Depreciation
Depreciation is the loss in value of property such as
machine, building, vehicle, or other investment over a
period of time, caused by one or more of the following
Unrepaired wear: accumulates as a function of
hours of use, severity of use
Deteriorations: The gradual decay, corrosion, or
erosion of the property
Obsolescence: reduction of value and due to
competition from newer and/or more productive
models. (driven either by Technology or Style)
Reduction in demand
Measuring depreciation
Since Depreciation is the loss in value over
a period of time it may be traced by simple
graphing the market value as a function of
time.
Annual
New cost
Depreciations
Book Value
Salvage Value
n
Depreciation accounting
Depreciation accounting is the systematic division
of the depreciable value of capital investment into
annual allocations over a period of years.
Reasons
To provide owners and manager with an estimate
of the current value of their capital investment.
Depreciation accounting for this purpose should
approximate actual market values.
To account for depreciation in a manner that yields
the maximum possible tax benefits. Depreciation
accounting for this purpose may not exceed strict legal
guideline but need not approximate market values.
Important parameters to Determine
Depreciation
Estimate the purchasing price or cost when new.
Estimate the economical life (time between
purchase new and disposal at resale or salvage
value), or recovery period for tax purpose.
Estimate the resale or salvage value (zero for tax
purpose).
Depreciation Methods
Straight line method
Sum –Of-Year Digit method
Decline balance method
Sinking fund method (this method is
not widely used)
Straight line method
Straight line (SL) method depreciation is the
simplest method to apply the most widely used
method of deprecation.
The annual depreciation, Dm, is constant and thus
the book value, BVm, decrease by a uniform amount
each year. The equation for SL depreciation is
Depreciation rate, Rm=1/N …………………(1)
Annual Depreciation, Dm = Rm*(P-F)
= (P-F)/N ……(2)
Example 1
Given the data below, find the annual depreciation and
graph showing the depreciation each year.
Dragline purchase price, P=Birr 80,000
Resale value after 7 yrs, F= Birr 24,000
Solution
Purchase price, P=Birr 80,000
Resale value after 7 yrs, F= Birr 24,000
Value to depreciate N=7 equal installments,
(P-F)= Birr 56,000
Dm = (P-F)/N= 56,000/7 =Birr 8,000
The Sum-Of-Year Digit Method
This is an accelerated depreciation (fast write-off)
method,
This method calculates depreciation for each year as the
total original depreciable value times a certain fraction.
N N 1
1) SOYD
2
2) The annual depreciation at end of year m is
N m 1
Dm P F
SOYD
3) The Book Value at the end of year m is
m N m / 2 0.5
Bvm P P F
SOYD
Example 2
Using the same, Birr 80,000 draggling as in example 1,
find and plot the allowable depreciation using the SOYD
method. Solution
Yea Depreciation allowed For this Book Value, Bvm at EOYm
r year, Dm (in Birr )
m
7/28 X Birr 56,000 14,000 80,000-14,000 66,000
6/28 X Birr 56,000 12,000 66,000-12,000 54,000
5/28 X Birr 56,000 10,000 54,000-10,000 44,000
4/28 X Birr 56,000 8,000 44,000-8,000 36,000
3/28 X Birr 56,000 6,000 36,000-6,000 30,000
2/28 X Birr 56,000 4,000 30,000-4,000 26,000
1/28 X Birr 56,000 2,000 26,000-2,000 24,000
56,000
Declined balance method
The declined balance methods are the accelerated
depreciation methods that provide for a larger share of
the cost of depreciation to be written of in the early year
less in the later years.
1. The depreciation rate, R is the depreciation multiple
divided by the estimated life, n.
For double decline Balance method, R= 2/N
For 1.75 decline balance depreciation, R= 1.75/N
For 1.5 decline balance depreciation, R=1.5/N
BVm1 R
Declined balance method
2. The depreciation Dm for any given year, m, and
given depreciation rate, R is
Dm RP 1 R or BVm 1 R
m 1
3. The book value for any year BVm is :
Bvm=P(1-R)m provided that Bvm≥ F
4. The age m, at which book value, Bvm will decline to
any future value, F, is:
ln F / P
m
ln 1 R
Note that the depreciation amount Dm is
determined by the book value only, and is not
influenced by the salvage value F (expecting the
Bvm-Dm-1 ≥ F). Therefore, the book value during
later years may follow any of the following
If F is Zero or very low, then Bvm may never reach F
BV may intersect F before N (BV is not permitted to be
less than F)
BV may intersect F at N (very rare case)
Sinking Fund method
End of Sinking fund Balance or Annual
year Accumulate Depreciation Depreciatio
n
1 B5,902.70*(F/A,10%,1) B5,902.7
0 5,902.70
2 B5,902.70*(F/A,10%,2) B12,903 7,000.30
3 B5,902.70*(F/A,10%,3) B19,588 6,685.00
4 B5,902.70*(F/A,10%,4) B27,395 7,807.00
5 B5,902.70*(F/A,10%,5) B36,037 8,642.00
6 B5,902.70*(F/A,10%,6) B45,543 9,506.00
7 B5,902.70*(F/A,10%,7) B56,00 10,457.00