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Lesson 5

This document discusses various depreciation concepts and methods. It defines depreciation as the decrease in value of physical assets over time and use. It then describes the straight-line, declining balance, and units-of-production depreciation methods. Examples are provided to demonstrate how to calculate annual depreciation amounts and book values for assets using each method. The document also discusses switching from declining balance to straight-line depreciation to fully depreciate an asset's cost basis over its useful life.

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205 views12 pages

Lesson 5

This document discusses various depreciation concepts and methods. It defines depreciation as the decrease in value of physical assets over time and use. It then describes the straight-line, declining balance, and units-of-production depreciation methods. Examples are provided to demonstrate how to calculate annual depreciation amounts and book values for assets using each method. The document also discusses switching from declining balance to straight-line depreciation to fully depreciate an asset's cost basis over its useful life.

Uploaded by

raman68
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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EKC 457

ENGINEERING ECONOMY
Depreciation Concepts and Terminology
Depreciation is the decrease in value of physical properties with the passage
of time and use.

Basis or cost basis


Book value (BV)
Market value (MV)
Salvage value (SV)

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The Classical (Historical) Depreciation Methods
Straight-Line (SL) Method

SL depreciation is the simplest depreciation method. It assumes that a constant


amount is depreciated each year over the depreciable (useful) life of the asset.

N = depreciable life (recovery period) of the asset in years


B = cost basis, including allowable adjustments
dk = annual depreciation deduction in year k(1 ≤ k ≤ N)
BVk = book value at end of year k
SVN = estimated salvage value at end of year N (market value)
d∗k = cumulative depreciation through year k

dk = (B − SVN)/N
dk∗ = k · dk for 1 ≤ k ≤ N
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BVk = B − d∗k
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Ex 1/ A tool has a cost basis of $200,000 and a 5 years depreciable life. The
estimated SV of is $20,000 at the end of 5 years. Determine the annual
depreciation amounts using the SL method. Tabulate the annual depreciation
amounts and the book value at the end of each year.

depreciation amount:

cumulative depreciation:

BV:

Note that the BV at the end of the depreciable life

is equal to the SV used to calculate the yearly

depreciation amount. 5
Declining-Balance (DB) Method

In the DB method (aka the constant-percentage method, the Matheson Formula,


reducing-balance depreciation) it is assumed that the annual cost of
depreciation is a fixed percentage of the BV at the beginning of the year.

The ratio of the depreciation in any one year to the BV at the beginning of the
year is constant throughout life of the asset and is designated by R (0 ≤ R ≤ 1).

In this method, R = 2/N when a 200% DB is being used (i.e., twice the SL rate of
1/N), and N equals the depreciable (useful) life of an asset. If the 150% DB
method is specified, then R = 1.5/N.

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Ex 2/ A tool has a cost basis of $4,000 and a 10-year depreciable life. The
estimated SV is zero at the end of 10 years. Use the DB method to calculate the
annual depreciation amounts and tabulate the annual depreciation amount and
BV for each year, when:

(a) R = 2/N (200% DB method)


(b) R = 1.5/N (150% DB method)

8
DB with Switchover to SL

Because the DB method never reaches a BV of zero, it is permissible to switch


from this method to the SL method so that an asset’s BVN will be zero (or some
other determined amount, such as SVN). Also, this method is used in calculating
the Modified Accelerated Cost Recovery System (MACRS) recovery rates (shown
later in Table 7-3).

The following table illustrates a switchover from double DB depreciation to SL


depreciation for Ex 2. The switchover occurs in the year in which an equal or a
larger depreciation amount is obtained from the SL method.

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It is apparent that d6 = $262.14. The BV at the end of year 6 (BV6) is $1,048.58.
Additionally, observe that BV10 is $4,000−$3,570.50 = $429.50 without
switchover to the SL method. With switchover, BV10 equals zero.
It is clear that this asset’s dk, d∗k , and BVk in years 7 through 10 are established
from the SL method, which permits the full cost basis to be depreciated over the
10-year recovery period.

The 200% DB Method with


Switchover to the SL Method
(Ex 2)

10
Units-of-Production Method

All the depreciation methods discussed to this point are based on elapsed time
(years) on the theory that the decrease in value of property is mainly a function
of time.

When the decrease in value is mostly a function of use, the units-of-production


method is normally used in this case.

This method results in the cost basis (minus final SV) being allocated equally
over the estimated number of units produced during the useful life of the asset.

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Ex 3/ A piece of equipment has a basis of $50,000 and is expected to have a
$10,000 SV when replaced after 30,000 hours of use. Find its depreciation rate
per hour of use, and find its BV after 10,000 hours of operation.

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