5/6/2020

DEPRECIATION

Prof. Jigisha Parikh

ChED, SVNIT

• An analysis of costs and profits for any business

operation requires recognition of the fact that physical
assets decrease in value with age.

• This decrease in value may be due to physical

deterioration, technological advances, economic
changes, or other factors which ultimately will cause
retirement of the property.

• The reduction in value due to any of these causes is a

measure of the depreciation.?

• The economic function of depreciation, therefore, can be

employed as a means of distributing the original expense
for a physical asset over the period during which the
asset is in use.

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• The total cost due to depreciation is the original or new

value of a property minus the value of the same
property at the end of the depreciation period.

• The original value is usually taken as the total cost of

the property at the time it is ready for initial use.

• In engineering design practice, the total depreciation

period is ordinarily assumed to be the length of the
property’s useful life, and the value at the end of the
useful life is assumed to be the probable scrap or
salvage value of the components making up the
particular property.

• It should be noted here that the engineer cannot wait

until the end of the depreciation period to determine
the depreciation costs.
• These costs must be prorated throughout the entire life
of the property, and they must be included as an
operating charge incurred during each year.
• The property value at the end of the depreciation period
and the total length of the depreciation period cannot be
known with certainty when the initial yearly costs are
determined.
• Consequently, it is necessary to estimate the final value
of the property as well as its useful life.
• In estimating property life, the various factors which may
affect the useful-life period, such as wear and tear,
economic changes, or possible technological advances,
should be taken into consideration.

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Purpose of Depreciation as a Cost

• Consideration of depreciation as a cost permits realistic
evaluation of profits earned by a company and, therefore,
provides a basis for determination of income taxes.

• Simultaneously, the consideration of depreciation as a cost

provides a means whereby funds are set aside regularly to
provide recovery of the invested capital.

• When accountants deal with depreciation, they must follow

certain rules which are established by the Bureau of
Internal Revenue for determination of income taxes.

• These rules deal with allowable life for the depreciable

equipment and acceptable mathematical procedures for
allocating the depreciation cost over the life of the asset.

TYPES OF DEPRECIATION
• Physical or Functional.

• Physical depreciation is the term given to the measure

of the decrease in value due to changes in the physical
aspects of the property. Wear and tear, corrosion,
accidents, and deterioration due to age or the elements
are all causes of physical depreciation.
• With this type of depreciation, the serviceability of the
property is reduced because of physical changes.

• Depreciation due to all other causes is known as

functional depreciation.

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• One common type of functional depreciation is

obsolescence.

• This is caused by technological advances or

developments which make an existing property
obsolete.
• Even though the property has suffered no
physical change, its economic serviceability is
reduced because it is inferior to improved types
of similar assets that have been made available
through advancements in technology.

• Other causes of functional depreciation

(1) change in demand for the service rendered by the property,

such as a decrease in the demand for the product involved
because of saturation of the market,
(2) shift of population center,
(3) changes in requirements of public authority,
(4) inadequacy or insufficient capacity for the service required,
(5) termination of the need for the type of service rendered,
and
(6) abandonment of the enterprise.

Although some of these situations may be completely

unrelated to the property itself, it is convenient to group
them all under the heading of functional depreciation.

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• Depletion
• Capacity loss due to materials actually consumed is
measured as depletion.
• Depletion cost equals the initial cost times the ratio of
amount of material used to original amount of material
purchased. This type of depreciation is particularly
applicable to natural resources, such as stands of timber or
mineral and oil deposits.

• Costs for Maintenance and Repairs

• The term maintenance conveys the idea of constantly
keeping a property in good condition; repairs connotes the
replacing or mending of broken or worn parts of a
property. The costs for maintenance and repairs are direct
operating expenses which must be paid from income, and
these costs should not be confused with depreciation costs.

• SERVICE LIFE
• The period during which the use of a property is
economically feasible is known as the service life
of the property.
• Both physical and functional depreciation are
taken into consideration in determining service life,
and, the term is synonymous with economic or
useful life.
• In estimating the probable service life, it is
assumed that a reasonable amount of
maintenance and repairs will be carried out at the
expense of the property owner.
• Refer Table 1.

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• SALVAGE VALUE
• Salvage value is the net amount of money obtainable from
the sale of used property over and above any charges
involved in removal and sale. If a property is capable of
further service, its salvage value may be high. This is not
necessarily true, however, because other factors, such as
location of the property, existing price levels, market supply
and demand, and difficulty of dismantling, may have an
effect.
• The term salvage value implies that the asset can give some
type of further service and is worth more than merely its
scrap or junk value.

• If the property cannot be disposed of as a useful unit, it can

often be dismantled and sold as junk to be used again as a
manufacturing raw material.
• The profit obtainable from this type of disposal is known as
the scrap, or junk, value.

• Salvage value, scrap value, and service life are usually

estimated on the basis of conditions at the time the
property is put in use.
• These factors cannot be predicted with absolute
accuracy, but improved estimates can be made as the
property increases in age.
• It is advisable, therefore, to make new estimates from
time to time during the service life and make any
necessary adjustments in the depreciation costs.
• Because of the difficulties involved in making reliable
estimates of salvage and scrap values, engineers often
neglect the small error involved and designate these
values as zero.
• Federal tax regulations generally limit salvage or scrap
values to 10 percent or less of the initial value of the
property.

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• PRESENT VALUE
• The present value of an asset may be defined as the value
of the asset in its condition at the time of valuation.

• Book Value, or Unamortized Cost

• The difference between the original cost of a property, and
all the depreciation charges made to date is defined as the
book value (sometimes called unamortized cost). It
represents the worth of the property as shown on the
owner’s accounting records.

• Market Value
• The price which could be obtained for an asset if it were
placed on sale in the open market is designated as the
market value. The use of this term conveys the idea that the
asset is in good condition and that a buyer is readily
available.

• Replacement Value
• The cost necessary to replace an existing property at any
given time with one at least equally capable of rendering the
same service is known as the replacement value.

• It is difficult to predict future market values or replacement

values with a high degree of accuracy because of
fluctuations in market demand and price conditions.

• On the other hand, a future book value can be predicted

with absolute accuracy as long as a constant method for
determining depreciation costs is used.

• It is quite possible for the market value, replacement value,

and book value of a property to be widely different from one
another because of unrealistic depreciation allowances or
changes in economic and technological factors.

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METHODS FOR DETERMINING DEPRECIATION

(1) arbitrary methods giving no consideration to

interest costs, and
(2) methods taking into account interest on the
investment.
• Straight-line, declining-balance, and sum-of-
the-years-digits methods are included in the
first class,
• while the second class includes the sinking-
fund and the present-worth methods.

where Va= asset or book value, dollars, and

a = the number of years in actual use.

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• Sinking-Fund Method

• The use of compound interest is involved in the

sinking-find method.
• It is assumed that the basic purpose of
depreciation allowances is to accumulate a
sufficient fund to provide for the recovery of the
original capital invested in the property.
• An ordinary annuity plan is set up wherein a
constant amount of money should theoretically
be set aside each year.
• At the end of the service life, the sum of all the
deposits plus accrued interest must equal the
total amount of depreciation.

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Since the value of R represents the annual depreciation cost, the yearly
cost for depreciation is constant when the sinking-fund method is used.

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• As shown in Fig. 9-3, this method results in book values

which are always greater than those obtained with the
straight-line method.

• Because of the effects of interest in the sinking-fund method,

the annual decrease in asset value of the property is less in
the early-life years than in the later years.

• Although the sinking-fund viewpoint assumes the existence

of a fund into which regular deposits are made, an actual
fund is seldom maintained.

• Instead, the money accumulated from the depreciation

charges is put to work in other interests, and the existence of
the hypothetical fund merely serves as a basis for this
method of depreciation accounting.

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