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Depreciation: Definition of Terms

Depreciation is the reduction in value of an asset over its useful life. It is calculated using various methods to allocate an asset's cost over its book value over time. Common depreciation methods include straight-line, which allocates depreciation equally over the asset's life, and declining balance, which allocates a higher percentage of depreciation in early years. Depreciation aims to match an asset's cost to the periods that benefit from its use.

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53 views6 pages

Depreciation: Definition of Terms

Depreciation is the reduction in value of an asset over its useful life. It is calculated using various methods to allocate an asset's cost over its book value over time. Common depreciation methods include straight-line, which allocates depreciation equally over the asset's life, and declining balance, which allocates a higher percentage of depreciation in early years. Depreciation aims to match an asset's cost to the periods that benefit from its use.

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Glyzel Dizon
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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DEPRECIATION

Depreciation is the reduction of fall in the value of an asset or physical property


during the course of its working life and due to the passage of time. The method used to
depreciate an asset is a way to account for the decreasing value of the asset to the owner and
to represent the diminishing value (amount) of the capital funds invested in it. In simpler terms,
it is the decrease in value of physical property due to the passage of time. Depreciation can be
calculated using a variety of methods.
It is a book method (noncash) to represent the reduction in value of a tangible
asset. The method used to depreciate an asset is a way to account for the decreasing value of
the asset to the owner and to represent the diminishing value (amount) of the capital funds
invested in it. The annual depreciation amount is not an actual cash flow, nor does it
necessarily reflect the actual usage pattern of the asset during ownership.
Depreciation basis is that part of the asset’s purchase price that is spread over
the depreciation period (service life).

DEFINITION OF TERMS
a. Value is the present worth of all the future profits that are to be received through the
ownership of a particular property.
b. The market value of a property is the amount, which a willing buyer will pay to a willing
seller for the property where each has equal advantage and I under no compulsion to buy
or sell.
c. Utility or use value of a property is what the property is worth to the owner as an
operating unit.
d. Fair value is the value, which is usually determined by the disinterested third party in order
to establish a price that is fair to be both seller and buyer.
e. Book value, depreciated book value, is the worth of the property as shown in the
accounting records of an enterprise.
f. Salvage value or resale value is the price that can be obtained from the property after it
has been used.
g. Salvage year is the time when the scarp value is equal to the book value.
h. Scrap value or junk value is the price that can be recovered if an asset is dispersed as a
junk.
i. Physical life of a property is the length of time during which it is capable of performing
the function for which it was designed and manufactured.
j. Economic life or useful life is the length of the time during which the property may be
operated at a profit.
PURPOSES OF DEPRECIATION
1. To provide for the replacement of the equipment either at the end of its physical or
economic life or at the time when its operation can no longer results in a satisfactory profit
2. To provide for the recovery of capital, which has been invested in physical property
3. To provide maintenance of capital to replace the decrease in the value of equipment
caused by physical or functional causes
4. To enable the cost of depreciation to be changes to the cost of producing products or
services that results from the use of the property

CAUSES OF DEPERECIATION

A. Physical Depreciation is due to the reduction of the physical ability of an equipment or


asset to produce results.
B. Functional Depreciation is due to the reduction in the demand for the function that the
equipment or asset was designed to render. This type of depreciation is often called
obsolescence.
C. Technological Depreciation
Newly developed means of accomplishing a function ma make the present
means uneconomical. New material improve safety and better quality at lower cost. New
developments make old design.
D. Depletion refers to the decrease in the value of a property due to the gradual extraction of
its contents.

METHODS OF COMPUTING DEPRECIATION

A. Straight Line Method


In this method of computing depreciation, it is assumed that the loss in value is
directly proportional to the age of equipment cost. It is the most common method used
wherein the cost of property is assumed to vary linearly with time.

Annual depreciation charge, d:


V −V s depreciable value
d= =
n economic life

Book value at any given year:


V a =V −d ( a)
Where:
V = original cost
Vs = salvage value
a = depreciable year

B. Sinking Fund Method


In this method, it is assumed that an imaginary fund called sinking fund is
established in which funds will accumulate for replacement purposes. The sinking fund is
invested yearly at a rate of i to amount to (V −V s ) at the end of life of the property.

Depreciation charge for any year, d:


(V −V s)(i)
d=
(1+i)n−1

Total depreciation for a period:


(1+i)a−1
d total =(V −V s)
[ (1+i)n−1 ]
Where:
V = original cost
Vs = salvage value
V - Vs = depreciable value
a = depreciable year
n = economic life

C. Declining Balance Method


In this method, it is assumed that the annual cost of depreciation is a fixed
percentage of the book value at the beginning of the year. This method is sometimes
known as constant percentage method or the Matheson Formula.

Depreciation charge for any year, a:


d a =V (1−k)a −1 k

Book value at year a:


V a =V (1−k )a

Matheson Formula:
Va n Vs
k =1−
√
a

V
¿ 1−
√ V

The value k is the constant percentage or the depreciation factor. Hence, k must be decimal
and a value less than 1. In this method, the salvage or scrap value must not be zero.

Where:
V = original cost
Vs = salvage value
Va = book value at year a
a = depreciable year
n = economic life

D. Double Declining Balance Method


This method is just like the declining balance method. In this method, the rate of
depreciation is now:
2
k=
n

Depreciation charge at any year a:


d a =V (1−k)a −1 k

Book value at the end of any year a:


V a =V (1−k )a
Where:
V = original cost
Va = book value at year a
a = depreciable year
n = economic life
k = depreciation factor

E. Sum-of-Years’ Digit (SYD) Method


This method assumes that the depreciation charge vary directly to the number of
years and inversely to the sum of the year’s digit.

Respective depreciation charges:

2
First year: d 1=(V −V s)
n+1
2(n−1)
Second year: d 2=(V −V s)
n(n+1)
2(n−2)
Third year: d 3=(V −V s)
n(n+1)

Sum of year’s digit, ∑ years:


n(n+1)
∑ years= 2
Depreciation charge at any year:
(n+ 1−a)
d a =(V −V s )
∑ years
Sum of reverse digits form n to (n+1-a):
a (2n+ 1−a)
∑ reverse digits= 2

Total depreciation for a period:

d total =(V −V s)
∑ reverse digits
2 ∑ years
Where:
V = original cost
Vs = salvage value
a = depreciable year
n = economic life

F. Hour Output Method


This method is considered depreciation due to the assets wear and tear,
therefore, decreasing the functionality of the machine. The functionality period and the
period the machine has used are given. The depreciation is directly proportional to the
period the asset has been used and the depreciable amount wherein the constant of
proportionality is the reciprocal of the economic life. In equation:

ha
da= (V −V s)
H
V a =V −d a
Where:
da = depreciation for the period
ha = hours the asset has been used
H = total hours of economic life
V = original cost
Vs = salvage value
Va = book value at year “a”
a = depreciable hour
G. Service Output Method
This method is similar to the hour output method, however, its computation is
based on how much the asset has been used. The equation will be:

Na
da= (V −V s )
N
V a =V −d a
Where:
da = depreciation for the period
Na = hours the asset has been used
N = total hours of economic life
V = original cost
Vs = salvage value
Va = book value at year “a”
a = depreciable hour

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