DEPRECIATION

Shiela Marie P. Bautista

Bstm 1a2-2

INTRODUCTION
The value of nearly all equipment, machinery, physical plant, buildings, vehicles
and electronic gadgets declines with use and with the passage of time. It is important in
business to be familiar with this decline in the value of physical assets to present realistic
values in the firms financial statement and to convert the reduction in the value of an
asset during an accounting period to an operating expense of that period. The cost of
this depreciation is physical deterioration because the companies use the assets and it
gradually wear out. Depreciation is an accounting procedure by which the recorded value
(or book value) of an asset is reduced during its projected lifetime in a rational and
systematic manner.
Depreciation procedures involve computing the depreciation amounts, and making
the appropriate accounting entries.

BASIC CONCEPTS
The service life (or useful life) of an asset is the length of time that the asset will
be used in the operation of the business. The amount that is expected to be recovered
upon the sale or disposal of the asset at the end of its service life is called salvage value
(or scrap value/residual value/trade-in value). The difference between the cost of
acquiring the asset and its estimated salvage value should be reported as part of the
businesss operating expense during the assets service life.
Depreciation method may be first categorized according to whether the decline in
value of an asset tends to be proportional to the amount of use, or to be primarily the
result of the passage of time. Machinery for which wear and tear on moving parts is the
main cost of deterioration would fall in the first category. Equipment for which
obsolescence is the prime cause of diminishing value would be in the second group.
For asset whose value depends mainly on age, two patterns are known for the
reduction in the value with respect to time. If there is a fixed decline in value, straightline depreciation is used. However, a lot of assets lose a disproportionate amount of their
value early in their service life. Vehicles are a good example of an asset that exhibits
such accelerated depreciation. In these cases, a systematic method is needed for
allocating diminishing amounts of depreciation to successive accounting period. The
depreciation is the cumulative total of all of all past current depreciation expenses
reported for the asset. An assets book value at any point in its service life is the
difference between the acquisition costs and the accumulated depreciation. That is:
Book value = Previous Book Value Current Depreciation Expense
Figure 10.1
Classification of Depreciation

The following variables will be in our mathematical treatment of the different

depreciation method:
AC = Acquisition Cost
AD = Accumulated Depreciation
ADEPP = Accumulated Depreciation at End of Previous Period
BV = Book Value
BVEPP = Book Value at End of Previous Period
CPDE = Current Periods Depreciation Expense
DE = Depreciation Expense
DEPP = Depreciation Expense per Period
DEPU = Depreciation Expense per Unit of Use/Produce
RV = Resale Value
TLU = Total Lifetime Units
SV = Salvage Value (or Scrap Value/Residual Value)
n = Total number of periods in the Service Life

Depreciation Formula:
DEPP =
BV = AC-AD
AD = ADEPP + CPDE
BV = BVEPP CPDE
DEPU =
DE = No of Units of produced x DEPU
DE = DR x BVEPP
DR =
d=1DR =
Cost base = AC SV

DE = DR x (AC SV)
STRAIGHT-LINE DEPRECIATION METHOD
The most common method of depreciation is the straight line method expressed by
the formula:
R=
Where:
R = depreciation charge per year or annual depreciation
C = original cost of the asset
S = estimated scrap value or salvage value
N = number of period in years, months and the like or useful life
C S = total depreciable cost
Example:
A car purchased for 420,000 has an estimated useful life of five years and a
scrap value of 20,000. Use the straight line method to find the depreciation expense
per year and construct a depreciation schedule.
Given:
C = 420,000
S = 20,000
N = 5 years
Solution:
Substituting the values in the formula:
R=
R=
R=
R = 80,000 per year
End of Year
0
1
2

Annual
depreciation
Expense

Accumulated
Depreciation

Book Value of
Assets

80,000
80,000

80,000
160,000

420,000
340,000
260,000

3
4
5
Total

80,000
80,000
80,000
400,000

240,000
320,000
400,000

180,000
100,000
20,000

Units of Production Method of Depreciation

In units of production method of depreciation, depreciation is charged according to
the actual usage of the asset. In units of production method, higher depreciation is
charged when their is higher activity and less is charged when there is low level of
operation. Zero depreciation is charged when the asset is idle for the whole period. This
method is similar to straight-line method except that life of the asset is estimated in
terms of number of operations or number of machine hours etc.
Such a method is useful where a company has many fixed assets with varying
usage.
Formula:
The following formula is used to calculate depreciation under this method:
Depreciation =

(Number of Units Produced/ Life in Number of Units)

(Cost Salvage Value)

Examples:
Example 1:
A plant costing $110 million was purchased on April 1, 2010. The salvage value
was estimated to be $10 million. The expected production was 150 million units. The
plant was used to produce 15 million units till the year ended December 31, 2010.
Calculate the depreciation on the plant for the year ended December 31, 2011.
Solution:
Depreciation = (15/150) ($110 million - $10 million) = $10 million

Example 2:
A coal mine was purchased by X Corporation for $16 million. It was estimated that
the mine has capacity to produce 200,000 tons of coal. The company extracted 46,000
tones during its first year of operation. Calculate the depreciation.
Solution:
Depreciation = (46,000/200,000) $16 million - = $3.68 million
SERVICE HOURS METHOD

The service hours method estimates depreciation on the productive capacity of the
asset per service hour. In this method, it assumes that the number of productive hours
decreases as the property becomes older.
Example:
A refrigerator purchased for 14,659.20 has an estimated life of 4 years and a
scrap value of 600.00. Use the straight-line method formula to find the depreciation.
Assume that the useful life of the refrigerator is estimated to be 16,260 hours and the
actual number of hours spent in the store each year are follows:
1st year : 5,840 hours
2nd year : 4,640 hours
3rd year : 3,440 hours
4th year : 2,240 hours
Use the service hours method to find the depreciation expense for each year and
construct a depreciation schedule.
Given:
C = 14,659.20
S = 600
N = 16,160 service hours
Use the formula for finding R, then s substitute the given values:
R=
Substitute the values above:
R=
R = 14,059.20 = 0.87 per hour
The annual depreciation as computed based on the corresponding serving hours
per year are as follows:
1st year : 5,840 x 0.87 = 5,080.00
2nd year : 4,640 x 0.87 = 4,036.80
3rd year : 3,440 x 0.87 = 2,992.80
4th year : 2,240 x 0.87 = 1,948.80
Depreciation Schedule Using the Service Hours Method

End of Year
0
1
2
3
4
Total

Annual
depreciation
Expense
5,080.00
4,036.80
2,992.80
1,948.80
14,059.20

Accumulated
Depreciation

Book Value of
Assets

5,080.80
9,117.60
12,110.40
14,059.20

14,659.20
9,578.40
5,541.60
2, 548.80
600.00

DOUBLE DECLINING BALANCE DEPRECIATION

The double declining balance method is an accelerated form of depreciation under
which the vast majority of the depreciation associated with a fixed asset is recognized
during the first few years of its useful life. This approach is reasonable under either of
the following two circumstances:

When the utility of an asset is being consumed at a more rapid rate during the early
part of its useful life; or

When the intent is to recognize more expense now, thereby shifting profit recognition
further into the future (which may be of use for deferring income taxes).

However, this method is more difficult to calculate than the more traditional straightline method of depreciation. Also, most assets are utilized at a consistent rate over their
useful lives, which does not reflect the rapid rate of depreciation resulting from this
method. Further, this approach results in the skewing of profitability results into future
periods, which makes it more difficult to ascertain the true operational profitability of
asset-intensive businesses.
To calculate depreciation under the double declining method, multiply the book value
at the beginning of the fiscal year by a multiple of the straight-line rate of depreciation.
The double declining balance formula is:
Double-declining balance (ceases when the book value = the estimated salvage value)
2 Straight-line depreciation rate Book value at the beginning of the year
A variation on this method is the 150% declining balance method, which
substitutes 1.5 for the 2.0 figure used in the calculation. The 150% method does not
result in as rapid a rate of depreciation at the double declining method.
Example of Double Declining Balance Depreciation
ABC Company purchases a machine for $100,000. It has an estimated salvage
value of $10,000 and a useful life of five years. The double declining balance
depreciation calculation is:

Year

Double-declining
balance depreciation
Net book computed as 2 SL
value,beginning
rate beginning
of year
NBV

Net book
value,
end of year

$100,000

$40,000

$60,000

60,000

24,000

36,000

36,000

14,400

21,600

21,600

8,640

12,960

12,960

2,960

Total

10,000 salvage value

$90,000

Sum-of-Years-Digits Method
Using this method, the annual depreciation can be solved by multiplying the total
depreciation can be solved by multiplying the total depreciable cost by a series of
fractions. The numerator of the fraction is the digit in the useful life of an asset and the
denominator will be the sum of the digit in the useful life of an asset. For example, the
useful life of a machine is four years, the sum of the digits is 10, that is 1+2+3+4.
Therefore, the depreciation rate would be 4/10 for the first year, 3/10 for the second
year,2/10 for the third year and 1/10 for the last year.
Example 1:
Hyacinth Incorporated purchased a machine for 450,000 on January 1, 2004. The
machine has an estimated useful life of five years and a scrap value of 45,000.00. Use
the sum-of-the-years digit method to compute the following:

Depreciation charges annually;

Book value on December 31, 2006; and

Construct a depreciation schedule

Solution:
Given:
Original cost = 450,000.00
Scrap value = 45,000.00
Estimated life span = 5 years

Depreciation charges annually

The sum of the five-year digit is:

1+2+3+4+5 = 15
Total Depreciation Cost = 450,000.00 - 45,000.00
= 405,000.00
2004: 405,000.00 x 5/15 = 135,000.00
2005: 405,000.00 x 4/15 = 108,000.00
2006: 405,000.00 x 3/15 = 81,000.00
2007: 405,000.00 x 2/15 = 54,000.00
2008: 405,000.00 x 1/15 = 27,000.00
Total = 405,000.00

Book value for December 31, 2006

2004: 405,000.00 x 5/15 = 135,000.00

2005: 405,000.00 x 4/15 = 108,000.00
2006: 405,000.00 x 3/15 = 81,000.00
Accumulated depreciation = 324,000.00
Book value = Original cost Accumulated depreciation on December 31, 2006
= 450,000.00 - 324,000.00
Book value = 126,000.00

Construct a depreciation schedule

End of the
year
0
1

Annual
Depreciation
Original cost
150,000 x

37,500.00

Accumulated
Depreciation
37,000.00

Book Value
150,000.00
112,500.00

2
3
4
5
6
7
8

25%
112,000 x
25%
84,375 x
25%
63,281.25
25%
47,460.94
25%
35,595.70
25%
26,696.77
25%
20,022.58
15,000.00

28,125.00

65,625.00

84,375.00

21,093.75

86,718.75

63,281.25

15,820.31

102,539.06

47,460.94

11,865.24

114,404.30

35,595.70

8,898.93

123,303.23

26,696.77

6,674.19

129,977.42

20,022.58

5,022.58

135,000.00

15,000.00

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