Depreciation -definitions
A decline in the value of a property due to gene genera rall wear wear and and tear tear or obso obsole lesc scen ence ce
Meth Method od of writi riting ng off off wear ear and and tear tear on asse assets ts that that are are used used to prod produc uce e inco income me..
Amou Amount nt of valu value e that that a poss posses essi sion on lose loses s over over time.
Deprecia ciation bas basis is that part of the asset’s purchase price that is spread over the deprec depreciat iation ion period period (servic (service e life). life).
Depreciation The cost is spread out over its estimated useful life in the form of an expense given various depreciation methods.
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Causes of Depreciation
Question: What are the causes of depreciation?
Answers: Fixed assets are those assets bought by the company for the intention to be used for a long periodof time. Fixed assets are said to depreciate over a period of time due to the following factors:
Causes of Depreciation 1) Physical deterioration i) Wear and tear – When a motor vehicle or machinery or fixtures and fittings are used, they eventually wear out. Some last many years, others last only a few year.
ii) Erosion, rust, rot and decay – Land may be eroded or wasted away by the action of wind, rain, sun and other elem ents of nature.
Sim ilarly, the m etals in m otor
vehicles or machinery will rust away.
Causes of Depreciation 2) Economic factors i) Obsolescence This is the process of becoming out of date. For instance, replacing a computer with old operating system with a new computerwith XP system. ii) Inadequacy This arises when an asset is no longer used because of the growth and changes in the size of the firm. For instance, a small ferryboat that is operated by a firm at a coastal resort will become entirely inadequate when the resort becomes more popular, to be more efficient and economical, the firm may replace it with a large ferryboat.
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Causes of Depreciation 3) The time factor (the effluxion of time) Some assets might have a lega l life fixed in terms of years. For example, the patents, and leasehold. You may agree to rent some buildings for 10 years.
This is
normally called a lease. When the years are finished, the lease is worth nothing to you, as it has finished. Whatever you paid for the lease is now of no value.
Causes of Depreciation
4) Depletion Other assets are of wasting character, perhaps due to the extraction of raw materials from them. These materials are then either used by the firm to make something else, or are sold in their raw state to other firms.
Natural
resources such as m ines, quarries and oi l wel ls com e under this heading.
Factors that affect the calculation of D epreciation Question: What are the factors that affect the calculation of depreciation? Answers: 1) Cost of asset (include expenses and capital expenditure incurred eg. The installation fees, the legal fees) 2) Estimated useful life of asset This is the number of years that the asset is expected to be used)
3) Residual or scrap value of the asset This is the value of the asset at the end of its life. 4) Method of calculating depreciation
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4 factors required for depreciation calculations 1.
Cost
2.
Residual Value (Salvage or Scrap Value) –
3.
Asset value at the end of its expected “useful life”.
Depreciable Cost
4.
Net purchase price. All reasonable and necessary expenditures to get the asset in place and ready for use.
Cost less residual value. Depreciable cost is allocated over the useful life of an asset.
Life
useful life period of the asset
Depreciation Methods
Straight-line Method
Accelerated Methods – Declining balance method – Sum-of-the-years digits
Production or Use Methods
Straight Line Method
This method spreads the depreciable costs evenly over the asset’s estimated useful life.
Annual depreciation is computed as follows:
Cost - Residual Value Estimated Useful Life =
$10,000 - $1000 = $1800 / year 5 years
Check the help for SLN function in Excel for more details
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The straight line formula
d
I S
D A
N
A I S N
S A
I
A I S
N
Where:N = life of the structure in years I = the original cost S = the values at the end of the life of structure d = the annual cost of depreciation DA = depreciation up to ageA years SA = the value oftheend ofA years
B 2 3 4 5 6 7 8 9 10 11 12 13 14 15
C
D
E
F
Depreciation Schedule Straight Line Method - SLN function Scrap Value Years -
perio d
DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5
1000 5
yrs
C o st
0 1 2 3 4 5
Annual Accumulated Carrying Value Depreciation Depreciation
10000 10000 10000 10000 10000 10000
0 1800 1800 1800 1800 1800 S ame e ac h year
0 1800 3600 5400 7200 9000
10000 8200 6400 4600 2800 1000
=D10-F10
Incre ase s De cre ase s Stop a t Un ifo rm ly Un ifo rm ly Re si du al V al ue
=SLN(D11,$D$5,$D$6)
Carrying Value(CV) = Cost – Accumulated Depreciation
Book Value The book value of a plant asset is the net cost of the asset after accumulated depreciation (the contra account) has been subtracted. $50,000 Beg. Book Value -12,000 Accum. Depre. $38,000 End. Book Value
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Example
Straight-Line Depreciation Schedule
An equal amount of depreciation is recorded each fiscal year.
Straight-line method (Examples) Example 1: ABC Ltd. Bought a machine at a cost of £80,000. The machine has an expected useful life of 5 years and at the end of the 5th year, it can be sold for £10,000. calculate depreciation per annum? Depreciation for 5 years would be: Cost
Annual Depreciation
Provision for Depreciation
NBV
Date of purchase
80,000
End of 1st year
80,000
14,000
14,000
66,000
End of 2cd year
80,000
14,000
28,000
52,000
rd
80,000
14,000
42,000
38,000
th
End of 4 year
80,000
14,000
56,000
24,000
End of 5th year
80,000
14,000
70,000
10,000
End of 3 year
80,000
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Straight-line method (Examples)
Example 2: ABC Ltd. Bought a machine at a cost of £80,000. The depreciation is to be charged at a 20% per annum on cost.
Solution:Depreciation per annum = £80,000 x 20% = £16,000 per year
Accelerated Depreciation Decling-Balance (DB) Method -Type 1.
Fixed DB method –
2.
Double DB method –
3.
computes depreciation at a fixed rate. computes depreciation at an accelerated rate.
Variable DB method – –
Also computes depreciation at an accelerated rate. switches to straight-line depreciation when depreciation is greater than the declining balance calculation
Check the help for DB, DDB and VDB functions in Excel for more details
Accelerated Depreciation Declining balance method Depreciation is calculated on a fixed percentage on the
Diminishing Balance of the Asset (the NBV). This results in a higher depreciation charge in the earlier years of the asset’s estimated useful life.
Example 3: A machine costs £50,000 is to be depreciated at 15% on Reducing Balance Method.
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Accelerated Depreciation Declining balance method
Cost
Annual Depreciation
Provision for Depreciation
NBV
Date of purchase
50,000
0
-
50,000
End of 1st year
50,000
50,000 x 15% = 7,500
7,500
42,500
End of
2cd
year
50,000
42,500 x 15% = 6,375
13,875
36,125
End of 3rd year
50,000
36,125 x 15% = 5,419
19,294
30,706
End of 4th year
50,000
30,706 x 15% = 4,606
23,900
26,100
50,000
26,100 x 15% = 3,915
27,815
22,185
End of
5th
year
The Matheson formula or declining balance method
The ratio of the depreciation in any one year to the salvage value at the beginning of that year is constant throughout the life of the structure and is designated by X.
X = the annual fixed ratio of depreciation
Deprecation during the first year (d1) = I X
Depreciation value (Book value) at the end of the 1st year = I – I X = I (1 – X)
Depreciation value (Book Value) at the end of n years (S) = I (1 – X)n S/I = (1 – X)n X = 1 – (S/I)(1/n)
Accelerated Depreciation Double-declining-balance method, it would Multiply the straight-line rate by two, e.g. 2/1 x ¼ = 2/4
Double-declining-balance = Book Value x depreciation expense
$25,000 = $50,000 x
2 x straight-line Expected useful life
2 4
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Double-Declining Balance Depreciation Schedule A
B
C
D
E
Double(A xB) ($50k - D) Declining- Beginning Debit Credit Ending Balance Book Depreciation Accumulated Book Year Rate Value Expense Depreciation Value 2004 2005 2006 2007
2/4 2/4 2/4 2/4
$50,000 25,000 12,500 6,250
$25,000 12,500 6,250 4,250
$25,000 $25,000 37,500 12,500 43,750 6,250 48,000 2,000
$6,250 – $2,000 (residual value) Accelerated Depreciation
Reasons for Using Accelerated Depreciation
1. An asset is more useful earlier in its life than later, and the useful life may be difficult to estimate. 2. Depreciation expense is deductible in computing taxable income and income taxes.
The second reason is the most common reason for using accelerated depreciation.
Comparison of Straight-Line and Accelerated Depreciation Methods in 2004
Straight-Line Accelerated Income before depreciation and taxes $100,000 Depreciation expense 12,000 Pretax income 88,000 Income taxes (35%) 30,800 Net income $ 57,200
$100,000 25,000 75,000 26,250 $ 48,750
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B 2 3 4 5 6 7 8 9 10 11 12 13 14 15
C
D
E
F
Depreciation Schedule Fixed Decling Method - DB function Scrap Value Years -
perio d
1000 5
yrs
DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5
C o st
0 1 2 3 4 5
Annual Accumulated Carrying Value Depreciation Depreciation
10000 10000 10000 10000 10000 10000
0 3690 2328 1469 927 585
0 3690 6018 7488 8415 9000
10000 6310 3982 2512 1585 1000
I ncreases Decreases Quickly Quickly
=D10-F10
Can't go be low scra p Value
=DB(D11,$D$5,$D$6,C11)
Carrying Value(CV) = Cost – Accumulated Depreciation
B 2 3 4 5 6 7 8 9 10 11 12 13 14 15
C
D
E
F
Depreciation Schedule Accelerated Double Decling Method - DDB function Scrap Value Years -
perio d
DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5
1000 5
yrs
C o st
0 1 2 3 4 5
10000 10000 10000 10000 10000 10000
Annual Accumulated Carrying Value Depreciation Depreciation
0 4000 2400 1440 864 296
0 4000 6400 7840 8704 9000
10000 6000 3600 2160 1296 1000
I ncreases Decreases Quickly Quickly
=D10-F10
Can't go be low scra p Value
=DDB(D11,$D$5,$D$6,C11)
Carrying Value(CV) = Cost – Accumulated Depreciation
Summary - depreciation
VDB
Variable-decli ng balance
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B
C
D
E
F
Depreciation Schedule
2 3 4 5 6 7 8 9
Asset Cost Scrap Value Years -
Formulae
Equipment 100,000 2000 5
C12 =SLN($D$5,$D$6,$D$7) D12=DB($D$5,$D$6,$D$7,B12) E12=DDB($D$5,$D$6,$D$7,B12) F12=VDB($D$5,$D$6,$D$7,B11,B12) D20=D19-C11
Depreciation Amt.
10
Years
11 12 13 14 15 16 17 18
1 2 3 4 5
SLN
19,600 19,600 19,600 19,600 19,600
DB
DDB
VDB
54,300 24,815 11,341 5,183 2,368
40,000 24,000 14,400 8,640 5,184
40,000 24,000 14,400 9,800 9,800
Value of Asset period
yrs
SLN
DOP End of Yr 1 End of Yr 2 End of Yr 3 End of Yr 4 End of Yr 5
19 20 21 22 23 24
0 1 2 3 4 5
100,000 80,400 60,800 41,200 21,600 2,000
DB
DD B
VDB
100,000 45,700 20,885 9,544 4,362 1,993
100,000 60,000 36,000 21,600 12,960 7,776
100,000 60,000 36,000 21,600 11,800 2,000
Comparison of Depreciation Methods Depreciation VsPeriod 60,000
SLN DB DDB VDB
50,000 t m 40,000 A n o i t 30,000 a i c e r p 20,000 e D
Asset value vs Life time
10,000 120,000
0
1
2
3
4
5
6
100,000
SLN
Period (years)
DB 80,000
DDB
e u l a V 60,000 t e s s A 40,000
VDB
20,000
0 0
1
2
3
4
5
6
Period(years)
Sum of digits plan
To obtain the depreciation charge in any year of life
by
the
(commonly
sum-of-the designated
year by
digits
SYD),
the
method digits
corresponding to the number of each year of life are listed in reverse order.
The sum of the digits is then 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 five years,
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Sum of digits plan year
Number of the year in reverse order (digits)
Depreciation
1
5
5/15
2
4
4/15
3
3
3/15
4
2
2/15
5
1
1/15
Sum of the digits
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Sum of digits plan
The depreciation for any year is the product of the SYD depreciation factor for that year and the depreciable value, I – S.
The general expression for the annual cost of depreciation for any year, A, when the total life is N, is
DA =
2( N A 1) N ( N 1)
( I S )
Activity Depreciation At the beginning of 2005 , Mom’s Cookie Company purchased a truck for $30,000. Management expects the useful life of the truck to be 100,000 miles, at which time it will be sold for $10,000.
Cost Value – Residual $30,000 – $10,000
$0.20 per mile
Expected Units 100,000 miles
Units-of-Production Depreciation
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Activity Depreciation If the truck were driven 12,000 miles in 2005, Hydro would record depreciation expense of $2,400 (12,000 x $0.20). Units-of-Production Depreciation
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