Module 5

DEPRECIATION

DEPRECIATION is the
INTENDED LEARNING OUTCOMES decrease in the value of physical
property with the passage of time.
At the end of the lesson, the students must
be able to: VALUE , in a commercial
sense, is the present worth of all
(a) Gain understanding of the basic concepts future profits that are to be
of depreciation; received through ownership of a
(b) Make out a table showing the yearly and particular property.
total depreciation as well as the book
MARKET VALUE of a
values of the asset at the beginning and
property is the amount which a
end of period ; and willing buyer will pay to a willing
(c) Find interest in learning the lessons. seller for the property where each
has equal advantage and is under
no compulsion to buy or sell.

UTILITY OR USE VALUE of a property is what the property is worth to the owner as
an operating unit.

FAIR VALUE is the value which is usually determined by a disinterested third party in
order to establish a price that is fair to both seller and buyer.

BOOK VALUE, sometimes called depreciated book value, is the worth of a property as
shown in the accounting records of an enterprise.

SALVAGE, or RESALE, VALUE is the price that can be obtained from the sale of the
property after it has been used.

SCRAP VALUE is the amount the property would sell for if disposed off as junk.

PURPOSES OF DEPRECIATION

1) To provide for the recovery of capital which has been invested in physical property.
2) To enable the cost of depreciation to be charged to the cost of producing products or
services that results from the use of the property.

Types of Depreciation

1) Normal depreciation
a) Physical

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 b) Functional
2) Depreciation due to changes in price level
3) Depletion

Physical depreciation is due to the lessening of the physical ability of the property to
produce results. Its common causes are wear and deterioration. Functional depreciation is
due to the lessening in the demand for the function which the property was designed to
render. Its common causes are inadequacy, changes in styles, population center shift,
saturation of markets or more efficient machines are produced.

Depreciation due to changes in price levels is almost impossible to predict and therefore
is not considered in economy studies.

Depletion refers to the decrease in the value of a property due to the gradual extraction of
its contents.

Physical and Economic Life

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

Economic life is the length of time during which the property may be operated at a profit.

Requirements of a Depreciation Method

1. It shall be simple.
2. It should recover capital.
3. The book value will be reasonably close to the market value at any time.
4. The method should be accepted by the Bureau of Internal Revenue.

Depreciation Methods

1. Straight Line Method

2. Sinking Fund Method
3. Declining Balance Method
4. Double Declining Balance Method
5. Sum-of-the years digit Method
6. Service-Output Method

We shall use the following symbols for the different depreciation methods:

L = useful life of the property in years

Co = the original cost

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 CL = the value at the end of the life, the scrap value (including gain or loss due to removal)
d = the annual cost of depreciation
Cn = the book value at the end of n years
Dn = depreciation up to age n years

THE STRAIGHT LINE METHOD

This method assumes that the loss in value is directly proportional to the age of the
property.

Co −¿ C
d= L
¿
L

Dn = n d = n ¿ ¿
Cn = Co - Dn

APPLICATIONS/EXERCISES

An electronic balance costs P90,000 and has an estimated salavage value at the end of its 10
years of life time. What would be the book value after three years, using the straight line
method in solving for the depreciation (1989 Ch.E. Board Problem).

Solution:
Co = P90,000 CL= P8,000 L = 10 n=3

Co −¿ C
d= L
¿
L

P 90,000−P 8,000
d= = P8,200 Annual depreciation
10
Dn = n d

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 D3 = 3 d = 3 (P8,200) = P24,600 Total depreciation after 3 years

Cn = Co - Dn
C3 = Co – D3 = P90000 – P24,600 = P65,400 Book value at the end of 3 years

Alternative Solution:
YEAR BV AT DEPRECIATION TOTAL BV AT
BEGINNING DURING THE YEAR DEPRECIATION END OF
OF YEAR d D YEAR
1 90,000 8,200 8,200 81,800
2 81,800 8,200 16,400 73,600
3 73,600 8,200 24,600 65,400
4 65,400 8,200 32,800 57,200
5 57,200 8,200 41,000 49,000
6 49,000 8,200 49,200 40,800
7 40,800 8,200 57,400 32,600
8 32,600 8,200 65,600 24,400
9 24,400 8,200 73,800 16,200
10 16,200 8,200 82,000 8,000

THE SINKING FUND FORMULA

This method assumes that a sinking fund is established in which funds will accumulate
for replacement. The total depreciation that has taken place up to any given time is assumed to be
equal to the accumulated amount in the sinking fund at the same time.
Dn Co-CL
0 1 2 3 n L
---------

d d d d d

C o−¿C
d= L
¿
F / A ,i %, L
Dn = d (F/A,i%, n)

Cn = Co - Dn

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 APPLICATIONS/EXERCISES

1) A broadcasting corporation purchased an equipment for P53,000 and paid P1,500

for freight and delivery charges to the job site. The equipment has a normal life of
10 years with a trade-in value of P5,000 against the purchase of a new equipment at
the end of the life.
(a) Determine the annual depreciation cost by the straight line method
(b) Determine the annual depreciation cost by the sinking fund method. Assume
interest at 6.5% compounde annually
(1975 ECE Board Problem)
Solution:
Co = P53,000 +P1,500 = P54,500 CL= P5,000 L = 10
(a) Using the Straight Line Method
Co −¿ C
d= ¿ L

P 54,500−P5,000
d= 10
= P4,950

(b) Using the Sinking Fund Method

C o−¿C
d= L
¿
F / A ,i %, L

P 54,500−P5,000
d=
F / A , 6.5 % , , 10

P 54,500−P5,000
d = ( 1+0.065 )10−1
[ ]
0.065

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 P 49,500
d=
13.3846
= P3,668

2) A firm bought an equipment for P56, 000. Other expenses including installation
amounted to P4,000. The equipment is expected to have a life of 16 years with a
salvage value of 10% of the original cost. Determine the book value at the end of 12
years by (a) straight line method and (b) sinking fund method at 12% interest.

Solution:
Co = P56,000 +P4,000 = P60,000 CL= P60,000(0.10) =P6,000
L = 16 n = 12 i = 12%

(a) Using the Straight Line Method

Co −¿ C
d= ¿ L

P 60,000−P 6,000
d= 16
= P3,375 Annual depreciation

D12 = 12 d = 12 (P3,375) = P40,500 Total depreciation after 12 years

Cn = Co - Dn
C3 = Co – D3 = P60000 – P40,500 = P19,500 Book value at the end of 12 years

(b) Using the Sinking Fund Method

C o−¿C
d= L
¿
F / A ,i %, L

P 60,000−P 6,000
d=
F / A , 12 % , , 16

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 P 60,000−P 6,000
d = ( 1+0.12 )12−1
[ ]
0.12
P 54,000
d=
42.7533
= P1,263 Annual depreciation

Dn = d (F/A,i%, n)

( 1+0.12 )12−1
D12 = d (F/A,12%, 12) = P 1,263[ ]
0.12
D12 = P1,263 (24.1331) = P30,480 Total depreciation after 12 years

Cn = Co - Dn
C12 = Co – D12
C12 = P60,000 – P30,480 = P29,520 Book value after 12 years

DECLINING BALANCE METHOD

In this method, sometimes called the constant percentage method or the Matheson
Formula, it is assumed that the annual cost of depreciation is a fixed percentage of the salvage
value at the beginning of the year. The ration of the depreciation in any year to the book value at
the beginning of that year is constant throughout the life of the property and is designated by k,
the rate of depreciation.
YEAR BV AT DEPRECIATION TOTAL BV AT END OF YEAR
BEGINNING DURING THE DEPRECIATION
OF YEAR YEAR D
d
1 Co d1 = k Co d1 C1= Co-d1 = Co(1-k)
2 Co (1-k) d2 = k C1 d1+ d2 C2= C1-d2 = Co(1-k)2
3 Co (1-k)2 d3 = k C2 d1+ d2+ d3 C3= C2-d3 = Co(1-k)3
... ... ... ... ...
n Co (1-k)n-1 dn = k Cn-1 d1+ d2+ d3+ …+ dn Cn= Cn-1-dn = Co(1-k)n
... ... ... ..
L Co (1-k)L-1 dL = k CL-1 d1+ d2+ d3+ …+ dL CL= CL-1-dL = Co(1-k)L

dn = Co (1-k) n-1 k

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Cn = Co (1-k) n = Co ¿
CL = Co (1-k) L

k=1 -
√
n Cn
Co
=1 -
√
L CL
Co

This method does not apply if the salvage value is zero, because k will be equal to one and d1
will be equal to Co.

APPLICATIONS/EXERCISES

A certain type of machine loses 10% of its value each year. The machine costs P2000
originally. Make out a schedule showing the yearly depreciation, the total depreciation and
the book value at the end of each year for 5 years. (1978 ME Board Problem).

Solution:
YEAR BV AT DEPRECIATION TOTAL BV AT END OF YEAR
BEGINNING DURING THE DEPRECIATION
OF YEAR YEAR D
d
1 2,000.00 200.00 200.00 1,800.00
2 1,800.00 180.00 380.00 1,620.00
3 1,620.00 162.00 542.00 1,458.00
4 1,458.00 145.80 687.80 1,312.20
5 1312.20 131.22 819.12 1,180.98

DOUBLE DECLINING BALANCE (DDB) METHOD

This method is very similar to the declining balance method except that the rate of
depreciation k is replaced by 2/L.

2 2
dn = Co (1- L ) n-1 L

2
Cn = Co (1- L ) n

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 2
CL = Co (1- L ) L

APPLICATIONS/EXERCISES

1) Determine the rate of depreciation, the total depreciation up to the end of the 8 th
year and the book value at the end of 8 years for an asset that costs P15,000 new and
has an estimated scrap value of P2,000 at the end of 10 years by (a) the declining
balance method and (b) the double declining balance method.

Solution:
Co = P15,000 CL= P2,000 L = 10 n=8

(a) Declining Balance Method

k= 1 -
√
L CL
Co
=1 -
√
10 P 2,000
P 15,000
= 0.1825 or 18.25% Rate of depreciation

Cn = Co (1-k) n
C8 = P15,000 (1-0.1825) 8 = P2,992.22 Book value at end of 8th year

Cn = Co - Dn
Dn = Co - Cn
D8 = Co – C8
D8 = P15,000 – P2,992.22 = P12,007.78 Total depreciation at end of 8th year

(b) Double Declining Balance Method

2 2
k=
L
= 10
= 0.20 Rate of depreciation

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 2
Cn = Co (1- L ) n

2
C8 = P15,000 (1- 10 ) 8 =P2,516.58 Book value at end of 8th year

D8 = P15,000 – P2,516.58 = P12,483.42 Total depreciation at end of 8th year

2) A plant bought a calciner for P220,000 and used it for 10 years, the life span of the
equipment. What is the book value of the calciner after 5 years of use? Assume a
scrap value of P20,000 for straight line method; P22,000 for declining balance
method and P20,000 for double declining balance method (1974 Ch.E. Board
Problem).

Solution:
Co = P220,000 L = 10 n=5

(a) Straight Line Method

CL = P20,000

Co −¿ C
d= L
¿
L

P 220,000−P 20,000
d= 10
= P20,000 Annual depreciation

D5 = 5 d = 5 (P20,000) = P100,000 Total depreciation after 5 years

Cn = Co - Dn
C5 = Co – D5 = P220000 – P100,00 = P120,000 Book value at the end of 5 years

(b) Declining Balance Method

CL = P22,000

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 Cn = C o ¿
C5 = P220,000 ¿ =P69,570
(c) Double Declining Balance Method

CL = P20,000

Cn = C o ¿
C5 = P220,000 ¿ =P72,090

SUM-OF-THE-YEARS DIGITS (SYD) METHOD

Let dn = depreciation charge during the nth year
dn = (depreciation factor)(total depreciation)

reverse digit
dn =
∑ of digits (Co - CL)

For example, for a property whose life is 5 years:

Year Year in Depreciation Factor Depreciation During
Reverse Order the Year
1 5 5/15 (5/15) (Co - CL)
2 4 4/15 (4/15) (Co - CL)
3 3 3/15 (3/15) (Co - CL)
4 2 2/15 (2/15) (Co - CL)
5 1 1/15 (1/15) (Co - CL)
∑of digits = 15

APPLICATIONS/EXERCISES

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 1. A structure costs P12,000 new. It is estimated to have a life of 5 years with a salvage
value at the end of life of P1,000. Determine the book value at the end of each year
of life.

Solution:

Co - CL = P12,000 – P1,000 = P11,000

Year Year in Depreciation During the Total BV at End of
Reverse Year Depreciation Year
Order
1 5 (5/15) (P11,000)=P3,666.67 3,666.67 8,333.33
2 4 (4/15) (P11,000)=P2,933.33 6,600.00 5,400.00
3 3 (3/15) (P11,000)=P2,200.00 8,800.00 3,200.00
4 2 (2/15) (P11,000)=P1466.67 10,266.67 1,733.33
5 1 (1/15) (P11,000)=P 733.33 11,000.00 1000.00
∑of digits = 15

2. A consortium of international communications companies contracted for the

purchase and installation of a fiber optic cable linking two major cities at a total
cost of US$ 960 million. This amount includes freight and installation charges
estimated at 10% of the above contract price. If the cable shall be depreciated over a
period of 15 years with zero salvage value:
(a) Given the sinking fund deposit factor of 0.0430 at 6% interest where n = 15,
what is the annual depreciation charge?
(b) What is the depreciation charge during the 8 th year using the sum-of-the-years
digits method? (1989 ECE Board Problem).

Solution:
Co = $960,000,000 CL = 0 L = 15
(a) Using the Sinking Fund Method

C o−¿C
d= L
¿ = (C o−¿C ¿ (A/F,i%, n)
F / A ,i %, L L

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 ( 1+0.06 )15−1
d = ( $ 960,000,000−0 ¿ [ ]
0.06
d = ( $ 960,000,000 ¿ ¿0) =$ 41,280,000

(b)Sum-of-the-Years Digits Method

L(L+ 1) 15(15+1)
Sum of digits = = = 120
2 2
Reverse digit corresponding to the 8th year of life = 8

reverse digit
dn =
∑ of digits (Co - CL)

8
d8 = ( $ 960,000,000) = $ 64,000,000
120

THE SERVICE-OUTPUT METHOD

This method assumes that the total depreciation that has taken place is directly
proportional to the quantity of output of the property up to that time. This method has the
advantage of making the unit cost of depreciation constant and giving low depreciation expense
during periods of low production.

Let T = total units of output up to the end of life

H = total working hours up to the end of life

Qn = total number of units of output during the nth year

Hn = total working hours during the nth year

Depreciation per unit of output = ¿ ) (Qn)

Depreciation per unit of service = ¿ ) (Hn)

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 APPLICATIONS/EXERCISES

A Television Company purchased machinery for P100,000 on July 1, 1979. It is

estimated that it will have a useful life of 10 years; scrap value of P4,000, production of
400,000 units and working hours of 120,000.
The company uses the machinery for 14,000 hours in 1979 and 18,000 hours in 1980.
The machinery produces 36,000 units in 1979 and 44,000 units in 1980. Compute the
depreciation for 1980 using each method given below:
(a) Straight line
(b) Working hours
(c) Output method
(1981 ME Board Problem)

Solution:
Co = P100,000 CL = 4,000 L = 10 years
T =400,000 units H = 120,000 hours

(a) Using Straight Line Method

Co −¿ C
d= L
¿
L

P 100,000−P 4,000
d1980 = 10
= P9,600

(b) Working Hours Method

d1980 = ¿ ) (Hn)

d1980 = ¿ ) (18,000) = P14,400

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 (c) Output Method

Depreciation per unit of output = ¿ ) (Qn)

d1980 = ¿ ) (44,000) = P10,560

EVALUATION

A machine costs P120,000 lasts 10 years and has a salvage value at the end of life of
P20,000. Make out a schedule showing the annual and total depreciation and the book
value at the beginning and end of year by the (a) straight line method, (b) declining balance
method, (c) double declining method, (d) SYD method, (e) sinking fund method with
interest at 12%, (f) service method with a 25,000 total working hours having 2,500 hours
per year, and (g) output method with total production of 4,000,000 units having 4,000 units
per year.

READINGS/ADDITIONAL INFORMATION

Balance Sheet and Income Statement

REFERENCES

De Garmo, E.P.; W. Sullivan and J. Canada.1984. Engineering Economy (7th Edition).EDCA

Publishing&Distributing Corporation.

Sta. Maria, H. 1993. Engineering Economy 2nd Edition. National Book Store, Inc.

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