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BASIC DEPRECIATION METHODS

1. Straight Line Method

2. Declining Balance Method

3. Sum of the Years Digits Method

4. Sinking Fund Method


BASIC DEPRECIATION METHODS

1 - The Straight Line Method

The straight line method of computing depreciation assumes that the loss in value is
directly proportional to the age of the structure. This straight line relationship gives
rise to the name of the method. Thus with this formula if :

L = Useful life of the structure in years,


C = The original cost,
d = The annual cost of depreciation,
Cn = The book value at the end of n years,
CL = The value at the end of the life of the structure, the scrap value (including gain or
loss due to removal), and
Dn = Depreciation up to age n years;

d = C – CL / L

Dn = n (C – CL) / L

Cn = C - n (C – CL) / L
-
Prof. Liaqat Ali Qureshi
BASIC DEPRECIATION METHODS

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 one year to the book
value at the beginning of that year is constant throughout
the life of the asset and is designated by K.

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

 Depreciation during the Ist year: d1 = C x k


 Depreciation during the nth year: dn = (Cn –1)k
 Salvage value at age n years: Cn = C(1 – k)n
 Book value at age n years: Cn = C(1 – k)n = C(CL / C) n / L

 Rate of depreciation:
n Cn L CL
k =1 - = 1 -
C C

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

 The declining balance procedure, like the straight line method,


is simple to apply. However, it has two weaknesses.
1- The annual cost of depreciation is different each year
and, from an engineering economy viewpoint, this is
inconvenient.
2- With this formula an asset can never depreciate to zero
value. This is not a serious difficulty, and in actual practice
computation of the theoretical depreciation rate k, seldom
is made. Instead, a reasonable value is assumed.
 A so-called Double Declining Balance Method also is used. In
this procedure the depreciation rate k is computed as 2/L, with
any prospective final salvage value being disregarded.

Prof. Liaqat Ali Qureshi


PROBLEM 5

Calculate the Total Depreciation and Book


value of a concrete mixer at the end of 4th year
by Straight Line Method and
Declining/Reducing Balance Method. The
mixer was initially purchased for Rs: 3,50,000/-
at an interest rate of 3.0 % and is estimated to
have a useful life of 12 years and a scrap value
of Rs: 25,000/- at the end of useful life.

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

3 - The Sum-of-the-Years’ - Digits Method


 In order to obtain the depreciation charge in any year of
life by the sum-of-the-years’-digits method (commonly
designated as SYD), the digits corresponding to the
number of each year of life are listed in reverse order.
 The sum of these digits then is determined.
 The depreciation factor for any year is the reverse digit
for that year divided by the sum of the digits.
 For example, for a property having a life of 5 years:

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

YEAR No. of the year in Depreciation Factor


reverse order (digits)
1 5 5/15
2 4 4/15
3 3 3/15
4 2 2/15
5 1 1/15
Sum of the digits = 15

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

 The depreciation for any year is the product of the SYD


depreciation factor for that year and the depreciable
value, C – CL.
 The general expression for the annual cost of
depreciation for any year n, when the total life is L, is

Depreciation factor = 2 (L – n + 1) / L (L + 1)
dn = ( C - CL ) x [2 (L – n + 1) / L (L + 1)]
Cn = C - [ 2( C - CL ) / L ] n + [(C – CL) / L(L+1) ] n (n+1)

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

4 - The Sinking Fund Formula

 The Sinking Fund Formula assumes that a sinking


fund is established in which funds will accumulate for
replacement purposes.
 The total depreciation that has taken place up to any
given time is assumed to be equal to the accumulated
value of the sinking fund at that time. In this manner
the invested capital is preserved.
 With this formula, if the estimated life, scrap value,
and interest rate on the sinking fund are known, a
uniform yearly deposit can be computed. This deposit
is the annual cost of depreciation. Prof. Liaqat Ali Qureshi
BASIC DEPRECIATION METHODS

 d1 = (C – CL) (A/F, i %, L), where


(A/F, i %, L) = i / [( 1 + i )L - 1]

 Dn = (C – CL) (A/F, i %, L) / (A/F, i %, n) , where

(A/F, i %, n) = i / [( 1 + i )n - 1]
 Cn = C - Dn

 dn = Dn - Dn-1

Prof. Liaqat Ali Qureshi


BASIC DEPRECIATION METHODS

5 - The Service Output Method

 Some companies attempt to compute the depreciation of


equipment on the basis of its output.
 When equipment is purchased, an estimate is made of the amount
of service it will render during its economic life.
 Depreciation for any period is then charged on the basis of the
service that has been rendered during that period.

Depreciation per unit of production


=(C – CL) / (estimated lifetime production in units)

Prof. Liaqat Ali Qureshi


COMPARISON OF FOUR BASIC DEPRECIATION METHODS

Prof. Liaqat Ali Qureshi


Sinking Fund Method

Example:
Nick bought a packaging machine for Rs 92,000. He
wants to replace it again in 6 years.
Sinking Fund Method (Contd.)

a) How much will he be able to resell it for after 6 years if it


depreciates on the reducing balance method at 21% p.a.
Sinking Fund Method (Contd.)

b) To replace a packaging machine with new will be more


expensive due to inflation. Inflation on a packaging machine is
expected to be 7% p.a. How much can Nick expect to pay for a
packaging machine in 6 years’ time?
Sinking Fund Method (Contd.)

c) So if he sells the old one to buy new, he will still need more
money. To make up what he will need he starts a sinking fund.
How much should be in the sinking fund after 6 years?