Depreciation

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 Introduction

 Calculation Fundamentals
Depreciations:
 Straight Line

 Sum of Years Digits

 Declining Balance

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 Depreciation
Depreciation is important because it affects the taxes that firms pay.
TAXES proportional to TAXABLE INCOME (PROFIT – COSTS)
COSTS = Maintenance Cost + Depreciated Initial Cost
Roughly speaking,
depreciation is a decrease in value of an asset each year.
Example
• A firm has 1,000,000 of taxable income. If its tax rate is 25%, it would pay
250,000 in taxes ignoring depreciation.
• If it can deduct 50,000 in depreciation charges, its net taxable income will
be 950,000. Thus, it would pay taxes of 0.25 (950,000) = 237,500.
• Depreciation saves 250,000 – 237,500 = 12,500 = 0.25(50,000). If it could
deduct more than 50,000 it would pay even less taxes.
• Individual investors encounter similar situations. If you invest 10,000 and
get a 10% return, your taxable income is 1,000.
If you are in the 25% tax bracket, the government takes 250, so your net
return is 750  7.5%.
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 Depreciation
Market value is the value others would
place on the property of interest
Depreciation can mean
 a decrease in market value,
 a decrease in the value to the owner.

Important reasons for depreciation include

 deterioration, A machine can begin to wear out and
no longer perform its function as well as
 obsolescence. when it was new.

Accountants define depreciation as follows:

the systematic allocation of the cost of an asset over its useful, or
depreciable, life.

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Depreciation: Requirements

In general business assets can only be depreciated if

they meet the following basic requirements:
 The property must have a useful life that can be determined, and
this life must be longer than one year

 The property must be an asset that decays, gets used up, wears
out, becomes obsolete, or loses value to the owner due to
natural causes

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Depreciation: Overview

Definition
 The number of years over which a machine is depreciated is
called its depreciable life

 Depreciation is a business expense the government allows

to offset the loss in value of business assets.

 Depreciation deductions reduce the taxable income of

businesses and thus reduce the amount of tax paid.

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 Depreciation Calculation Fundamentals

Example. Year Depreciation Book Value

(dt ) (BVt )
A PC costs 1,800. Its annual
0 1,800
depreciation charges are 800, 600,
and 350 for three years. 1 800 1,000
2 600 400
3 350 50
 1,800 is called the cost, initial cost, or cost basis.
 dt denotes the depreciation deduction in year t.
 Thus d1 = 800, d2 = 600, d3 = 350.
 BVt denotes the book value at the end of year t.

BV0 = cost basis (e.g., 1,800)

BV1 = BV0 – d1 = cost basis – d1 (e.g., 1,000)
BV2 = BV1 – d2 = cost basis – (d1 + d2) (e.g., 400)
BV3 = BV2 – d3 = cost basis – (d1 + d2 + d3) (e.g., 50)

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Depreciation Calculation Fundamentals
BVt = cost basis – (d1 + d2 + … + dt)
This equation is used to compute the book value of an asset at the end
of any time t.
Book value can be viewed as the remaining unallocated cost of an asset:

Book value = Cost – Depreciation charges made to date

Note:
If the item has a salvage value then the final book value will be the
salvage value.
Example:

The book value of the PC declines during the useful life from a value of

B = 1,800 at time 0 in the recovery period, to a value of S = 50 at time 3

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Depreciation Methods

Some of the common methods used to calculate

deprecation included

 Straight line,

 Sum-of-the-years digits, and

 Declining balance.
Each method requires estimates of the asset’s useful life and

salvage value.

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 Straight Line (SL) Depreciation
Year Initial Book Depr. EOY Book
Value Charge Value
Example 0 900
An asset has a cost of B = 900, 1 Cost = 900 166 734
a useful life of N = 5 years, and 2 734 166 568
an EOL salvage value of 3 568 166 402
S = 70. 4 402 166 236
5 236 166 Salvage Value
With straight line depreciation, 70
we would compute the Total Depr.: 830
following: Initial
Book Value Cost
Annual depreciation charge: 900
di = (B-S)/N
Salvage
= 830/5 = 166. Value

The book value of the asset

70
decreases by $166 each year
1 2 3 4 5 N
Useful Life 10
 Sum-Of-Years Digits (SOYD) Depreciation
Example
An asset has a cost of B = 900, a useful life of N = 5 years, and an
EOL salvage value of S = 70. With SOYD depreciation, we would
compute the following
Year Life Multiplier B-S Depreciation Charge EOY Book Value
0 900
1 5 5/15 830 277 623
2 4 4/15 830 221 402
3 3 3/15 830 166 236
4 2 2/15 830 111 125
5 1 1/15 830 55 70

15 1 830

The product of the multiplier and B-S for the year is the depreciation charge
for the year. Note the multipliers add to 1.

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Sum-Of-Years Digits (SOYD) Depreciation
dt=(N+1-t)/SOYD(B-S)= 2(N+1-t)/[N(N+1)](B-S)

SOYD depreciation causes larger decreases in book value in earlier

years than in later years.

Book Value SOYD Depreciation

looks like this.

Salvage value N

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Declining Balance Depreciation
For straight line depreciation with N years, the rate of decrease each year is 1/N.
Declining balance depreciation uses a rate of either 150% or 200% of the straight-line
rate.
Since 200% is twice the straight-line rate, it is called double declining balance (DDB).
The DDB equation for any year is

DDB depreciation dt = (2/N) ( Book value)

Book value = Initial cost – total charges to date,
So,
DDB deprec. dt = (2/N) (Initial cost – total charges to date)
It can be shown for DDB, that the depreciation schedule in year t is given by:
DDB depreciation in year t = (2B/N)(1 – 2/N)t-1
For 150% declining balance depreciation, the depreciation in year t is given by:
DDB depreciation in year t =(1.5 B/N)(1 – 1.5/N)t-1.
we just replace each “2” in the DDB formula by “1.5”.

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Declining Balance Depreciation: Example
Example
An asset has a cost of B = 900, a useful life of N = 5 years, and an EOL
salvage value of S = 70. With DDB depreciation, we would compute the
following
Year Multiplier Cost – Depreciation EOY
depreciation Charge Book
charges to date Value
0 900
1 2/5 900 360 540
2 2/5 540 216 324
3 2/5 324 130 194
4 2/5 194 78 116
5 2/5 116 46 70
830

If the salvage value of this example had not been 70, a modification of DDB would be
necessary.
Several possibilities exist:
• stop further depreciation when the book value equals the salvage value;
• “switch over” from DB depreciation to straight line.
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Exercise

• An equipment costs 10,000 birr with a salvage value of 2,000

birr. Useful life of the item in taxpayer’s hands is 5 years.
Calculate, the depreciation value in the useful life this
equipment using all the three methods

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Thank you

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