Scribd
Upload
41 views31 pages

5 - Depreciation

The document discusses various concepts and methods related to depreciation of assets. It defines depreciation as the decrease in value of physical assets over time and use. It then describes different depreciation methods like straight-line, declining balance, and units-of-production. Straight-line depreciation assumes a constant amount is deducted each year, while declining balance uses a fixed percentage of the book value each year. Units-of-production bases depreciation on the number of units expected to be produced. Examples are provided to demonstrate calculating depreciation amounts under different methods.

Uploaded by

dewatharschinia19
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
41 views31 pages

5 - Depreciation

The document discusses various concepts and methods related to depreciation of assets. It defines depreciation as the decrease in value of physical assets over time and use. It then describes different depreciation methods like straight-line, declining balance, and units-of-production. Straight-line depreciation assumes a constant amount is deducted each year, while declining balance uses a fixed percentage of the book value each year. Units-of-production bases depreciation on the number of units expected to be produced. Examples are provided to demonstrate calculating depreciation amounts under different methods.

Uploaded by

dewatharschinia19
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 31

Week 05

Depreciation Concepts and Terminology


• Depreciation is the decrease in value of physical
properties with the passage of time and use.
• More specifically, depreciation is an accounting
concept that establishes an annual deduction against
before-tax income such that the effect of time and use
on an asset’s value can be reflected in a firm’s
financial statements.
Depreciation Concepts and Terminology… p/2
• Depreciation is a noncash cost that is intended to “match”
the yearly fraction of value used by an asset in the
production of income over the asset’s life.
• The actual amount of depreciation can never be established
until the asset is retired from service.
• Because depreciation is a noncash cost that affects income
taxes, we must consider it properly when making after-tax
engineering economy studies.
Depreciation Concepts and Terminology… p/3
• Depreciable property is property for which depreciation is allowed
under federal, state, or municipal income tax laws and regulations.
• Property is depreciable if it meets the following basic requirements:
1. It must be used in business or held to produce income.
2. It must have a determinable useful life, and the life must be longer than
one year.
3. It must be something that wears out, decays, gets used up, becomes
obsolete, or loses value from natural causes.
4. It is not inventory, stock in trade, or investment property.
Depreciation Concepts and Terminology… p/4
• Depreciable property is classified as either tangible or intangible.
• Tangible property can be seen or touched, and it includes two main
types called personal property and real property.
• Personal property includes assets such as machinery, vehicles, equipment,
furniture, and similar items.
• Real property is land and generally anything that is erected on, growing on, or
attached to land. Land itself, however, is not depreciable, because it does not
have a determinable life.
• Intangible property is personal property such as a copyright, patent,
or franchise.
Depreciation Concepts and Terminology… p/5
• A company can begin to depreciate property it owns when
the property is placed in service for use in the business and
for the production of income.
• Depreciation stops when the cost of placing an asset in
service has been recovered or when the asset is sold,
whichever occurs first.
Straight-Line (SL) Method
• SL depreciation is the simplest depreciation method. It assumes that
a constant amount is depreciated each year over the depreciable
(useful) life of the asset.
• If we define
Straight-Line (SL) Method… p/2

• Note that, for this method, you must have an estimate of the final
Salvage Value (SV), which will also be the final Book Value (BV) at the
end of year N. In some cases, the estimated SVN may not equal an
asset’s actual terminal Market Value (MV).
Example 7-1: SL Depreciation
A laser surgical tool has a cost basis of $200,000 and a five-
year depreciable life. The estimated SV of the laser is $20,000
at the end of five years. Determine the annual depreciation
amounts using the SL method. Tabulate the annual
depreciation amounts and the book value of the laser at the
end of each year.
Example 7-1: Solution
Example 7-1: Solution… p/2
Declining-Balance (DB) Method
• In the DB method, sometimes called the constant-percentage
method, it is assumed that the annual cost of depreciation is a fixed
percentage of the BV at the beginning of the year.
• The ratio of the depreciation in any one year to the BV at the
beginning of the year is constant throughout the life of the asset and
is designated by R (0 ≤ R ≤ 1).
• In this method, R = 2/N when a 200% DB is being used (i.e., twice the
SL rate of 1/N), and N equals the depreciable (useful) life of an asset.
• If the 150% DB method is specified, then R = 1.5/N.
Declining-Balance (DB) Method… p/2
• The following relationships hold true for the DB method:

• Notice that Equations (7-5) through (7-8) do not contain a term for
SVN.
Example 7-2: DB Depreciation
• A new electric saw for cutting small pieces of lumber in a
furniture manufacturing plant has a cost basis of $4,000 and
a 10-year depreciable life. The estimated SV of the saw is
zero at the end of 10 years. Use the DB method to calculate
the annual depreciation amounts when
1. R = 2/N (200% DB method)
2. R = 1.5/N (150% DB method).
• Tabulate the annual depreciation amount and BV for each
year.
Example 7-2: Solution
Example 7-2: Solution… p/2
DB with Switchover to SL
• Because the DB method never reaches a BV of zero, it is
permissible to switch from this method to the SL method so
that an asset’s BVN will be zero (or some other determined
amount, such as SVN).
• Table 7-1 illustrates a switchover from double DB
depreciation to SL depreciation for Example 7-2.
• The switchover occurs in the year in which an equal or a
larger depreciation amount is obtained from the SL method.
DB with Switchover to SL… p/3
• From Table 7-1, it is apparent that d6 = $262.14. The BV at
the end of year six (BV6) is $1,048.58.
• Additionally, observe that BV10 is $4,000−$3,570.50 =
$429.50 without switchover to the SL method in Table 7-1.
With switchover, BV10 equals zero.
• It is clear that this asset’s dk, dk∗ , and BVk in years 7 through
10 are established from the SL method, which permits the
full cost basis to be depreciated over the 10-year recovery
period.
Units-of-Production Method
• All the depreciation methods discussed to this point are based on
elapsed time (years) on the theory that the decrease in value of
property is mainly a function of time.
• When the decrease in value is mostly a function of use, depreciation
may be based on a method not expressed in terms of years.
• The units-of-production method is normally used in this case.
Units-of-Production Method… p/2
• This method results in the cost basis (minus final SV) being allocated
equally over the estimated number of units produced during the
useful life of the asset.
• The depreciation rate is calculated as
Example 7-3: Depreciation Based on Activity
Apiece of equipment used in a business has a basis of
$50,000 and is expected to have a $10,000 SV when
replaced after 30,000 hours of use. Find its depreciation
rate per hour of use, and find its BV after 10,000 hours
of operation.
Example 7-3: Solution
Example 7-7: Comparison of Depreciation Methods

The La Salle Bus Company has decided to purchase a


new bus for $85,000 with a trade-in of their old bus.
The old bus has a BV of $10,000 at the time of the
trade-in. The new bus will be kept for 9 years before
being sold. Its estimated SV at that time is expected to
be $5,000.
Example 7-7: Solution
• First, we must calculate the cost basis. The basis is the original
purchase price of the bus plus the BV of the old bus that was traded
in.
• Thus, the basis is $85,000 + $10,000, or $95,000.
Example 7-7: Solution… p/3
Example 7-7: Solution… p/4

You might also like