.

The profit obtainable from this type of

disposal is known as the scrap, or junk,
value.
 Present Value
The present value of an asset may
be defined as the value of the asset
in its condition at the time of
valuation.

There are several different types of

present values, and the standard
meanings of the various types should
be distinguished
Book Value/Unamortized
Cost
The difference between the original cost
of a property, and all the depreciation
charges made to date is defined as the
book value (sometimes called
unamortized cost). It represents the
worth of the property as shown on the
owners accounting records.
 Market Value
The price which could be obtained for
an asset if it were placed on sale in the
open market is designated as the
market value. The use of this term
conveys the idea that the asset is in
good condition and that a buyer is
readily available
 Replacement Value
The cost necessary to replace an
existing property at any given time
with one at least equally capable of
rendering the same service is known
as the replacement value.
 Methods For Determining
Depreciation
Depreciation costs can be determined by a
number of different methods, and the design
engineer should understand the bases for the
various methods.
Depreciation accounting methods may be
divided into two classes:
Arbitrary methods giving no consideration to
interest costs.
Methods taking into account interest on the
investment
 Arbitrary methods

Straight-line
Declining-balance
Sum-of-the-years-digits methods
 Methods taking into account
interest
Sinking-fund
The present-worth methods.
 Straight-Line Method
It is assumed that the value of the property
decreases linearly with time. Equal amounts are
charged for depreciation each year throughout the
entire service life of the property.

It is calculated by taking the purchase or acquisition

price of an asset subtracted by the salvage value
divided by the total productive years/useful life the
asset can be reasonably expected to benefit the
company.
 Multiple Straight-line
Depreciation.
Because it is impossible to estimate exact
service lives and salvage values when a
property is first put into use, it is sometimes
desirable to re estimate these factors from time
to time during the life period of the property.

If this is done, straight-line depreciation can be

assumed during each of the periods, and the
overall method is known as multiple straight-
line depreciation.
Unit-of-production or Service
Output Method