Depreciation and Depletion

Module 6
Depreciation

• It 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.

• It is the decrease in the value of a property, such as machinery,

equipment, building or other structure, due to long time of service.

• Excluded from this definition are the properties whose values increases
with time , such as antiques, paintings of the masters, rare stamps, rare
coins, and in most cases land.
Depreciation must always be included in the cost of production of
any product or the rendering of any service where equipment is
used for the following reasons:

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 no longer results in a satisfactory profit.
2. To provide for the maintenance of capital to replace the
decrease in the value of equipment caused by physical or
functional causes.
 TYPES OF DEPRECIATION
Decreases in the value of property with the passage of time are due mainly to the following:
(1)Physical depreciation caused by the following:
a. Deterioration due to the effects of various chemical and mechanical factors on
the materials composing the property. Included in this are rusting of metal
parts, decay of wooden parts of a structure, and the discoloration and
cracking of plastic parts.
b. Wear and tear due to abrasion, friction between moving parts of equipment, impact,
vibration, or fatigue of the materials in the property. It is determined by use rather than by age. Sudden physical damage to
a
property due to accidents and disasters, such as fire, flood earthquake, tidal waves and other unforeseen acts of nature are
excluded from the determination of decrease in value.
(2) Functional depreciation which is due to a decrease in the demand for the function
of the equipment for which it was designed. Such depreciation is caused by the
following:
a. Inadequacy of the equipment.
b. Obsolescence caused by the invention of more efficient equipment and machines
to perform the same task.
c. Changes in methods of production.
d. Changes in styles and designs of the goods produced on the equipment.
e. Transfer of population due to various causes.

3. Changes in the price levels of similar property. If price levels rise during the life of a
property, even if the original investment has been recovered through proper
depreciation procedure, the recovered capital will be insufficient to provide an
identical replacement. It is the capital that has depreciated, and not the property.
DEPRECIATION COST

The depreciation cost depends upon the physical or economic life of the equipment
and its first cost.
The physical life of an equipment is the length of time during which it is capable of
performing the function for which it was designed and manufactured.
The economic life of an equipment is the length of time during which it will operate
at a satisfactory profit. Even though the equipment can still perform its function, but if
it can only operate at a loss, then it is considered economically dead. Replacement is
in order.
The life of any property is usually different to determine accurately. In many cases,
the determination of life is independent toa great extent upon the experience of the
men managing the enterprise in the use of similar equipment. For purpose of taxation,
the US Internal Revenue Service has prepared a list of equipment with their
corresponding lives.
DEPRECIATION COST
The first cost of any property includes the original purchase price, freight and
transportation charges to the site, installation expenses, initial taxes and permits to
operate, and all other expenses needed to put the equipment into operation.
The amount to be recovered, equal to the depreciation cost, is the difference
between the first cost and the salvage or scrap value of the equipment.
Salvage value, sometimes called second-hand value, is defined to be the amount
for which the equipment or machine can be sold as second hand. It implies that the
machine can still perform its function.
Scrap or junk value is the amount the equipment can be sold for, when disposed off
as junk. This implies that the equipment cannot be used anymore for the function for
which it was designed.
Requirements for a Depreciation Method
A depreciation method should fulfill the following requirements:
1. Payments to the depreciation fund should be equal to the loss in value due to
depreciation.
2. The method should be simple.
3. Prior to its adoption, approval of the method should be secured from the Bureau of
Internal Revenue.
4. To be satisfactory, the actual value of the equipment should, at all times, be equal
to the book value. It will be necessary from time to time to check the actual value
against the book value, and in case the two values are not in agreement,
adjustments should be made.
Types of Depreciation
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 o render. This type of depreciation is often called
OBSOLESCENCE.
 Methods of Computing Depreciation:
1. Straight Line Method Straight Line Method
a. It is simple and is more widely used than any other Annual Depreciation, d
method. 𝑪𝒐 − 𝑪𝒏
𝒅=
b. It does not need annuity tables nor computing 𝒏
machines for using it. Book value at the end of “m” years of using; cm
c. It gives a uniform annual charge. Cm  Co  Dm
d. It is acceptable to the Bureau of Internal Revenue.
e. It does not take into account the interest or profit where: Co = 1st cost
earned on on the accumulated depreciation fund. Cn = cost after “n” years
Likewise, operation and maintenance costs are = salvage/scrap value
disregarded. n = life of property
Dm = total depreciation after “m” years
Dm = d(m)
2. Sinking Fund Method
a. It is also relatively simple, though it will require the use of annuity tables in the absence of the
electronic calculator.
b. It also gives a uniform annual charge.
c. A sinking fund is created in which funds accumulate for replacement purposes.
d. All amounts in the sinking fund earn interest.
e. Usually the company uses the amount accumulated in its operations, and therefore
the amount in the fund is assumed to earn a certain profit or interest.
f. It is generally the method used for economy
study purposes.

d
 Co  Cn  i
Annual Depreciation Charge, d
1  i   1
n

Book value at the end of “m” years of using, Cm

Cm  Co  Dm

where :
d 1  i   1
m

Dm =  
i
3. Decline Balance Method
a. The basic method assumption for this method is that the annual cost of
depreciation is a constant percentage of the salvage value at the beginning of
the year.
b. The annual depreciation charges, different each year, decrease from year to
year,
greatest during the first year and least in the last year of life of the property.
c. With this formula, however, a property can never depreciate to zero value.
Matheson Formula
Cn Cm
K  1 n or K = 1 - m
Co Co

The value of K is the constant percentage. K must be decimal and value less
than 1. In this method, the salvage/scrap value must not be zero.
4. Sum-of-years Digit (SYD) Method
a. It provides very rapid depreciation during the early years of life of the property,
and therefore enables faster recovery of capital.
b. It is easier to use than the Matheson Formula.
c. Properties can be depreciated to zero value.
d. The basic assumption for the method is that the value of the property decreases
at a decreases at a decreasing rate.

Respective Depreciation Charges: Book value at the end of "m" years of using Cm
n
1st year: d1 = (Co - Cn ) Cm = Co - (d1 + d2 + d3 + d4 + ... dn)
 years
n  n  1
2nd year: d2 =(Co - Cn )
n 1
 years
 years  2
n2
3rd year: d2 =(Co - Cn )
 years
Depletion
Certain natural resources such as mines,quarries, oil and gas wells, and
timber lands are called “wasting” or “depleting” assets due to the gradual
extraction of the contents of such properties. To provide for the recovery
of capital invested in such assets, a depletion fund is provided. The annual
charge set aside in the fund is called depletion cost rather than
depreciation cost.
It is usual practice to return annually a part of the investment of each
investor instead accumulating a depletion fund. The yearly amount paid to
an investor consists of two parts: part of the capital invested and the
dividends or profit of the investor.
Methods in computing Depletion charge for a year
1. Unit or factor Method
The depletion charge depends upon the initial cost of the property and number of
units in the property.
Depletion =

2. Percentage or Depletion Allowance Method

Depletion = Fixed Percentage of Gross Income
or
Depletion = 50% of the net taxable income
Note: use the smaller depreciation charge
Problem 1:
A machine cost P100,000 and estimated life of 10 years,
with a salvage value of P5,000. What is the book value after 5
years using.
A. Straight line method
B. Sinking fund method with i=10%
C. Declining balance method
D. Sum-of-years digit method
A. Straight line method
Soln:
Co = 100,000 d= Cm = Co – Dm
Dm = d(m)
Cn = 5,000 = = 100,000 – 47,500
= 9,500 (5)
n = 10 years d = P9,500 Cm = P52,500
Dm = P47,500
m = 5 years
Cm = ?
B. Sinking fund method with i = 10%
Soln:
Dm =
d= =
Dm = P36,391.34
=

d = 5,960.81
 Period
C. Declining balance
0 100,000
method
1 0.259(100,000) =25,900 74,100
K=1-
2 0.259(74,100) =19,191.9 54,908.10
=1- 3 0.259(54,908.10)=14,221.20 40,686.90
= 0.259 4 0.259(40,686.90)=10,537.91 30,148.99
5 0.259(30,148.99)=7,808.59 22,340.4
D. Sum-of-years digit method
d4 =

=
d2 =
d4 = 12,090.91
=
=
= 55 d2 = 15,545.45 d5 =

=
d1 =
d3 = d3 = 10,363.64

=
= Cm = Co – (d1+d2+d3+d4+d5)

d1 = 17,272.73 = 100,000 -
d3 = 13,818.18
Cm = P30,909.10
Problem 2:
Shell Phils has a total gross income for a particular year of
P500,000,000.00. The taxable income after taking all
deductions except for depletion is P185,000,000. What is the
allowable allowance for that particular year? Take percentage
of gross income for oil ass 22%.
Soln:
Using depletion allowance method
depletion charge = 0.22(500,000,000)
= 110,000,000

depletion charge = 50% (185,000,000)

= 92,500,000

* The allowance depletion charge = P92,500,000

Problem 3:
An oil company developed an oil well which is estimated to
contain 5,000,000 barrels of oil at an initial cost of 5 billion. What
is the depletion charge during the year where it produces half
million barrel of oil? Use unit or factor method in computing
depletion.

Soln:
total depletion charge =
= 500,000,000