Module 4

DEPRECIATION
Definition of Terms

 Depreciation – it is the decrease in the value of a

fixed asset, or the value of physical property, with the
passage of time.
 Value – is the present worth of all the future profits
that are to be received through the ownership of a
particular property.
 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 is under
no compulsion to buy and sell.
Definition of Terms
 Utility or Use Value of Property – is what the property is
worth to the owner as an operating unit.
 Fair Value – is the value which is usually determined by
the disinterested third party in order to established a price
that is fair to both seller and buyer.
 Book Value – is the worth of the property as shown in the
accounting records of an enterprise. It is sometimes called
as depreciated book value.
 Salvage or Resale Value – is the price that can be
obtained from the property after it has been used. Salvage
Year is the year when scrap value is equal to book value.
 Scrap Value or Junk Value – is the price that can be
recovered if an asset is disposed as a 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 property.
Causes of Depreciation

 Physical Depreciation – it is due to

wear and tear of the asset.
 Functional Depreciation – it is due to
the obsolescence of the asset.
 Depletion – refers to the decrease in
the value of a property due to the
gradual extraction of its contents.
 Monetary Depreciation – depreciation
due to changes in price level.
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 or Useful Life – is the
length of time during which the
property may be operated at a profit.
Methods Used to
Determine Depreciation

1. Straight Line Method

2. Declining Balance Method
3. Double Declining Balance Method
4. Sum-of-Years’ Digit Method
5. Sinking Fund Method
6. Hour Output Method
7. Service Output Method
Depreciation Methods

We shall use the following symbols for different depreciation methods.

 
L = useful life of the property in years
Co = the original cost
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

8
 1. The Straight Line Method
The method assumes that the loss in value is directly proportional
to the age of the property.
is the simplest depreciation method. It assumes that a
constant amount is depreciated each year over the depreciable (useful) life
of the asset
 

Cn = CO – Dn

L = useful life of the property in years

Co = the original cost
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 9

Dn = depreciation up to age n years

Example
An electronic balance costs P90,000 and has an estimated salvage value of
P8,000 at the end of 10 years life time. What would be the book value after
three years, using the straight line method in solving for the depreciation?

10
A machine shop purchased 10 years ago a milling machine for P60,000. A straight-line
depreciation reserve had been provided based on a 20-year life of the machine. The
owner of the machine shop desires to replace the old milling machine with a modern
unit having many advantages costing P100,000. It can sell the old unit for P20, 000.
How much new capital will be required for the purchase?

Solution:

11
Straight Line Method
The straight line method is the simplest way in
computing for depreciation. In this method, the
depreciation each year is constant and the interest
rate is being neglected.

𝐕 − 𝐕𝐬 Where:
𝐝= V = original cost/value
𝐧 VS = salvage value
Va = book value
𝐕𝐚 =𝐕 − 𝐚×𝐝 d = depreciation
D = total depreciation after n years
𝐃=𝐝×𝐧 n = economic life
a = depreciable year
1. A tax and duty free importation of a 30-horsepower sand mill for paint manufacturing costs
P360,000, CIF Manila. Bank charges, arrester and brokerage cost P5,000. Foundation and
installation costs were P25,000. Other incidental expenses amount to P20,000. Salvage value
of the mill is estimated to be P60,000 after 20 years. Find the appraisal value of the mill using
straight-line depreciation at the end of
a.) 10 years,
b.) 15 years

2. Equipment bought for Php60,000 is expected to last for 30 years. If the book
value after 20 years is Php20,000, how much is the depreciation each year? Find
the book value after 10 years.

13
Sample Problems
on Straight Line Method
1. Prepare a depreciation table for an asset which was
bought at Php15,000 and useful for a period of 7
years. Estimated salvage value is 10% of its original
cost.
2. Equipment bought for Php60,000 is expected to last
for 30 years. If the book value after 20 years is
Php20,000, how much is the depreciation each year?
Find the book value after 10 years.
3. A machine which costs Php10,000 was sold as scrap
after being used for 10 years. If the scrap value was
Php500, determine the total depreciation and book
value at the end of the 5th year.
Sample Problems
on Straight Line Method
4. Delivery jeeps purchased by KH Company cost
Php180,000 each. Past records indicate that jeeps
should have an economic life of 10 years. They can
be sold from an average of Php50,000 each year after
10 years of use. The company receives 9% interest on
investment funds. Using straight line method:
Determine:
a. the depreciation charge during 3 years
b. the depreciation reserve accumulated at the
end of 3 years
C. book value at the end of 3 years.
2) 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 ratio 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 designed by k, the rate of depreciation

16
Example
A certain type of machine loses 10% of its value each year. The machine costs P2, 000
originally. Make out a schedule showing the yearly depreciation, the total
depreciation and the book value at the end of each year for 5years.

Solution:
Year Book value at Depreciation Total Book value at
beginning of during the year depreciation at end of year
year 10% end of year

Note:
This method does not apply, if the salvage value is zero, because k will be
equal to one and d1 will be equal to C0.
17
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 𝑛−1 2
𝑑𝑛= 𝐶0 ቀ1 − ቁ (3 - 11)
𝐿 𝐿
𝑛
2
𝐶𝑛= 𝐶0 ቀ1 − 𝐿ቁ (3 - 12)
2 𝐿
𝐶𝐿= 𝐶0 ቀ1 − ቁ (3 - 13)
𝐿

When the DDB method is used, the salvage value should not be
subtracted from the first cost when calculating the depreciation charge

18
Example
Determine the rate of depreciation, the total rate of depreciation up to the
end of the 8th 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.

19
Declining Balance Method or
Reducing Balance Method

In this method, the net book value at the end of each

period can be simply computed by multiplying the
original market price by a fix percentage repeatedly
until it reaches the salvage value. This method is also
called Matheson’s Formula.

𝐚 −𝟏
𝐝 𝐚 =𝐤𝐕(𝟏−𝐤) 𝐕𝐚 =𝐕 (𝟏−𝐤)𝐚

𝐤=𝟏−
𝐕𝐬
𝐕
𝐧

√ Where:
k = depreciation factor or rate
1. A machine worth Php800,000 is bought from China.
Freight charges amount to Php200,000. If the scrap value of
the machine is Php50,000 that occurs at the end of 17 years.
Compute (a) the depreciation and (b) book value at the end
of 11 years.
2. Equipment bought for Php60,000 is expected to last for 30
years. If the scrap value after 20 years is Php20,000. How much
is the depreciation for year 10?
Double Declining
Balance Method

This is the same as declining balance method except that k

is replaced by 2/n.
𝟐
𝐤=
𝐧

Sample Problem on Double Declining Balance Method

A plant bought a calciner for Php220,000 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 Php20,000 for straight-line method; Php22,000 for
declining balance method and Php20,000 for double-
declining balance method.
 PROBLEM

A plant bought a calciner for Php220,000 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 Php20,000 for straight-line method;
Php22,000 for declining balance method and Php20,000
for double-declining balance method

23
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
that time.

24
Example
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 16years with a
salvage value of 10% of the original cost. Determine the book value at the end of
12years by (a) the straight line method and (b) sinking fund method at 12% interest.

Solution:
CO = P65,000 + P4,000 = P60,000 CL = P60,000(0.10) =P6,000
L = 16 n=12 i-12%

25
Sum-of-Years’ Digit Method
This method uses the year’s digit (in reverse order)
in computing for the depreciation.
( 𝐧+𝟏 −𝐚 ) 𝐧(𝐧+𝟏)
𝐝𝐚= (𝐕 − 𝐕 𝐬 ) 𝐒𝐘𝐃=
𝐒𝐘𝐃 𝟐

𝐃=
𝐚 ( 𝟐𝐧+𝟏 − 𝐚 )
𝐧(𝐧+𝟏)
(𝐕 − 𝐕 𝐬 )
𝐕 𝐚 =𝐕 −
(
𝐚 𝐧−
𝒂 𝟏
+
𝟐 𝟐 )
( 𝐕 − 𝐕 𝐬)
𝐒𝐘𝐃

Where: SYD = sum-of-years’ digit

 The Sum-of-the-Years’-Digits (SYD) Method

Let dn = depreciation charge during the nth year

dn = (depreciation factor)(total depreciation)
dn =

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

Year Year in Reverse Order Depreciation Factor Depreciation during the
year

1 5 5/15 (5/15)(C0 - CL)

2 4 4/15 (4/15)(C0 - CL)
3 3 3/15 (3/15)(C0 - CL)
4 2 2/15 (2/15)(C0 - CL)
5 1 1/15 (1/15)(C0 - CL)

Σ of digits=15

27
Example
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:
C0 – CL = P12,000 –P1,000 = P11,000
Year Year in reverse Depreciation during the year Book value during the year
order
1 5 (5/15)(P11,000)= P3,667 P8,333
2 4 (4/15)(P11,000)= P2,933 P5,400
3 3 (3/15)(P11,000)= P2,200 P3,200
4 2 (2/15)(P11,000)= P1,467 P1,733
5 1 (1/15)(P11,000)= P733 P1,000
Σ of digits = 15

28
Example
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 %
compounded annually.

29
Problem on Sum of Years’ Digit Method

An industrial plant bought a generator set for Php90,000.

Other expenses including installation amounted to
Php10,000. The generator set is to have a life of 17 years
with a salvage value at the end of life at Php5,000.
Determine the depreciation charge during the 13 th year
and the book value at the end of 13 years by:
(a) Declining balance method
(b)Double declining balance method
(c) Sum-of-Years’ digit method (Table)
d) sinking fund method assuming interest is 6%
compounded annually.
Problem on Sinking Fund Method
A broadcasting company purchased an equipment for
Php53,000 and paid Php1,500 for freight and delivery charges
to the job site. The equipment has a normal life of 10 years
with a trade-in value of Php5,000 against the purchase of a
new equipment at the end of the life. Determine the annual
depreciation cost using:
(a) straight line method
(b) sinking fund method assuming interest is 6%
compounded annually
 
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

Qn= total number of units of product during the nth year
 
Depreciation per unit of output =
 
(3 - 15)

32
Example
A television Company purchased machinery for P100,000 on July 1,1979. It is estimated that
it will have a useful life of 10years; scrap value of P4,000, production of 400,000 hours 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:

(1) Straight line

(2) Working hours
(3) Output method
Solution:
C0 = P100,000 CL = P4,000 L = 10 years
T = 400,000 units H = 120,000 hours

33
What Depreciation Method Should Be Used?
It is worth mentioning what the National International Revenue Code says
about depreciation specifically Section 29(f).

(1) General rule. “There shall be allowed as a depreciation deduction a reasonable allowance
for the exhaustion, wear and tear (including reasonable allowance for obsolescence) of
property used in the trade or business.
(2) Use of certain methods and rates. The term “reasonable allowance” as used in the
preceding paragraph shall include (but not limited to) an allowance computed in
accordance with regulations prescribed by the Secretary of Finance, under any of the
following methods:
(A) The straight line method.
(B) Declining balance method, using a rate not exceeding twice the rate which would have
been used had the annual allowance been computed under the method described in the
paragraph (f)(1).
(C) The sum-of-the-years-digits method, and
(D) Any other method which may be prescribed by the Secretary of Finance upon
recommendation of the Commissioner of Internal Revenue.
Notes: Taxpayer may enter into an “agreement in writing specifically dealing with
the useful life and rate of depreciation of any property, the rate
34
so agreed upon
shall be biding.”
Sinking Fund Method
Sinking fund method presents the idea of annuity in
computing for the depreciation. The interest rate
for the worth of money is being considered so as to
have the depreciable value.

[ 𝐢
] [ ]
𝐚
𝐝=(𝐕 − 𝐕 𝐬 ) (𝟏+𝐢) −𝟏
𝐧 𝐃=(𝐕 − 𝐕 𝐬 )
(𝟏+𝐢) −𝟏 (𝟏+ 𝐢)𝐧 − 𝟏
Hour Output method
In this method, the functionality period and the
period the machine has been used is considered.
Depreciation is computed based on the wear and
tear of the machine.

𝐡𝐚
𝐝 𝐚 = (𝐕 − 𝐕 𝐬 )
𝐇
𝐕𝐚 =𝐕 − 𝐝 𝐚

Where:
H = total hours of economic life
ha = number of hours the asset has been used
Service Output method
Similar to the hour output method, this method
based its computation on how much the asset has
been used.
𝐐𝐚
𝐝𝐚=
𝐐
(𝐕 − 𝐕 𝐬 ) 𝐕𝐚 =𝐕 − 𝐝 𝐚

Where:
Q = total amount that the asset can give service
Qa = amount of the asset has been used
1. An electric bulb bought for Php100 is guaranteed to be useful
for 50 hours. A certain company uses the said bulb for 10 hours a
day. If there is no scrap value for the bulb. Compute the daily
depreciation and create the depreciation table throughout its
economic life.
2. A tire bought for Php1,000 is expected to be useful in traveling
100 km after which it can be sold as scrap for Php50. (a) If the
pedometer displays a value of 85 km, what is the book value of the
tire? (b) How much did the owner need to travel for the tire to
amount to Php80?
3. 2.\ Equipment bought for Php60,000 is expected to last for
30 years. If the scrap value after 20 years is Php20,000. How
much is the depreciation for year 10?