UNIT-3b

DEPRECIATION
Depreciation:

 Physical assets decrease in value with age.

 This decrease in value may be due to physical

deterioration, technological advances, economic
changes, or other factors which ultimately will cause
retirement of the property.
Purpose of Depreciation as a Cost :

 Permits realistic evaluation of profits earned by a company .

 Basis for determination of Federal income taxes.

 Provides a means whereby funds are set aside regularly to

provide recovery of the invested capital.
TYPES OF DEPRECIATION

• Physical depreciation

• Functional depreciation.

• Depletion
Physical depreciation:
 The measure of the decrease in value due to changes
in the physical aspects of the property.

 Wear and tear, corrosion, accidents, and deterioration

due to age are all causes of physical depreciation.

 With this depreciation, the serviceability of the

property is reduced because of physical changes.
Functional depreciation:

 Decline in the productive or service ability of a capital asset

due to obsolescence.

This is caused by technological advances or developments

which make an existing property obsolete.

 Even though the property has suffered no physical change, its

economic serviceability is reduced because it is inferior to
improved types of similar assets that have been made available
through advancements in technology.
Other causes of functional depreciation :

 Change in demand for the service rendered by the

property, such as a decrease in the demand for the product
involved because of saturation of the market.

 Changes in requirements of public authority

 Inadequacy or insufficient capacity for the service

required.

 Termination of the need for the type of service rendered.

 Abandonment of the enterprise.

Depletion: Capacity loss due to materials actually
consumed is measured as depletion.

• Depletion cost=

Initial cost X

This type of depreciation is particularly applicable to natural

resources, such as stands of timber or mineral and oil
deposits,fisheries etc.
TERMINOLOGY:
Service life:
 The period during which the use of a property is
economically feasible is known as the service life
of the property.
Both physical and functional depreciation are taken into consideration in determining service life.

 Other names are economic or useful life.

 In estimating the probable service life, it is

assumed that a reasonable amount of maintenance
and repairs will be carried out at the expense of
the property owner.
SALVAGE VALUE:

 Salvage value is the net amount of money obtainable

from the sale of used property over and above any
charges involved in removal and sale.

 The term salvage value implies that the asset can

give some type of further service and is worth more
than merely its scrap or junk value.
 If the property cannot be disposed of as a useful unit,
it can often be dismantled and sold as junk to be used
again as a manufacturing raw material.

 The profit obtainable from this type of disposal is

known as the scrap or junk value.

 Salvage value, scrap value, and service life are

usually estimated on the basis of conditions at the
time the property is put in use.
PRESENT VALUE

The present value of an asset may be defined as the

value of the asset in its condition at the time of
valuation.
Book Value, or Unamortized Cost:

 The difference between the original cost of a

property, and all the depreciation charges made to
date is defined as the book value.

 It represents the worth of the property as shown on

the owner’s accounting records.
Market Value:

 The price which could be obtained for an asset if it

were placed on sale in the open market.

 The use of this term conveys the idea that the asset is
in good condition and that a buyer is readily
available.
Replacement Value:

 The cost necessary to replace an existing property at

any given time with one at least equally capable of
rendering the same service.
METHODS FOR DETERMINING DEPRECIATION

In general, depreciation accounting methods may

be divided into two classes:

(1)Arbitrary methods giving no consideration to

interest costs.
 Straight-line method
 Declining-balance method
 Sum-of-the-years-digits method.
(2)Methods taking interest into account on the
investment.

 Sinking-fund method
 Present-worth methods.
Straight-Line Method:

it is assumed that
 The value of the property decreases linearly with
time.

 Equal amounts are charged for depreciation each year

throughout the entire service life of the property.
 The annual depreciation cost may be expressed in
equation form as follows:

The asset value (or book value) of the equipment at

any time during the service life may be determined from
the following equation:
 Because of its simplicity, the straight-line method is
widely used for determining depreciation costs.

 Because it is impossible to estimate exact service

lives and salvage values when a property is first put
into use, it is sometimes desirable to re estimate these
factors from time to time during the life period of the
property.

 If this is done, straight-line depreciation can be

assumed during each of the periods, and the overall
method is known as multiple straight-line
depreciation.
 The straight-line method may be applied on the basis of units
of production instead of life years.

 The depreciation may be based on miles, gallons, tons, number

of unit pieces produced, or other measures of service output.
This is called unit-of-production or service output.

 This method is particularly applicable when depletion occurs,

as in the exploitation of natural resources.
• Merits of Straight Line method:
• i)Simplicity :Calculation of depreciation under this method is very
simple and therefore the method is widely popular. Once the
amount of depreciation is calculated, the same amount is written
off as depreciation each year. Hence this method is simple and
calculations are easier to understand.
• ii) Asset is completely Written Off : Under this method, the book
value of an asset is reduced to net scrap value or zero value. In
other words, in the books of accounts the value of the asset at the
end of its useful life is equal to zero or its residual value.
LIMITATIONS OF STRAIGHT LINE METHOD:

i)Difficulty in Computation : When there are various machines

having different life-spans, the computation of depreciation
becomes complicated because the depreciation on each machine
will have to be calculated separately for each asset.

ii) Illogical :It is well known that the expense on its repairs and
maintenance increases as the asset becomes older. Thus, the total
burden on Profit and Loss Account, depreciation plus repair
expenses, is more in later years in comparison to earlier years. This
is illogical because the efficiency and productivity of the asset is
more in earlier years and less in later years.
Q) A piece of equipment originally costing $40,000 was put
into use 12 years ago. At the time the equipment was put
into use, the service life was estimated to be 20 years and
the salvage and scrap value at the end of the service life
were assumed to be zero. On this basis, a straight-line
depreciation fund was set up. The equipment can now
be sold for $10,000, and a more advanced model can be
installed for $55,000. Assuming the depreciation fund is
available for use, how much new capital must be supplied
to make the purchase?
• The original investment for an asset was $10,000, and the
asset was assumed to have a service life of 12 years with
$2000 salvage value at the end of the service life. After the
asset has been in use for 5 years, the remaining service life and
final salvage value are re estimated at 10 years and $1000,
respectively. Under these conditions, what is the depreciation
cost during the sixth year of the total life if straight-line
depreciation is used?
• The owner of a property is using the unit-of-production
method for determining depreciation costs. The original value
of the property is $55,000. It is estimated that this property can
produce 5500 units before its value is reduced to zero: i.e., the
depreciation cost per unit produced is $10. The property
produces 100 units during the first year, and the production
rate is doubled each year for the first 4 years. The production
rate obtained in the fourth year is then held constant until the
value of the property is paid off. What would have been the
annual depreciation cost if the straight-line method based on
time had been used?
Q)A reactor of special design is the major item of equipment in a
small chemical plant. The initial cost of the completely
installed reactor is $60,000, and the salvage value at the end of
the useful life is estimated to be $10,000. Excluding
depreciation costs for the reactor, the total annual expenses for
the plant are $100,000. How many years of useful life should
be estimated for the reactor if 12 percent of the total annual
expenses for the plant are due to the costs for reactor
depreciation? The straight-line method for determining
depreciation should be used.
Declining-Balance (or Fixed Percentage) Method

 The annual depreciation cost is a fixed percentage of

the property value at the beginning of the particular
year.

 The fixed-percentage (or declining-balance) factor

remains constant throughout the entire service life of
the property

 The annual cost for depreciation is different each

year.
The above equation determines the fixed percentage
factor, and the equation is sometimes designated as
the Matheson formula.
Comparison of
straight-line,
Multiple straight-line,
sum-of-the-years-digits,
and declining-balance
methods for determining
depreciation.
Comparison with the straight-line method

 Declining-balance depreciation permits the

investment to be paid off more rapidly during the
early years of life.

 The increased depreciation costs in the early years are

very attractive to concerns just starting in business,
because the income-tax load is reduced at the time
when it is most necessary to keep all pay-out costs at
a minimum.
 The textbook relationship presented in the previous
eq’s is seldom used in actual practice, because it
places too much emphasis on the salvage value of the
property.

 It is certainly not applicable if the salvage value is

zero.

 To overcome this disadvantage, the value of the

fixed-percentage factor is often chosen arbitrarily.
Double declining balance method or 200% method:

 f = Two times the reciprocal of the service life n

when salvage valve is zero.

 f=Two times the min.depreciation rate obtained with

st.line method when salvage value is not zero.

 This permits approximately two-thirds of the

depreciable value to be written off in the first half of
the useful 1ife.
 It should be noted that the value of the asset cannot
decrease to given salvage value at the end of the
service life and may possibly be greater than the
salvage or scrap value.

 To handle this difficulty, it is sometimes desirable to

switch from the declining-balance to the straight-line
method after a portion of the service life has expired.
This is known as the combination method.

 It permits the property to be fully depreciated during

the service life, yet also gives the advantage of faster
early-life write-offs.
The main advantage of the declining-balance and the
combination methods is

 They permit greater depreciation allowances in the

early life of the property than in the later life.

 They are particularly applicable for units in which

the greater proportion of the production occurs in the
early part of the useful life or when operating costs
increase markedly with age.
Types of declining-balance
methods for determining
depreciation.
MERITS OF DIMINISHING BALANCE METHOD

• i) Equal Burden on Profit & Loss Account The productivity of the asset is more
hence its contribute to profit is also relatively greater. Therefore the cost charged
in terms of depreciation should also be greater. In the initial year, the depreciation
charges are more and repair expenses are less. In later years, depreciation charges
are less and repair expenses are more. Hence the total burden, depreciation plus
repair expenses, is some what equal on Profit & Loss Account for each year.

DEMERITS OF DIMINISHING BALANCE METHOD

• i) Asset cannot be completely written off : Under this method, the value of an
asset is not reduced to zero even when there is no scrap value. ii) Complexity :
Under this method, the rate of depreciation cannot be determined easily.
Q)The original value of a piece of equipment is
$22,000, completely installed and ready for
use. Its salvage value is estimated to be $2000
at the end of a service life estimated to be 10
years. Determine the asset (or book) value of
the equipment at the end of 5 years using:
(a) Straight-line method.
(b) Textbook declining-balance method.
(c) Double declining-balance (200 percent)
method
Sum-of-the-Years-Digits Method:

 The annual depreciation is based on the number of

service-life years remaining and the sum of the
arithmetic series of numbers from 1 to n, where n
represents the total service life.

 The yearly depreciation factor is the number of useful

service-life years remaining divided by the sum of the
arithmetic series.

 Annual depreciation cost =

Yearly depreciation factor X the total depreciation (v-vs)
• The equations which apply for determining annual
depreciation by the sum-of-the-years-digits method
are
 This method gives results similar to those
obtained by the declining-balance method.

 Larger costs for depreciation are allotted

during the early-life years than during the later
years.

 This method has the advantage of permitting

the asset value to decrease to zero or a given
salvage value at the end of the service life.
Q)The initial installed cost for a new piece of equipment is
$10,000, and its scrap value at the end of its useful life is
estimated to be $2000. The useful life is estimated to be 10
years. After the equipment has been in use for 4 years, it is
sold for $7000. The company which originally owned the
equipment employs the straight-line method for determining
depreciation costs. The total income-tax rate for the company
is 34 percent of all gross earnings. Capital-gains taxes amount
to 34 percent of the gain. How much net saving after taxes
would the company have achieved by using the alternative (in
this case, reducing-balance) depreciation method instead of the
straight-line depreciation method?
Q) A piece of equipment having a negligible salvage
and scrap value is estimated to have a service life of
10 years. The original cost of the equipment was
$40,000.
Determine the following:
(a) The depreciation charge for the fifth year if double
declining-balance depreciation is used.
(b) The depreciation charge for the fifth year if sum-of-
the-years-digits depreciation is used.
© The percent of the original investment paid off in the
first half of the service life using the double
declining-balance method.
(d) The percent of the original investment paid off in the
first half of the service life using the sum-of-the-
years-digits method.
Q) A property has an initial value of $50,000, service
life of 20 years, and final salvage value of $4000. It
has been proposed to depreciate the property by the
text-book declining-balance method. Would this
method be acceptable for income-tax purposes if the
income-tax laws do not permit annual depreciation
rates greater than twice the minimum annual
depreciation rate with the straight-line method?
Q)A concern has a total income of $1 million/year, and
all expenses except depreciation amount to
$6OO,OOO/year. At the start of the first year of the
concern’s operation, a composite account of all
depreciable items shows a value of $850,000, and the
overall service life is estimated to be 20 years. The
total salvage value at the end of the service life is
estimated to be $50,000. Thirty percent of all profits
before taxes must be paid out as income taxes. What
would be the reduction in income-tax charges for the
first year of operation if the sum-of-the-years-digits
method were used for depreciation accounting instead
of the straight-line method?
Q)In order to make it worthwhile to purchase a new piece of
equipment, the annual depreciation costs for the equipment
cannot exceed $3000 at any time. The original cost of the
equipment is $30,000, and it has zero salvage and scrap value.
Determine the length of service life necessary if the equipment
is depreciated (a) by the sum-of-the-years-digits method, and
(b) by the straight-line method.
Q) A materials-testing machine was purchased for
$20,000 and was to be used for 5 years with an
expected residual salvage value of $5000. Graph the
annual depreciation charges and year-end book
values obtained by using:
(a) Straight-line depreciation.
(b) Sum-of-digits depreciation.
© Double-declining-balance depreciation.
Q)The total value of a new plant is $2 million. A
certificate of necessity has been obtained
permitting a write-off of 60 percent of the
initial value in 5 years. The balance of the
plant requires a write-off period of 15 years.
Using the straight-line method and assuming
negligible salvage and scrap value, determine
the total depreciation cost during the first year.
Sinking-Fund Method:
 This method takes compound interest.

 It is assumed that the basic purpose of depreciation allowances

is to accumulate a sufficient fund to provide for the recovery
of the original capital invested in the property.

 An ordinary annuity plan is set up where in a constant amount

of money should theoretically be set aside each year.

 At the end of the service life, the sum of all the deposits plus
accrued interest must equal the total amount of depreciation.
Total amount of depreciation after a years = V - V,
Salient features of sinking fund method :

 The yearly cost for depreciation is constant when the sinking-

fund method is used
 This method results in book values which are always greater
than those obtained with the straight-line method.
 Because of the effects of interest in the sinking-fund method,
the annual decrease in asset value of the property is less in the
early-life years than in the later years.
 Theoretically, the method would be applicable for depreciating
any property that did not undergo heavy service demands
during its early life and stood little chance of becoming
obsolete or losing service value due to other functional causes.
 Although the sinking-fund viewpoint assumes the
existence of a fund into which regular deposits are
made, an actual fund is seldom maintained. Instead,
the money accumulated from the depreciation
charges is put to work in other interests, and the
existence of the hypothetical fund merely serves as a
basis for this method of depreciation accounting.
SINGLE-UNIT AND GROUP DEPRECIATION :

• In depreciation accounting procedures, assets may be depreciated

on the basis of individual units or on the basis of various types of
property groups or classifications.

The single-unit method:

 In this method assets are be depreciated on the basis of individual
units .
 It requires keeping records on each individual asset.
 This method is simple, But the large number of detailed records
are required which makes the accounting expenses very high.
• To simplify the accounting procedures, many
concerns combine their various assets into groups for
depreciation purposes.
• There are several types of group accounts
employed, and the most common among these are
composite accounts, classified accounts, and vintage-
group accounts.
• composite accounts:
Includes all depreciable assets in one single group,
and an overall depreciation rate is applied to the
entire account.
With this method, the composite depreciation rate
must be re determined when important changes occur
in the service lives of the individual assets.
Classified accounts :
 It is possible to classify properties into general
types, such as machinery and equipment, office
furniture and fixtures, buildings, and
transportation equipment. The records for these
groups are known as classified accounts.
 A classified account is similar to a composite
account because many items are included in the
same group, regardless of life characteristics
vintage-group accounts :

 It includes similar assets having approximately the

same service lives.
 A separate record is kept for each group and the same
depreciation rate is applied to all the items included
in each account.
 With this method, the advantages of single-unit
depreciation are obtained since life characteristics
serve as the basis.
ADJUSTMENT OF DEPRECIATION ACCOUNTS
The estimated service life and salvage value of a property are
seldom exactly equal to the actual service life and salvage value. It
is, therefore, advisable to adjust depreciation accounts by making
periodic re estimations of the important variables.
When a property is retired under conditions which do not permit
exact agreement between estimated and actual values, the
difference between the book depreciation and the actual
depreciation may be handled in one of the following ways:
•The gain or loss may be credited or charged on the financial
record for the current period;
•The difference may be credited or charged to a special
depreciation reserve; or
•The difference may be carried on the books for amortization
during a reasonable future period.
According to the income-tax laws, any gain on the retirement of
a property is taxed as a capital gain. However, losses cannot be
subtracted from the taxable income unless the maximum
expected life was used.
Because of the losses involved when a property must be retired
before the end of its estimated service life, some concerns
prefer to use a combination of methods(multiple st line
methods, double declining balance method).
A special depreciation reserve is built up by continuing the book
depreciation of properties whose actual service lives exceed the
estimated service lives. This fund is then used to handle losses
due to early retirement of assets.
The final choice of method for adjusting depreciation accounts
depends on the accounting policies of the individual concern and
on income-tax regulations.
• The total value of a new plant is $2 million. A
certificate of necessity has been obtained permitting a
write-off of 60 percent of the initial value in 5 years.
The balance of the plant requires a write-off period of
15 years. Using the straight-line method and
assuming negligible salvage and scrap value,
determine the total depreciation cost during the first
year.
• A materials-testing machine was purchased for
$20,000 and was to be used for 5 years with an
expected residual salvage value of $5000. Graph the
annual depreciation
charges and year-end book values obtained by using:
(a) Straight-line depreciation.
(b) Sum-of-digits depreciation.
© Double-declining-balance depreciation
• An asset with an original cost of $10,000 and
no salvage value has a depreciation charge of
$2381 during its second year of service when
depreciated by the sum-of digits method. What
is its expected useful life?