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1 The University of Birmingham The Birmingham Business School Department of Accounting and Finance Accounting Theory (07 1 !

"#$ Depreciation %ethods and &alculations

'ntroduction According to Baxter (1971: 46) a depreciating assets value is linked with a series o cash transactions! "he cash a#ounts in $uestion are the variations in the general cash low caused solel% &% the assets age (or' with use(assets' use) (Baxter' 1971: 46)! )or calculating depreciation' the relevant cash lows are: ( ( ( ( the initial cost' increases in repair costs and other annual outla%s' scrap value' and declines in earnings in the rare cases where a single asset in luences revenues!

"he a&ove approach is consistent with Baxters view that depreciation is the worsening o cash prospects (Baxter' 1971 : *+) and a nu#&er o exa#ples ollow to illustrate this approach' &ased on Baxter (1971 : 41(11+)! Depreciation of a single asset( ignoring cost of capital Assu#e a depreciating asset with an initial cost o ,1-'---' a ive %ear li e' no scrap proceeds' and re$uiring a ,.'--- overhaul at the end o the third %ear! Also' the ,.'--overhaul is to &e treated as a &elated part o the assets price and not expensed in the %ear in which it is incurred &ut added to and written o ro# the assets value on ac$uisition! /ust as the ,1-'---' the ,.'--- overhaul is a sacri ice #ade to o&tain the assets &ene its and is di erent ro# the ,1-'--- onl% in its ti#ing! "o urther 0usti % the treat#ent a&ove' consider a #anager co#paring cost esti#ates or two 0o&s! "he #anager will &e #isled i consecutive issues o a #aterial ro# stores are charged at one rate to /o& A ()1)2) and at another rate to /o& B (31)2)! As &oth store issues can &e replaced at the sa#e cost' the sacri ices per unit are in act indistinguisha&le! 1 the sacri ice o using up a depreciating asset rese#&les that o using up stores' the charge or each unit o the assets input should &e the sa#e! "his would not &e achieved &% capitalising the overhaul when it occurs at the end o %ear +! "here ore' in the exa#ple a&ove' the task set is to depreciate ,1.'--- over ive %ears and this will pro&a&l% &e done as ollows:

4arek + 5epreciation 4ethods and 6alculation

7ear end 1! 2utla%s .! Annual cost (1.'--- x -!.-) +! 8et change in value 4! 9alue at %ear end

, 1-'--1-'--1-'---

1 , (.'4--) (.'4--) 7'6--

. , (.'4--) (.'4--) *'.--

+ , .'--(.'4--) (4--) 4':--

4 , (.'4--) (.'4--) .'4--

* , (.'4--) (.'4--) (

"he igures a&ove can &e used to illustrate the concept o deprival value which is ound &% co#paring two alternative &udgets #apping uture outla%s i the owner: ( ( continues in possession o the asset (the ;have< colu#n)' and is deprived o the asset (the ;have not< colu#n)!

=owever' i the owner were suddenl% deprived o the existing asset' a replace#ent asset would &e purchased' either second hand or new! Assu#ing the owner continues the polic% o &u%ing new assets' the &udgets will re lect the latter choice! Assu#e that the deprival value o the asset at the end o %ear . needs to &e calculated' the &udgets will co#pare cash lows as ollows: ( ( i le t with the existing asset' and i the owner is deprived o the asset!

1n the latter case the owner will replace the asset with a new #achine identical to the one replaced! =owever' in order to #ake the &udgets co#para&le' account #ust &e taken o the act that the new asset will last two %ears longer than the existing asset (at the &eginning o %ear + it still has a ive %ear li e)! "his is done &% calculating a ;closing stock< igure or the value o the unexpired &ene its o owning the asset still present at the end o %ear *! =ave &udget , 2utla%s >nd o %ear . 8ew asset 7ear + 2ld asset overhaul ?tart o %ear * 8ew asset overhaul 9alue o + %ear old asset at end o 7ear * Bene it o ownership (excess o have not colu#n) .'--@@@@@ .'--@@@@@ .'--*'.-=ave not &udget , 1-'--.'--1.'--4':-7'.--

"his is the sa#e as the value calculated in the irst ta&le &ut would di er i the replace#ent asset were not identical! "he a&ove calculation #a% &e si#pli ied &% using annual e$uivalents &ased on average cost per %ear!

4arek + 5epreciation 4ethods and 6alculation

+ =ave &udget , 2utla%s 7ear + 2ld asset overhaul 7ears +(* 8ew assets average annual cost (+ x .'4--) Bene it o ownership .'--@@@@@ *'.-7'.-=ave not &udget ,

"his procedure o using an annual e$uivalent cost is a help ul si#pli ication in #an% cases! 1t is to &e noted that actual accounting practice will pro&a&l% di er ro# the a&ove approach in that the overhaul o ,.'--- would not &e added to the assets value and depreciated until the overhaul expenditure has actuall% &een incurred' as ollows: 7ear end 1! 2utla% .! 5epreciation (1-'--- x -!.-) 5epreciation (6'--- x -!*-) +! 8et change in value 4! 9alue at %ear end , 1-'--(.'---) 1-'--1-'--(.'---) :'--(.'---) (.'---) 6'--1 , . , + , .'--(.'---) 6'--(+'---) (+'---) +'--(+'---) (+'---) ( 4 , * ,

Depreciation of a single asset( allo)ing for cost of capital Assu#e the sa#e data as or the previous exa#ple &ut that the cost o capital is .-A per annu# and that cash transactions (except initial outla%) occur on the last da% o the %ear! "he present value o the cash outla%s taking into account a .-A cost o capital are: , 1nitial outla% 1-'--2verhaul (.'--- x 1@@) (1!.-)+ 1'1*7 "otal present value 11'1*7 >$uivalent annual annuit% cost at .-A per annu# or * %ears: (11'1*7 x -!++44) 7ear end 1! .! +! 4! 2utla%s 6ost o capital (-!.- x 9t(1) Annual cost 8et change in value , 1-'--1-'--1-'--.'--(+'7+1) (1'7+1) :'.69 1'6*4 (+'7+1) (.'-77) 6'19. 1 , . , B + , .'--1'.+: (+'7+1) (49+) *'699 +'7+1 4 , 1'141 (+'7+1) (.'*9-) +'1-9 * , 6.. (+'7+1) (+'1-9) (

*! 9alue at %ear end

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4 "he deprival value &udgets will also show the sa#e values given static conditions! =ave &udget , 2utla%s Cresent value o overhaul (.'--- x 1) 1!.Cresent value o depreciation (+'7+1 x .!1-6*D) 1'667 @@@@@ 6'19. =ave not &udget ,

7':*9

Bene it o ownership at end o %ear . (D Annuit% actor at .-A or + %ears)! Depreciation of a long succession of assets

"he decision to ac$uire a depreciating asset saddles a going concern ir# with a set o cash transactions which re lect an entire succession o uture replace#ents (0ust as the decision not to &u% an asset is a decision in avour o so#e di erent pattern o cash lows' perhaps consisting o #ore rentals or wages)! =ence the cash lows stretch out into the uture consisting o an initial cost repeated ever% ive %ears and a succession o regular overhauls &etween the initial costs! Allowance #a% &e #ade or predicted changes in the siEe and ti#ing o the cash lows' &ut in general there is no alternative to treating the cash low patterns as perpetuit%! 5epreciation is an econo#ic loss &ecause it #akes the uture cash low pattern worse! )or the asset in $uestion' this annual cost has &een esti#ated at ,+'7+1! An annual cost o ,+'7+1 incurred in perpetuit% has a present value at .-A per annu# o : +'7+1 B ,1:'6** -!."he relevant &udgets taking into account a perpetual succession o replace#ent assets are as ollows:
7ear end =ave not &udget =ave &udget Asset value 5ecline in asset value 6ost o capital at .-A Annual cost 1:'6* * 1:'6* * -1 1:'6* * :'6** 1-'-1 1:'6* * 1-'+: 6 :'.69 1'7+1 .'--+'7+1 . 1:'6* * 1.'46 + 6'19. .'-77 1'6*4 +'7+1 + 1:'6* * 14'9* 6 +'699 .'49+ 1'.+: +'7+1 +1 1:'6* * 1.'9* 6 *'699 4 1:'6* * 1*'*4 7 +'1-: .'*91 1'14+'7+1 * 1:'6* * 1:'6* * +'1-: 6.+ +'7+1 *1 1:'6* * :'6** 1-'--

"o understand a depreciating assets value correctl%' one should view the asset not as per#anent wealth &ut as the te#porar% lightening o a &urden! 1 the ir# needs &ut has not %et ac$uired the irst asset' it aces the &urden o a ull perpetuit% o cash pa%#ents including the irst asset (,1:'6**)! 2nce the asset is ac$uired' the prospect is less &urdenso#e (,:'6**)! But' as replace#ent and overhaul pa%#ents loo# nearer' the prospect deteriorates

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&ut is less &ad than that aced &% a deprived owner! "he depreciation charge e#erges clearl% ro# the a&ove ta&le as the worsening o a cash prospect! "o what extent do current depreciation #ethods re lect the conclusion reached a&oveF 5o current depreciation #ethods cater or an assets patterns o cash low and activit%F "hese $uestions are addressed &elow! The simpler depreciation methods 1n this section are considered the si#pler #ethods o depreciation: straight line' reducing &alance' su#(o (digits and the service unit #ethods! Gepairs and #aintenance costs are also taken into account! "he e#phasis is on the pattern o cash lows i#plied &% each depreciation #ethod! Straight line depreciation "he depreciation calculation is as ollows: Annual depreciation B c H s n )or an asset costing (c) ,1'.*- with a scrap value (s) o ,*- and a + %ear li e (n)' then 1'.*- H *- B ,4-+ "he straight line #ethod its an asset that satis ies two conditions! Gelevant cash lows each %ear #ust &e constant and the input units #ust coincide with accounting periods' i!e!' the assets use #ust &e spread evenl% over ti#e! Assu#ing a repair cost o ,1-- per %ear' deprival value &udgets run as ollows: 7ear end =ave &udget 2utla%s: 1nitial cost Gepairs ?crap value "otal Init cost per %ear =ave not &udget Annual rental 8et &ene it (depreciation) 1'.* 1-1-1-(*-) 1 . , + +1 "otal 1'.* +-(*-) 1'**1'*-

*-4--

*-4--

*-4--

@@@ *-

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6 9alue at end o %ear 1'.* :*4**-

4arek + 5epreciation 4ethods and 6alculation

7 *educing +alance method "he depreciation calculation under this #ethod is #ore co#plex &ecause value alls each %ear &% a ixed proportion o itsel and the or#ula &elow calculates this proportion: Croportion B 1 n
s c

)or our exa#ple' the calculation is as ollows:


1 + *B -!6*: 1'.*-

"he calculated proportion o 6*!:A writes the initial cost o ,1'.*- down to the scrap value o ,*- over a + %ear period as ollows: 7ear 1 depreciation (1'.*- x -!6*:) 7ear . depreciation J(1'.*- H :..) x -!6*:K 7ear + depreciation J(1'.*- H :.. H .:.) x -!6*:K "otal depreciation 1nitial cost ?crap value , :.. .:. 96 1'.-1'.**-

Lhat cash low patterns are i#plied &% these depreciation iguresF 6learl%' i the annual depreciation charge is to &e constant' increasing repairs and #aintenance costs are i#plied! 1t ollows' so#ewhat surprisingl%' that an asset loses value ast in its trou&le( ree da%s' and slowl% when the repair &ills soar! "hat soaring repair &ills are i#plied &% the reducing &alance #ethod is illustrated &elow in the deprival value &udgets in which the i#plied repair &ill is the &alancing igure! 7ear end =ave &udget 2utla%s: 1nitial cost Gepairs (&alancing igure) ?crap value "otal Init cost per %ear =ave not &udget Annual rental 8et &ene it (depreciation)
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. ,

+1

"otal 1'.* 1'.6 6 (*-) .'46 6 :. .

1'.* *47.6 (*-)

:.. :..

:.. .:.

:.. 96

@@@@ *-

: 9alue at end o %ear 1'.* 4.: 146 *-

8ote that the depreciation rate calculated &% the reducing &alance #ethod can &e greatl% a ected &% a change in the scrap value! )or exa#ple' i the scrap value were to increase to ,1--' the depreciation rate alls to *6!9A per annu#! Sum,of,digits method "his #ethod calculates depreciation with the aid o a raction! "he deno#inator is a unction o the assets use ul li e! 1n our exa#ple it is (+ M . M 1 B) 6! )or an asset with a our %ear li e it is (4 M + M . M 1B) 1-' and so on! "he nu#erator is the nu#&er o %ears o re#aining li e at the start o that %ear! 5epreciation calculations or the asset are as ollows: , 7ear 1 (1'.*- H *-) x +N6 6-7ear . (1'.*- H *-) x .N6 4-7ear + (1'.*- H *-) x 1N6 .-"he cash low pattern i#plied is si#ilar to that under the reducing &alance #ethod' however' the su#(o (digits #ethod is easier to use and attaches little i#portance to scrap value! 7ear end =ave &udget 2utla%s: 1nitial cost Gepairs (&alancing igure) ?crap value "otal Init cost per %ear =ave not &udget Annual rental 8et &ene it (depreciation) 9alue at end o %ear 1'.* 1 . , + +1 "otal 1'.* 6-(*-) 1':6-

1'.* .-4-(*-)

6-6-6*-

6-4-.*-

6-.-*-

@@@@ *-

"he a&ove three depreciation #ethods are overwhel#ingl% popular! Lhere the% are used #erel% &ecause the% are si#ple' the% #a% not #atch the cash low patterns o the depreciating asset! >ach o the a&ove #ethods i#plies an underl%ing cash low pattern and should onl% &e used with assets which #atch that pattern i the o&0ective is a constant annual charge or depreciation over the assets use ul li e! &omposite provision for depreciation and repairs and maintenance

4arek + 5epreciation 4ethods and 6alculation

9 "his #ethod is rarel% used &ut is designed to calculate a constant annual charge &ased on a total cost igure or the asset co#&ining depreciation and repairs and #aintenance charges' whose cash low pattern is not assu#ed &e orehand &ut is &ased on actual esti#ates! Assu#e or exa#ple that repair costs or the three %ears are expected to &e ,:-' ,.+- and ,17-! "he pattern is neither constant (as assu#ed &% the straight line #ethod) nor is it rising (as assu#ed in the reducing &alance and su#(o (digit #ethods)!

7ear end =ave &udget 2utla%s: 1nitial cost Gepairs ?crap value "otal Init cost per %ear =ave not &udget Annual rental 8et &ene it (depreciation) 9alue at end o %ear

. ,

+1

"otal 1'.* 4:(*-) 1'6: *6 -

1'.* :.+17(*-)

*64:1'.* 77-

*6++44-

*6+9*-

@@@ *-

6learl%' the #ethod re$uires accurate predictions o uture repairs and #aintenance charges &ut these direct esti#ates should &e no worse than the indirect orecasts i#plied &% other #ethods! Also' and this see#s logical' the assets &ook value is sensitive to its state o repair H the &ook value sinks when repairs are due and rises when the% have &een done! Service unit method "he assu#ption so ar has &een that a constant annual depreciation charge is re$uired &ecause the asset provides e$ual nu#&ers o service units each %ear (e!g!' as in a lease)! =owever' this #a% not &e the case or ever% asset' especiall% those which depreciate through use (e!g!' wasting assets such as #ineral rights depleted &% extraction)! "he service unit #ethod deals with such cases! Assu#e that the exa#ple asset produces di erent nu#&ers o units or each %ear o activit%: 4--' *-- and +--' or exa#ple! 7ear end ?ervice units =ave &udget 2utla%s: 1nitial cost ?crap value
4arek + 5epreciation 4ethods and 6alculation

, 1'.*-

1 4-,

. *-,

+ +-,

+1 ,

"otal 1'.-, 1'.*(*-)

(*-)

1"otal 6ost per service unit =ave not &udget Annual rental 8et &ene it each %ear 4-4-*-*-+-+-@@@ *1'.-1

4arek + 5epreciation 4ethods and 6alculation

11

9alue at %ear end

1'.*-

:*-

+*-

*-

"he service unit #ethod #a% &e co#&ined with a repairs and #aintenance esti#ate as ollows: 7ear end =ave &udget 2utla%s: 1nitial cost Gepairs ?crap value "otal 6ost per service unit =ave not &udget Annual rental 8et &ene it each %ear 9alue at end o %ear 1'.* 1'.* :.+17(*-) 1 . , + +1 "otal 1'.* 4:(*-) 1'6: 1! 4

*64:77-

7-47+--

4..**-

*-

Lhere cost o capital is negligi&le' this last #ethod see#s the &est si#ple #ethod or assets which depreciate with use! )or assets which depreciate over ti#e (and hence %ield one service unit per %ear) the straight line #ethod co#&ined with a repairs and #aintenance esti#ate see#s #ost appropriate! Depreciation methods recognising cost of capital Baxter (1971 : :1(11+) #aintains that depreciation #ethods should take the cost o capital (whether e$uit%' de&t or a co#&ination o &oth) into account! "he conse$uences o not taking cost o capital into account are illustrated in the exa#ple &elow! &ost of capital ignored Assu#e a ti#e(asset costing ,1:'--- with a 4 %ear li e and no scrap value depreciated on a straight line &asis at ,4'*-- per annu#! "his is the onl% asset owned &% a &usiness with a capital o ,1:'--- and operating pro it &e ore depreciation o ,11'--- per annu#! All pro its are paid out as dividends at the end o the %ear! Geproduced &elow are the &alance sheets o the ir# at inception and or the our %ears that the asset is operated!

4arek + 5epreciation 4ethods and 6alculation

1. Balance sheets as at %ear ?tart 1:'--( 1:'--.-O1 , 1:'--4'*-1+'*-4'*-1:'--6apital 1:'--1:'--1:'--.-O. .-O+ .-O4 1:'--1:'--( 4'*-1+'*-1:'--1:'--1:'---

)ixed asset at cost 5epreciation 8et &ook value 6urrent assets Bought with %ears depreciation Bought in earlier %ears 6u#ulative

1:'--9'--9'--4'*-4'*-9'--1:'--1:'---

1:'--1+'*-4'*-4'*-9'--1+'*-1:'--1:'---

8ote that as the ixed asset (the pri#ar% asset) is used up and depreciated' it results in the &uild up o other (current) assets (the secondar% asset) &ecause operating pro it o ,11'--per annu# is restricted to ,6'*-- &% the depreciation charge o ,4'*-- and onl% ,6'*-- is distri&uted as a dividend leaving ,4'*-- in the ir#! "he rational #anager would not have this secondar% asset sitting around idl% &ut would invest it at the cost o capital (sa% 4.A per annu#) to produce returns as detailed &elow! Cro it and loss account %ear ending 2perating pro it &e ore depreciation 5epreciation 8et pro it Gevenue at 4.A on secondar% asset "otal pro it or %ear 5ividend Getained pro it or %ear .-O1 11'--4'*-6'*-( 6'*-6'*-( .-O. , 11'--4'*-6'*-1':9:'+9:'+9( .-O+ 11'--4'*-6'*-+'7:1-'.:1-'.:( .-O4 11'--4'*-6'*-*'671.'171.'17(

As the secondar% asset grows in siEe it &egins to have a &ig e ect upon the ir#s structure and #a% raise revenue or reduce costs and hence change the pattern o cash lows! 1n the pro it and loss accounts a&ove' &% %ear 4' the pro it o the ir# has al#ost dou&led as a result o revenue generated &% the secondar% asset! 2 course' the cost o capital o 4.A exaggerates the igures &ut the point is nevertheless proven! At the end o %ear 4' the secondar% assets #a% &e sold to generate the ,1:'--- needed to purchase a new asset and &egin the production c%cle over again! 1n .-O*' total pro it or the %ear once again alls to ,6'*-- and the c%cle o rising and alling pro its &egins again! "his oscillation o the pro it igures under#ines their use ulness and are poor guides to current consu#ption (the dividend)! )urther#ore' the reported pro it igures are a poor guide in deciding whether the pro0ect should &e undertaken in the irst place! Piven a cost o capital o 4.A per annu#' the owner o a capital su# o ,1:'--- would expect a return o (1:'--- x -!4.) ,7'*6- &ut the pro it in the irst %ear is onl% ,6'*--! Las the invest#ent a #istakeF "he net present value o the pro it is:
4arek + 5epreciation 4ethods and 6alculation

1+ 6ash in lows (11'--- x 1!79*.) 6ash out low 8et present value , 19'747 1:'--M1'747

2n this &asis' the pro0ect should &e undertaken and the irst %ear pro it gives a #isleading view o the pro0ects worth! 1n looking at the &alance sheet' total assets are valued at ,1:'--- or all %ears' data which con lict with the pattern o rising earnings signalled &% the pro it and loss account! "he i#plication is that the &alance sheet values o the asset are too low and that the use o straight line depreciation is creating a secret reserve out o which the extra pro its are paid! &ost of capital incorporated "he pro&le#s outlined a&ove disappear when the cost o capital is taken into account! Because the ti#e value o #one% is now &eing taken into account' the owner o the &usiness has a di erent attitude to the service potential o the asset: the owner values the service potential o an% given %ear #ore than the service potential one or #ore %ears hence! )or exa#ple' a capital su# o ,1:'--- at a cost o capital o 4.A per annu# will purchase the ollowing our %ear annuit%: , (1:'--- x -!**7) 1-'-.6 =owever' each %ears cash low with a no#inal value o ,1-'-.6 has a di erent value to the owner once the ti#e value o #one% is taken into account: , A#ount due: one %ear hence (1-'-.6N1!4.) 7'-61 two %ears hence (1-'-.6N1!4..) 4'97. three %ears hence (1-'-.6N1!4.+) +'*-. 4 our %ears hence (1-'-.6N1!4. ) .'46* "otal 1:'--"hese igures are a good guide to depreciation! Assu#e that the owner is valuing the asset at the end o the .-O1 inancial %ear! 3ooking ahead three %ears' the owner has the ollowing service potential le t: , .-O. (one %ear awa%) 7'-61 .-O+ (two %ears awa%) 4'97. .-O4 (three %ears awa%) +'*-. "otal 1*'*+* 9alue o asset at start o .-O1 1:'--5epreciation or .-O1 .'46* "hus depreciation' taking into account the cost o capital' has a low(high pattern! =owever' in order to give a constant annual charge to the pro it and loss account' the cost o capital

4arek + 5epreciation 4ethods and 6alculation

14 itsel #ust have a high(low pattern! "his is intuitivel% correct: consider the situation in which ,1:'--- was &orrowed to purchase the asset on hire purchase ter#s with annual instal#ents pa%ing o capital and interest! "he schedule o repa%#ents is as ollows: 7ear .-O1 .-O. .-O+ .-O4 2pening lia&ilit% , 1:'--1*'*+4 1.'-+. 7'-*9 1nterest at 4.A , 7'*66'*.4 *'-*+ .'96* 1nstal#ent , 1-'-.6 1-'-.6 1-'-.6 1-'-.6 6losing lia&ilit% , 1*'*+4 1.'-+. 7'-*9 (.)

"he interest charges' the cost o capital' have a high(low pattern! 2 course' #one% is not ree and providers o inance need to &e rewarded whether the% are third parties or e$uit% shareholders! "he earlier exa#ple #a% now &e reconstructed taking the cost o capital into account! Balance sheets as at %ear )ixed asset at cost 5epreciation 8et &ook value 6urrent assets Bought with %ears depreciation Bought in earlier %ears 6u#ulative Balance sheet total 6apital Cro it and loss accounts %ear ended 2perating pro it &e ore depreciation 5epreciation 8et operating pro it Gevenue at 4.A on secondar% asset "otal pro it or %ear 5ividend Getained pro it or %ear ?tart 1:'--( 1:'--.-O1 , 1:'--.'46* 1*'*+* .'46* ( 1:'--1:'-- .'46* 1:'--1:'--.-O. 1:'--*'967 1.'-++ +'*-. .'46* *'967 1:'--1:'--.-O+ 1:'--1-'9+9 7'-61 4'97. *'967 1-'9+9 1:'--1:'--.-O+ 11'--4'97. 6'-.: .'*-6 :'*+4 :'*+4 ( .-O4 1:'--1:'--( 7'-61 1-'9+9 1:'--1:'--1:'--.-O4 11'--7'-61 +'9+9 4'*94 :'*++ :'*++ (

.-O1 11'--.'46* :'*+* ( :'*+* :'*+* (

.-O. , 11'--+'*-. 7'49: 1'-+* :'*++ :'*++ (

"otal pro its or the %ear are now si#ilar in all %ears and are an excellent guide to consu#ption and to the worth o the pro0ect as a whole! =owever' the sa#e cannot &e said o the net operating pro it igure! "he actor% #anager' whose &onus #a% depend on this igure' will wonder wh% the accounts show a declining a#ount when the assets are &eing operated with e$ual e icienc% in each %ear! "he i#pression &eing given &% the pro it and loss account is that #anu acturing pro its are alling while pro its ro# inancial operations are rising!
4arek + 5epreciation 4ethods and 6alculation

1* "he ke% ele#ent here is the depreciation #easure' o course! "he accounts a&ove are correct i depreciation is #easured as a all in value &etween the start o the %ear and the input date! =owever' the% do not #easure correctl% the all in value as at the input date! A si#ple exa#ple will serve to highlight the distinction! Assu#e that at the start o the %ear' the ir# is aced with a tax &ill o ,1'4.- pa%a&le at the end o the %ear! "he ir# decides to set aside ,1'--- now to pa% or the tax &ill which at an interest rate o 4.A per annu# will provide the re$uired a#ount on the due date! "he net cost to the ir# o the tax &ill is ,1'--- and it is these net costs that are #easured in the depreciation igures a&ove! =owever' one #a% argue that the cost o the tax &ill is ,1'4.-' its value at the ti#e the lia&ilit% is settled! =ence' the asset set aside to und the tax &ill increases in value to ,1'4.- &e ore &eing reduced to Eero when the lia&ilit% is paid! "he argu#ent is that all assets &ehave in this wa% once the cost o capital is taken into account! "ake or exa#ple a capital su# o ,1:'--- invested in a deposit account at an interest rate o 4.A per annu# in order to service an annual expenditure o ,1-'-.6! "he ollowing rises and alls in value #a% &e recorded as the store o wealth is used up: 2pening &alance 7ear 1 1nterest at 4.A >xpenditure in %ear 1 2pening &alance %ear . 1nterest at 4.A >xpenditure in %ear . 2pening &alance %ear + 1nterest at 4.A >xpenditure in %ear + 1nterest at 4.A >xpenditure in %ear 4 6losing &alance in %ear 4 , 1:'--7'*6.*'*61-'-.6 1*'*+4 6'*.4 ..'-*: 1-'-.6 1.'-+. *'-*+ 17'-:* 1-'-.6 7'-*9 .'96* 1-'-.4 1-'-.4 (

"his rather la&orious exa#ple illustrates the rises and alls in asset value that lie &eneath the net cost o the expenditure o ,1:'---! A ixed asset is a store o wealth o a si#ilar nature to a store o cash on deposit earning interest and rises and alls in value in a si#ilar #anner! A depreciating ixed asset does not provide a cash annuit% (as in the exa#ple a&ove) &ut does provide an annuit% o input services and hence its value rises as well as alls over ti#e! "he sa#e argu#ent #a% &e #ade in ter#s o the cost o the input services provided &% the asset! 1n %ear .-O1' the asset costs a depreciation charge o ,.'46*! But this a#ount understates the cost o the asset &ecause &% investing in the asset the ir# has also orsaken invest#ent inco#e o (1:'--- x -!4.) ,7'*6-! "his is an opportunit% cost which when added to the depreciation results in a total annual charge o (.'46* M 7'*6-) ,1-'-.*! "his exercise #a% &e repeated or each o the %ears as ollows:

4arek + 5epreciation 4ethods and 6alculation

16 .-O1 5epreciation 8et cost o capital on ,1:'--- less secondar% assets: .-O1 (1:'--- x -!4.) .-O. J(1:'--- H .'46*) x -!4.K .-O+ J(1:'--- H *'967) x -!4.K .-O4 J(1:'--- H 1-'9+9) x -!4.K "otal cost per annu# .'46* .-O. , +'*-. .-O+ 4'97. .-O4 7'-61

7'*66'*.* *'-*4 1-'-.* 1-'-.7 1-'-.6 .'966 1-'-.7

As a result o the a&ove anal%sis' the ir#s pro it and loss account can now &e re( written to include the whole cost o #achine ownership! Cro it and loss accounts %ear ending 4anu acturing account 2perating pro it &e ore depreciation 5epreciation 6ost o capital Cro it on #anu acturing )inance account 6ost o capital on #achine ?econdar% revenue "otal pro it or %ear 5ividend Getained or %ear .-O1 .-O. , 11'--+'*-. 6'*.* 97+ 6'*.* 1'-+* :'*++ :'*++ ( .-O+ 11'--4'97. *'-*4 974 *'-*4 .'*-6 :'*+4 :'*+4 ( .-O4 11'--7'-61 .'966 97+ .'966 4'*94 :'*++ :'*++ (

11'--.'46* 7'*697* 7'*6( :'*+* :'*+* (

"he revised pro it and loss account now includes the whole cost o the ixed asset charged against revenues while the inance section records its appreciation in value over ti#e! "he actor% is shown to have #ade an annual surplus o a&out ,97*' 0usti %ing the decision to purchase the ixed asset in the irst place in line with the net present value calculation (97* x 1!79*. B) ,1'7*-! "he net result re#ains unchanged &ut the $ualit% o the data has i#proved considera&l%! "here is onl% one #ethod o accounting depreciation which charges operations with a high constant cost and credits the inancial section with the cost o capital: the annuit% #ethod o depreciation! 1t is not #uch used or depreciating assets &ut there is nothing in principle against it &eing so used' as the a&ove exa#ple illustrates! "he techni$ue is particularl% use ul in #aking pro its co#para&le where the inancing o assets di ers! )or exa#ple' = is a holding co#pan% with three su&sidiaries' A' B and 6' all alike in siEe and activit%! >ach su&sidiar% needs ,1-'--- o initial current assets and #achiner% with a cost o ,.-'---' a .- %ear li e and no scrap value! ?u&sidiaries A and B purchase the #achiner% while 6 hires it on a .- %ear lease or an annual pa%#ent o ,1'744!

4arek + 5epreciation 4ethods and 6alculation

17 >ach su&sidiar% is inanced di erentl%! 1n A' = takes up ,+-'--- o ordinar% shares at par or cash! = provides B with ,1-'--- o cash and the su&sidiar% &orrows ,.-'--- at 6A per annu#! 6 is provided with ,1-'--- o initial cash! "he cost o capital or all our co#panies is 6A per annu#! Accounts or the irst %ear o operations or each su&sidiar% run as ollows: Cro it and loss accounts ?ales less current costs 5epreciation 1nterest paid Annual rental 8et pro it Balance sheets )ixed asset 8et current assets "otal assets less current lia&ilities 6reditors due a ter one %ear 6apital and reserves 2rdinar% share capital Cro it and loss account Geturn on =s initial invest#ent A , .'+44 1'--1'+44 19'--1.'+44 +1'+44 +1'+44 +-'--1'+44 +1'+44 -!-44: B , .'+44 1'--1'.-144 19'--11'144 +-'144 .-'--1-'144 1-'--144 1-'144 -!-144 6 , .'+44 1'744 6--

1-'6-1-'6-1-'6-1-'--6-1-'6--!-6

2n the &asis o these results' the non(accountant chair#an o = suggests that the #anagers o su&sidiaries A and 6 should receive a &onus &ut that the #anager o B should &e ired! =owever' the pro it igures o the su&sidiaries #a% &e rendered co#para&le were A and B to use the annuit% #ethod o depreciation' as illustrated in the exa#ple &elow! At an annual interest rate o 6A' a capital su# o ,.-'--- will purchase a twent% %ear annuit% o (.-'--- x -!-:7.) ,1'744 per annu#! Piven straight line depreciation' the annual depreciation charge is (1'744 x 1@@ B) ,*44! "he cost o capital is (.-'--- x (1!-6).-!-6) ,1'.--! Cro it and loss accounts ?ales less current costs 5epreciation 6ost o capital Annual rental 2perating pro it A , .'+44 *44 1'.-6-B , .'+44 *44 1'.-6-6 , .'+44 1'744 6--

4arek + 5epreciation 4ethods and 6alculation

1: 1nterest paid 6ost o capital "otal pro it Balance sheets )ixed asset 8et current assets 6reditors due a ter one %ear +1':-6apital and reserves 2rdinar% share capital Cro it and loss account Geturn on =s initial invest#ent +-'--1':-+1':--!-6 (1'.--) 1'.-6-19'4*6 11'144 +-'6-.-'--1-'6-1-'--6-1-'6--!-6

1'.-1':-19'4*6 1.'+44 +1':--

6--

1-'6-1-'6-1-'6-1-'--6-1-'6--!-6

All three su&sidiaries are using their resources e$uall% well and this has &een #ade transparent &% the calculations a&ove using the annuit% #ethod o depreciation!

4arek + 5epreciation 4ethods and 6alculation