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Depreciation Is the decrease in value of physical properties with use and time.

. It is an accounting concept an annual deduction against before tax income such that the effect of time can be reflected in a firms financial statement. A non-cash cost that affects income taxes. Can involve deterioration or obsolescence Depreciation accounting is to account for the cost of fixed assets in a pattern that matches their decline in value EMM3604 Cost Accounting and Engineering Economy over time.
Assoc.Prof Dr.Rosnah Mohd.Yusuff

Asset Depreciation
Fixed Assets resources that are acquired to provide future cash flows. Economic depreciation Physical dep
The gradual decrease in utility in an asset with use and time. Functional dep

Depreciation
Accounting depreciation The systematic allocation of an assets value in portions over its depreciable life
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Book dep Tax dep

Physical dep
a reduction in an assets capacity to perform its intended service due to physical impairment. due to interaction with environment corrosion, rotting and due to wear and tear of use.

Functional dep
as a result of changes in the organization or in technology obsolescence, declining need of the asset, or inability to meet increased quantity and/or quality demands.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Economic dep Economic dep =purchase price market value Accounting dep use to assess financial position of organization. Asset dep, cost of fixed assets are capitalized their costs are distributed by subtracting them as expenses from gross income. A fraction of the cost of the asset is chargeable as an expense in each accounting period in which the asset provide service to the firm.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Depreciation Concepts & Terminology


Depreciating an asset requires:
1. What is the cost of the asset 2. What is the assets value at the end of its useful life 3. What is depreciable life of an asset 4. What method of dep do we choose?

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Cont
Depreciable Property
a. It must be used in business or held to produce income b. It must have a definite service life, and that life must be longer than a year. c. It must be something that wears out, decays, get used up, obsolete, or loses value from natural causes. d. It is not inventory, stock in trade, or investment property.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Definitions
Adjusted (Cost) basis original cost basis of the asset, adjusted by allowable increases or decreases. Ex. cost of any improvement to a capital asset with a useful life greater than one year, the original cost basis. Casualty or theft loss. Basis, or cost basis initial cost of acquiring an asset (purchase price + any sales taxes), including transportation expenses and other expenses making the asset serviceable.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Cont
Book Value (BV) the worth of a depreciable property shown on the accounting records of a company. Original cost basis include any adjustments, less all allowable depreciation or depletion deductions. (Book Value) = adjusted cost basis - (dep deduction) Market Value (MV) the amount that will be paid by a willing buyer to a willing seller. The MV J=1 approximates the present value of what will be received through ownership of the property, including the time value of money.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Definitioncont

Recovery period
The number of years over which the basis of a property is recovered through the accounting process.

Recovery rate
A percentage (in decimal form) for each year of the MACRS recovery period that is utilized to compute an annual depreciation deduction.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Definitioncont

Recovery period
The number of years over which the basis of a property is recovered through the accounting process.

Recovery rate
A percentage (in decimal form) for each year of the MACRS recovery period that is utilized to compute an annual depreciation deduction.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Definitioncont Salvage Value (SV)


the estimated value of a property at the end of its useful life. It is the expected value or selling price of a property when the asset can no longer be used productively by its owner. The term net salvage value is used when expenses are incur in disposing property. a cash outflow deducted from cash inflow to obtain final net SV. the expected (estimated) period of time that a property will be used to produce income/owners expects to productively use it. Referred as Depreciable Life sometimes. Actual Useful Life of an asset, maybe different than its depreciable life. Determine service life of an asset IRS guidelines.

Useful life

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Example:
A company purchased an automatic hole-punching machine priced at RM62, 500. The vendors invoice included a sales tax of RM3263. The company also paid the inbound transportation charges of RM725 as well as labour cost of RM2150 to install the machine in the factory. The site was also prepared before installation at a cost of RM3500. Determine the cost basis for the new machine for depreciation purpose. Cost of new machine RM62,500 Freight 725 Installation Labour 2,150 Site Preparation 3,500 Cost of machine (cost basis) RM68,875

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Depreciation Methods
1. 2. Book dep for financial reports, balance sheet, income statement. Tax dep for calculating taxes. depreciating assets more quickly allows firms to defer paying income taxes. Permit a higher dep in earlier years than book dep, tax benefit is enjoyed earlier. Pay lower taxes in earlier years, better cash position because of time value of the funds.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Book Depreciation Methods


EE - dep in the context of income tax computation.
firms use book dep methods for financial reporting to stockholders and outside parties to reflect the actual loss in value of asset still use for income tax purposes.

1. straight line method 2. accelerated method DB, SOYD. 3. unit of prod method
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Straight line method (SL)


Assumes fixed assets provides its services in a uniform fashion. A constant amount is depreciated each year over the useful life of the asset.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

SLcont
dk d* BV = = = (B - SVn) / N d for 1 k N B - d

N =depreciable life of the assets in years B =cost basis d =annual dep deduction in year (1 N) BV=book value at the end of year SV=estimated salvage value at end year N d* =cumulative dep through year

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

SLexample
A new electric saw for cutting small pieces of lumber in a furniture manuf. Plant has a cost basis of RM4000 and a 10-year depreciable life. The estimated SV of the saw is zero at the end of 10 yrs. Determine the annual dep using SL and the BV at the end of each year.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

SLexample (cont)
d = at year 5, d5 = d*5 = BV = = (4000 0) / 10 RM 400 5 (4000 0) =RM 2000 10 4000 5(4000-0) 10 RM 2000

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

SLexample (cont)
EOY, 0 1 2 3 4 5 6 7 8 9 10

RM400 400 400 400 400 400 400 400 400 400

dk

BVR RM 4000 3600 3200 2800 2400 2000 1600 1200 800 400 0

The final SV is the final book value


EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Declining Balance (DB) method


sometimes called constant percentage method or the Matheson Formula. Assumes the annual cost of dep is a fixed percentage of BV at the beginning of the year. The fixed fraction, is = (1/N) (multiplier) Multiplier commonly used 1.5 (150% DB) and 2.0 (200%, or DDB). As N , dep is highest in the first year and decreases over the assets depreciable life.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

DBcont
D1 = D2 D3 Dn Bn Ii = (I D1) = I (1-) = (I D1- D2) = I (1 ) = I (1-) n-1 = I (1-) n

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

DBExample

The following information for a computer system:


Cost Basis of the asset, I = RM10,000 Useful Life, N = 5 years. Estimated SV = RM778.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

DBExample (cont)
Use same a. = d6 = d*6 = BV6= example as SL:2/N = 0.2 4000 (1-0.2)5 (0.2) = 4000 [ 1-(1-0.2)6 ] = 4000 (1-0.2)6 =

RM262.14 RM2951.42 RM1,048.58

b. = 1.5/N = 0.15 d6 = 4000 ( 1- 0.15)5 (0.15) = RM266.22 d*6 = 4000 [ 1 (1 - 0.15)6] = RM2491.40 BV6 = 4000 (1 0.15)6 = RM1508.60 Using = 0.2
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

DBExample (cont)
EOY, 0 1 2 3 4 5 6 7 8 9 10 d 800 640 512 409.60 327.68 262.14 209.72 167.77 134.22 107.37 BV 4000 3200 2560 2048 1638.40 1310.72 1048.58 838.86 671.09 536.87 429.50

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Sum of the years digit (SOYD)


If N = SOYD depreciable life of the asset, = n (n+1) 2 d = (B - SVN) . [ 2 (N + 1) ] N(N+1) Book Value BV= B [ 2 ( B- SVN) ] + [ (B - SVN) ] ( + 1) N N(N+1) d* = B - BV
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

SOYDexample
Using same ex: d4 = 400 [ 7 / 25 ], N = 10 = 509.09

SOYD = 10 (11) = 55 2

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

SOYDexample (cont)
EOY, 0 1 2 3 4 5 10 d 727.27 645.55 581.82 509.09 436.36 72.73 BV 4000 d1 = 4000 (10 / 55) 3272.73 d2 = 4000 (9 / 55) 2618.18 d3 = 4000 (8 / 55) 2036.36 1527.27 109.91 0

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

DB switchover to SL DB BV never reaches zero can switch to SL Switchover occur when SLDep > DBdep

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

DB switchover to SLex d6 = RM262.14, BV6 = RM1048.58 BV10 = RM429.50 With switchover, BV10 = 0, since in year 6 Dbdep = SLdep= RM262.14 switch to SL thru year 7-10, SLdep>DBdep
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Example (cont)
BOYear, DB SL BV 6 262.14 = 262.14 1310.72 7 209.72< 262.14 1048.58 8 167.77< 262.14 786.44 9 134.22< 262.14 524.30 10 107.37< 262.14 262.16 Total depreciation : DDB = RM3,570.50

SL =

RM4000.

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Units of Production Method


SL, DB, SOYD -decrease in value as a function of time. When decrease in value is mostly a function of use, the cost basis (minus final SV) is allocated equally over the estimated number of units produced during the useful life of the asset. The depreciation rate: Depreciation per unit prod = B -SVN estimated lifetime prod in units
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Example
A piece of equipment has a basis of RM50,000 and SV is RM10,000, when replaced after 30,000 hrs. of use. Find the dep rate per hour of use, and its BV after 10,000 hrs of operation.

Dep per unit of prod =RM50,000 10,000 30, 000

RM1.33

After 10, 000 hrs, BV = 50, 000 RM1.33 hr Or BV = RM36, 700 #


EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

(10,000)

MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)

Practice in US
1981-ACRS 1986 MACRS asset dep law dictate depreciation rates for all personal and real property take advantage of accelerated methods of capital recovery

EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

MACRS (cont)

MACRS Dt = dtB dt = dep rate provided by the Govt. Book Value, BVt = BVt-1 - Dt BVt = first cost sum of j=t acc. dep j=1 = B Dj
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

MACRS (cont)
First cost B is always completely depreciated as MACRS assumes that the estimated SV=0. Recovery periods are standardized to the values of 3,5,7,10,15 and 20 years for personal property. For real property commonly 39 years, possible to justify 27.5 year recovery period. For Annual Dep: First Cost (unadjusted) X MACRS rate (from table). the dep rate incorporate the DDB method (d = 2/n) and switch to SL dep during recovery period for property starts with DDB (dt = 2/n) SL rate (dt = 1/n) when SL method offers a faster write-off.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

MACRS (cont)
Real property -SL method for n = 39. Annual percentage dep rate =1/39 = 0.02564. the MACRS forces partial recovery in years 1 to 40.
Year 1 1.391% Year 2 39 2.564% Year 40 100 d1 100 dt 100 d40 = = = 1.177%.

MARCS dep rates are presented for 1 year longer than stated recovery period n. is built in half year convention imposed by the MACRS system.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Why??? a. Reduced Performance deterioration of parts, expected level of reliability/productivity is not achieved, increased cost of operation, higher scrap and rework costs, lost sales, and larger maintenance expenses. b. Altered requirements - New requirements accuracy, speed etc. c. Obsolescence - competition, rapidly changing technology of automation, computers, communication.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Replacement Analysis

Replacement Analysis (cont)


Basic concepts -compare alternatives. Defender asset currently owned (or in place). Challenger(s) other alternative(s) Perspective - of analysis consultant or outsider. - neither own or use the asset
To acquire the defender, we must invest the going market value of the defender alternative.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Replacement Analysis (cont)


Estimated market or trade-in-value the First Cost of the defender alternative. - economic life, AOC & SV for defender past cost are irrelevant in replacement analysis - includes sunk cost.
Sunk cost = present BV-present MV

Sunk cost should not be included in the economic analysis. It represents capital loss.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Replacement Analysis (cont)


Time Value of Money Interest manifestation of the time value of money the increase between an original sum of money borrowed and final amount owed, original amount owned (investment) and final amount accrued. Principal original investment or loan amount.

Interest=total amount now - original principal


If ve
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

lose money and no interest.

Replacement Analysis (cont)


If you borrowed money

Interest

=amount owed now-original principal

Interest rate : Percent interest rate = interest accrued per time unit x 100% original amount unit of time used interest period
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Replacement Analysis (cont)


Examples 1) Investment RM100, 000 and withdrew a total of RM106, 000 exactly 1 year later. a. Interest gained: RM106, 000 100, 000 = RM60, 000 b. Interest rate: 6000 / yr x 100% = 6% per year. 100,000
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Replacement Analysis (cont)


2) You borrowed RM20,000 from a bank for a year at 9% interest. a. interest : RM20,000 (0.09) = RM1800 b. Total due at end of year : = sum of principal + interest = RM20, 000 + RM1800 = RM 21,800
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff

Replacement Analysis (cont)


3) How much money has to be deposited one year ago to have RM1000 now at an interest rate of 5% per year. What is the interest earned? Let X be the original deposit Total = original + original (interest rate) RM1000= + ( 0.05) = (1+0.05) = 1000 / (1.05) = RM952.38.
EMM3604 Cost Accounting and Engineering Economy Assoc.Prof Dr.Rosnah Mohd.Yusuff