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CE 22 Engineering Economy Depreciation and Depletion 1

DEPRECIATION AND DEPLETION




DEPRECIATION

- A decrease in value of physical properties with
the passage of time

- An accounting concept that establishes an
annual deduction against before-tax income
such that the effect of use and time on an
assets value is reflected in a flows financial
statement.

- Non-cash cost that affects income taxes.


VALUE

- The PW of all the future profits that are to be
received through ownership of a particular
property.


MARKET VALUE

- What will be paid by a willing buyer to a willing
seller for a property where each has equal
advantage and is under no compulsion to buy or
sell.


CE 22 Engineering Economy Depreciation and Depletion 2

SALVAGE OR RESIDUAL VALUE

- The price that can be obtained from the sale of
the property after it has been used.


ESTIMATED SALVAGE

- used to represent an assets terminal value to be
built into depreciation calculations (not
necessarily equal to MV or SV)


BOOK VALUE

- worth of a property as shown on the accounting
records of a company.
- is (original cost) minus (amounts charged as
depreciation expense) minus (amount of cap,
still invested and must be recovered)


ADJUSTED COST BASIS - changes to the
original cost of certain types of property caused by
various types of improvements or casualty losses.

AMORTIZATION - the distribution of the cost of
certain types of property, usually intangible, over a
prescribed period of time.

CE 22 Engineering Economy Depreciation and Depletion 3

BASIS (OR COST BASIS) - the cost of acquiring
an asset, including normal costs of making the
asset serviceable.


BV
k
= cost basis
j ) ON DEPRECIATI (
k
1 j



Where k- end of yr. k (1 k N)


DEPLETION the gradual lessening in value of a
mineral or oil deposit etc. by its removal for use in
a business activity.




WHAT CAN BE DEPRECIATED?

Property is depreciable if it meets these
requirements

1) It must be used in business or held for the
production of income.
2) It must have determinable life, and the life must
be longer than 1 year.
3) It must be something that wears out, decays,
gets used up, becomes obsolete, or loses value
from natural causes.
CE 22 Engineering Economy Depreciation and Depletion 4


DEPRECIATION METHODS

Allowed Depreciation Methods (BIR)
1) Straight Line Method
2) Declining Balance Method
3) Declining Balance with switchover to straight
line
4) Sum of the Years Digits (SYD) Method



1) STRAIGHT LINE METHOD
- Simplest; assumes that a constant amount is
depreciated each year over the life of the asset.

d
k
=
(
,
\
,
(
j

N
ES B
N


d
k
* = kd
k
for 1 k N

BV
k
= B d
k
*

Where:
N = depreciable life of the asset in years
B = cost basis
d
k
= annual depreciation deduction in year k (1 k N)
BV
k
= Book value at the end of year k
ES
N
= estimated salvage value in year N
d
k
* = cumulative depreciation through year k

CE 22 Engineering Economy Depreciation and Depletion 5

2) DECLINING BALANCE METHOD

- constant percentage method/Matheson formula
- assumes that the annual cost of depreciation is a
fixed percentage of the BV at the beginning of the
year.
- Ratio of depreciation in any one year to the beginning
of the year is constant throughout the life of the asset.
- Designated by R (0 R 1)

R = 2/N when 200% declining balance is being
used.
(For straight line 1/N)

d
1
= B(R)
d
k
= B(1-R)
K-1
(R )
d
k
* = B[1-(1-R)
K
]
BV
k
= B(1-R)
k

BV
N
= B(1-R)
N


3) SUM OF THE YEARS DIGITS (SYD)

DEPRECIATION DEDUCTION

1- digits corresponding to number of each permissible
year of life are first listed in reverse
2- sum is determined
3- depreciation factor =
digits the of sum
listing reverse from . no

CE 22 Engineering Economy Depreciation and Depletion 6

Depreciation for any year is the product of the
SYD factor for that year and the difference
between the cost basis (B) and the ES
N


d
k
= (B-ES
N
)
]
]
]
,

,
+
+
) 1 N ( N
) 1 k N ( 2


BV
k
= B -
]
]
]
,

,

N
) ES B ( 2
N
k +
]
]
]
,

,
+

) 1 N ( N
) ES B (
N
k (k+1)

d
k
* = B - BV
k



4) DECLINING BALANCE WITH
SWITCHOVER TO STRAIGHT LINE

- Declining balance does not consider ES
N

- To achieve a specific amount (salvage) it is
permissible to switch to the straight-line method.
- Switchover occurs in the year where a larger
depreciation amount is obtained from the
straight-line method.