Depreciation Terminology
Definition: Book (noncash) method to represent decrease in value of
a tangible asset over time
Two types: book depreciation and tax depreciation
Book depreciation: used for internal accounting to track value of assets
Tax depreciation: used to determine taxes due based on tax laws
In USA only, tax depreciation must be calculated using MACRS;
book depreciation can be calculated using any method
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Common Depreciation Terms
First cost P or unadjusted basis B: Total installed cost of asset
Book value BVt: Remaining undepreciated capital investment in year t
Recovery period n: Depreciable life of asset in years
Market value MV: Amount realizable if asset were sold on open market
Salvage value S: Estimated trade-in or MV at end of asset’s useful life
Depreciation rate dt: Fraction of first cost or basis removed each year t
Personal property: Possessions of company used to conduct business
Real property: Real estate and all improvements (land is not depreciable)
Half-year convention: Assumes assets are placed in service in midyear
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Straight Line Depreciation
Book value decreases linearly with time
B
Dt = n- S Where: Dt = annual depreciation charge
t = year
B = first cost or unadjusted basis
S = salvage value
n = recovery period
BVt = B - tDt Where: BVt = book value after t years
SL depreciation rate is constant for each year: d = dt = 1/n
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Example: SL Depreciation
An argon gas processor has a first cost of $20,000 with a
$5,000 salvage value after 5 years. Find (a) D3 and (b) BV3
for year three. (c) Plot book value vs. time.
Solution: (a ) D3 = (B – S)/n
= (20,000 – 5,000)/5 (c) Plot BV vs. time
= $3,000 BVt
20,000
(b) BV3 = B – tDt 11,000
= 20,000 – 3(3,000) 5,000
= $11,000
0 3 5 Year, t
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Double Declining Balance (DDB) Depreciation
Determined by multiplying BV at beginning of year by fixed percentage d
Max rate for d is twice straight line rate, i.e., d ≤ 2/n
Cannot depreciate below salvage value
Depreciation for year t is obtained by either relation:
Dt = dB(1 – d)t-1 = dBVt-1
Where: Dt = depreciation for year t
d = uniform depreciation rate (2/n for DDB)
B = first cost or unadjusted basis
BVt -1 = book value at end of previous year
Book value for year t is given by:
BVt = B(1 – d)t
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Example: Double Declining Balance
A depreciable construction truck has a first cost of $20,000 with a
$4,000 salvage value after 5 years. Find the (a) depreciation, and
(b) book value after 3 years using DDB depreciation.
Solution: (a) d = 2/n = 2/5 = 0.4
D3 = dB(1 – d)t-1
= 0.4(20,000)(1 – 0.40)3-1
= $2880
(b) BV3 = B(1 – d)t
= 20,000(1 – 0.4)3
= $4320
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Switching Between Depreciation Methods
Switch between methods to maximize PW of depreciation
t=n
PWD = ∑ Dt (P/F,i%,t)
t=1
A switch from DDB to SL in latter part of life is usually better
Can switch only one time during recovery period
Procedure to switch from DDB to SL:
1) Each year t compute DDB and SL depreciation using the relations
DDDB = d(BVt-1) and DSL = BVt-1 / (n-t+1)
2) Select larger depreciation amount, i.e., Dt = max[DDDB, DSL]
3) If required, calculate PWD
Alternatively, use spreadsheet function VDB(B,S,n,start_t,end_t) to determine Dt
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Unit-of-Production (UOP) Depreciation
v Depreciation based on usage of equipment, not time
v Depreciation for year t obtained by relation
actual usage for year t
Dt = (B – S)
expected total lifetime usage
Example: A new mixer is expected to process 4 million yd3 of concrete over
10-year life time. Determine depreciation for year 1 when 400,000 yd3 is
processed. Cost of mixer was $175,000 with no salvage expected.
Solution: 400,000 (175,000 – 0) = $17,500
D1 = 4,000,000
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Depletion Methods
Depletion: book (noncash) method to represent decreasing
value of natural resources
Two methods: cost depletion (CD) and percentage depletion (PD)
Cost depletion: Based on level of activity to remove a natural resource
Ø Calculation: Multiply factor CDt by amount of resource removed
Where: CDt = first cost / resource capacity
Ø Total depletion can not exceed first cost of the resource
Percentage depletion: Based on gross income (GI) from resource
Ø Calculation: Multiply GI by standardized rate (%) from table
Ø Annual depletion can not exceed 50% of company’s taxable income (TI)
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Example: Cost and Percentage Depletion
A mine purchased for $3.5 million has a total expected yield of one
million ounces of silver. Determine the depletion charge in year 4 when
300,000 ounces are mined and sold for $30 per ounce using cost
depletion?
Solution: Let depletion amounts equal CDA4 and PDA4
Factor, CD4 = 3,500,000/ 1,000,000 = $3.50 per ounce
CDA4 = 3.50(300,000) = $1,050,000
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