Chapter 5

Depreciation

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  Depreciation is the decrease in value of physical
properties with the passage of time.
 Depreciation: the decline in the value of the asset.
 As time elapses, every asset undergoes a progressive loss of
value resulting from:

1) Physical factors: wear and tear,

2) Functional factors: technological change

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Introductory points

 Asset: property that is acquired and exploited for monetary gain such as
machines, vehicles, office building, planes, ships, boats, computers, etc.
 First Cost of an Asset: total expenditure required to place an asset in
operating condition.
 E.g. If an asset is purchased, it includes the purchase price related and

all incidental expenses such as transportation, tax, assembly, expert

advice, etc.
 Salvage Value or Residual Value: the price at which a fixed asset is
expected to be sold at the end of its useful life.

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 Book Value: the value of an asset displayed on

the documents of the firm.

 E.g. if the first cost of an asset is $20,000 and the depreciation

charges to date total $14,000 the current book value is $6,000

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 An Asset is Depreciable If

1. The asset is used for business purposes in the production

of income.
2. The asset has a useful life that can be determined, and the
useful life is longer than one year.
3. The asset decays, gets used up, wears out, becomes
obsolete or loses value from natural causes.
4. It is not inventory, stock in trade, or investment property.

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Depreciation and Expenses
 Expenses - subtracted from business revenues as
they
occur (time frame < one year).
 Labor

 Utilities

 Materials

 Insurance, etc.
 Depreciation - subtracted from business expenses over
time as the asset is used up (applies to assets with > 1 year
useful life).
 Machinery

 Installation and Maintenance costs

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Classification of Assets
 Tangible - can be seen, touched, and felt.
 Real - land, buildings, and things growing on, or
attached to the land.
 Personal - equipment, furnishings, vehicles,
office
machinery, or not defined as real property.
 Intangible - has value but cannot be seen or
touched,
In general buildings and equipment are
examples include patents, land
depreciable; copyrights,
is not. and trade
marks.
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 Depreciation for Tax Purposes
 Depreciation is used to allocate an asset’s loss of value over time.
 Depreciation is deducted from revenue and reduces the taxable
income of a business over time which produces a cash flow on an
after tax-basis.

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 Tax Effects of Depreciation

 Since depreciation is a recognized business expense, it reduces

the taxes the firm is required to pay.
 Thus, every depreciation charge creates a tax savings for that
year, and amount of the savings is the function of the amount of
the depreciation charge and the rate at which the firm's profits
are taxed.

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 Depreciation Methods

 There are several methods of accounting depreciation fund. These

are as follows:
 Straight line method of depreciation
 Declining balance method of depreciation
 Sum of the years digits method of depreciation
 Sinking-fund method of depreciation
 Service output method of depreciation

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Straight Line Method of Depreciation
 In this method of depreciation, a fixed sum is charged as the
depreciation amount throughout the lifetime of an asset such
that the accumulated sum at the end of the life of the asset is
exactly equal to the purchase value of the asset.

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 Here, we make an important assumption that inflation
is
absent.

Let

P= first cost of the asset,

F= salvage value of the asset,

n = life of the asset,

B t = book value of the asset at the end of the period t, D t =

depreciation amount for the period t.

The formulae for depreciation and book value are as follows:

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 Example: A company has purchased an equipment whose
first cost is Birr. 100,000.00 with an estimated life of eight
years. The estimated salvage value of the equipment at the
end of its lifetime is Birr. 20,000. Determine the depreciation
charge and book value at the end of various years using the
straight line method of depreciation.

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....Straight Line Depreciation
Solution

P= Birr. 100,000 F= Birr. 20,000 n = 8 years

D t = (P– F)/n = (100,000 – 20,000)/8 = Birr. 10,000

In this method of depreciation, the value of D t is the same for all the years. The

calculations pertaining to B t for different values of tare summarized in

Table 1.

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...Straight Line Depreciation
Table 1: D t and B t Values under Straight line Method of Depreciation

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Declining Balance Method of Depreciation

 In this method of depreciation, a constant percentage of the book value of the

previous period of the asset will be charged as the depreciation amount for the
current period.
 This approach is a more realistic approach, since the depreciation charge
decreases with the life of the asset which matches with the earning potential of
the asset.
 The book value at the end of the life of the asset may not be exactly equal to
the salvage value of the asset. This is a major limitation of this approach.


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Let;
P= first cost of the asset,

F= salvage value of the asset,

n= life of the asset,

B t = book value of the asset at the end of the period t,

K= a fixed percentage, and

D t = depreciation amount at the end of the period t.

The formulae for depreciation and book value are as follows:

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 The formulae for depreciation and book value in terms of P
are as follows:

While availing income-tax exception for the depreciation amount paid

in each year, the rate K is limited to at the most 2/n. If this rate is
used, then the corresponding approach is called the double declining
balance method of depreciation.

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 ….. Declining Balance Method of Depreciation

 Example: Consider the previous example and demonstrate the calculations

of the declining balance method of depreciation by assuming 0.2 for K.
 Solution

P= Birr. 1,00,000 F= Rs. 20,000 n= 8 years K= 0.2

The calculations pertaining to D t and B t for different values of years summarized in

Table 2 using the following formulae:

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…Declining Balance Method of Depreciation
Table 2: D t and B t according to Declining Balance Method of Depreciation

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Cont...

 Also we can calculate the depreciation and book value For specific period.
For example take period five and calculate the depreciation and book value
at this period.
 Solution
P= Birr. 1,00,000 F= Birr. 20,000 n= 8 years K= 0.2

=Birr. 8,192

= Birr. 32,768

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 Sum-of-the-Years-Digits Method of Depreciation

 In this method of depreciation also, it is assumed that the book value of the
asset decreases at a decreasing rate. If the asset has a life of eight years, first the
sum of the years is computed as
Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 = n(n+ 1)/2
 The rate of depreciation charge for the first year is assumed as
the highest and then it decreases. The rates of depreciation for the years 1–8,
respectively are as follows: 8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.
 For any year, the depreciation is calculated by multiplying the corresponding
rate of depreciation with (P– F).

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 Cont. ..

 The formulae for D t and B t for a specific year t are as follows:

Example: Consider the previous example and demonstrate the

calculations of the sum-of-the-years-digits method of depreciation.

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 Solution
 P= Birr. 1,00,000 F= Birr. 20,000 n= 8 years
 Sum = n(n+ 1)/2 = 89/2 = 36
 Therates for years 1–8, are respectively 8/36, 7/36,
6/36,
5/36, 4/36, 3/36, 2/36 and 1/36.
 Thecalculations of D t and B t for different values
are
summarized in Table 3. using the following formulae:

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Table 3: D t and B t under Sum-of-the-years-digits Method of Depreciation

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 Sinking Fund Method of Depreciation
 In this method of depreciation, the book value decreases
at increasing rates with respect to the life of the asset. Let
 P= first cost of the asset,
 F=Future value
 S= Salvage value of the asset,
 n= life of the asset,
 i = rate of return compounded annually,
 A= the annual equivalent amount,
 B t= the book value of the asset at the end of the period t, and

 D t = the depreciation amount at the end of the period t.

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 The loss in value of the asset (P– F) is made available and the form of
cumulative depreciation amount at the end of the life of the asset by setting
up an equal depreciation amount (A) at the end of each period during the life
time of the asset.
 A= (P– S) [A/F, i, n]
 The fixed sum depreciated at the end of every time period earns an interest
at the rate of i% compounded annually, and hence the actual depreciation
amount will be in the increasing manner with respect to the time period. A
generalized formula for D t is

 D t = (P– S) (A/F, i, n) (F/P, i, t– 1)

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 The formula to calculate the book value at the end of period t is
 B t = P– (P– S) (A/F, i, n) (F/A, i, t)

 The above two formulae are very useful if we have to calculate D t and B t for
any specific period. If we calculate B t and D t for all the periods, then the
tabular approach would be better.
 Example: Consider the previous example and give the calculations regarding
the sinking fund method of depreciation with an interest rate of 12%,
compounded annually.

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 Solution
 P= Birr. 1,00,000 S= Birr. 20,000 n= 8 years i = 12%
 A= (P – S) [A/F, 12%, 8] = (100,000 – 20,000) * 0.0813 = Birr.
6,504.
Where, [A/F, 12%, 8] = = 0.0813
 In this method of depreciation, a fixed amount of Rs. 6,504 will be
depreciated at the end of every year from the earning of the asset. The
depreciated amount will earn interest for the remaining period of life of the
asset at an interest rate of 12%, compounded annually. For example, the
calculations of net depreciation for some periods are as follows:

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 Depreciation at the end of year 1 (D1) = Birr. 6,504.
 Depreciation at the end of year 2 (D2) = 6,504 + 6,504 X 0.12 =
Birr. 7,284.48
 Depreciation at the end of the year 3 (D3) = 6,504 + (6,504
+ 7,284.48) X 0.12 = Birr. 8,158.62
 Depreciation at the end of year 4 (D4) = 6,504 +
(6,504 +
7,284.48 + 8,158.62) X 0.12 = Birr. 9,137.65
 These calculations along with book values are summarized
in Table 4.

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 Cont. …
• Table 4: D t and B t according to Sinking Fund Method of Depreciation
 Service Output Method of Depreciation or Unit Production Method

• In some situations, may not be realistic to compute

it
depreciation based on time period. In such cases, the
depreciation is computed based on service rendered by an
asset. Let
• P= first cost of the asset
• S= salvage value of the asset
• X= maximum capacity of service of the asset during its lifetime
• x= quantity of service rendered in a period.
• Then, the depreciation is defined per unit of service rendered:
• Depreciation/unit of service = (P– S)/X

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 Cont …

Example: The first cost of a road laying machine is Birr. 8,000,000. Its salvage
value after five years is Birr. 50,000. The length of road that can be laid by the
machine during its lifetime is 75,000 km. In its third year of operation, the
length of road laid is 2,000 km. Find the depreciation of the equipment for that
year.

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 Cont …

• Solution
• P= Birr. 80,00,000 S= Birr. 50,000 X= 75,000 km x= 2,000
km

= Birr. 212,000

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 END

a l l t h e best…….