MODULE III

INTRODUCTION

Lesson 1 Depreciation
Concepts and
Terminology

Lesson 2 Depreciation
Methods

MODULE III

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DEPRECIATION

Nothing in this world is certain but death and taxes.

—BenjaminFranklin(1789)

 INTRODUCTION

Most assets are worthless as they age. Production equipment gradually

becomes less valuable through wear and tear. Instead of charging the full
purchase price of a new asset as one-time expense, the outlay is spread over the
life of the asset in the records. Annual depreciation deductions arc intended to
match the yearly fraction of value used by an asset in the production of income
over the assets actual economic life. The actual amount of depreciation can
never be established until the asset is retired from service.
This module provides the analysis of depreciation in Engineering
Economics.

OBJECTIVES

After studying the module, you should be able to:

1. Understand and use the basic terminology of depreciation.

2. Understand and apply the different methods of depreciation such as the
straight-line method, declining and double declining balance method, sum
of the year’s digit method, sinking fund method and the service output
method.

 DIRECTIONS/ MODULE ORGANIZER

There are two lessons in the module. Read each lesson carefully then
answer the exercises/activities to find out how much you have benefited from
it. Work on these exercises carefully and submit your output to your instructor.
In case you encounter difficulty, discuss this with your instructor during the face-
to-face meeting.

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Lesson 1

 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 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.
In general, 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.
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. In contrast, 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. We will not discuss the depreciation of intangible assets in this chapter
because engineering projects rarely include this class of property.
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.
Property is considered to be placed in service when it is ready and available for
a specific use, even if it is not actually used yet. Depreciation stops when the
cost of placing an asset in service has been recovered or when the asset is sold,
whichever occurs first.

Additional Definitions
The following list is intended to supplement the previous definitions provided in
this lesson:

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Adjusted (cost) basis .The original cost basis of the asset, adjusted by allowable
increases or decreases, is used to compute depreciation deductions. For
example, the cost of any improvement to a capital asset with a useful life greater
than one year increases the original cost basis, and a casualty or theft loss
decreases it. If the basis is altered, the depreciation deduction may need to be
adjusted.
Basis or cost basis. The initial cost of acquiring an asset (purchase price plus
any sales taxes), including transportation expenses and other normal costs of
making the asset serviceable for its intended use; this amount is also called the
unadjusted cost basis.
Book value. The worth of a depreciable property as shown on the accounting
records of a company. It is the original cost basis of the property, including any
adjustments, less all allowable depreciation deductions. It thus represents the
amount of capital that remains invested in the property and must be recovered
in the future through the accounting process. The BV of a property may not be
an accurate measure of its market value. In general, the BV of a property at the
end of year k is:
Book value at the end of year k = adjusted cost basis –total depreciation
deduction from year 0 to year k.
Market value (MV). The amount that 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. The MV approximates the present value of what will be received
through ownership of the property, including the time value of money (or profit).
Recovery period. The number of years over which the basis of a property is
recovered through the accounting process. For the classical methods of
depreciation, this period is normally the useful life.
Salvage value . The estimated value of a property at the end of its useful life.∗
it is the expected selling price of a property when the asset can no longer be
used productively by its owner. The term net salvage value is used when the
owner will incur expenses in disposing of the property, and these cash outflows
must be deducted from the cash inflows to obtain a final net SV.
Useful life. The expected (estimated) period that a property will be used in a
trade or business to produce income. It is not how long the property will last but
how long the owner expects to productively use it.

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Learning Activity

1. How are depreciation deductions different from other production or

service expenses such as labor, material, and electricity?

2. Explain the difference between real and personal property.

3. Explain how the cost basis of depreciable property is determined.

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Lesson 2

 Depreciation Methods

We shall use the following symbols for the different depreciation methods.
L=useful life of the property in years.
Co=the original cost/cost basis or the adjusted cost basis
CL=the value at the end of life, the scrap value.
d= the annual cost of depreciation
CN=the book value at the end of N years
DN=depreciation up to age of N years.

1. 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,:
𝐶𝑜 − 𝐶𝐿 𝑁(𝐶𝑜 − 𝐶𝐿 )
𝑑= ; 𝐷𝑁 = ; 𝐶𝑁 = 𝐶𝑜 − 𝐷𝑁
𝐿 𝐿
Note that, for this method, you must have an estimate of the final salvage value,
which will also be the final book value at the end of year N. In some cases, the
estimated salvage value may not equal an asset’s actual terminal market value.
Example. A laser surgical tool has a cost basis of 200,000 and a five-year
depreciable life. The estimated salvage value 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.
𝐶𝑜 − 𝐶𝐿 200,000 − 20,000
𝑑= = = 36,000.00
𝐿 5
The depreciation and book value amounts for each year are shown in the
following table.

EOY,N Depreciation ,d Book Value, CN

0 ------- 200,000.00
1 36,000.00 164,000.00
2 36,000.00 128,000.00
3 36,000.00 92,000.00
4 36,000.00 56,000.00
5 36,000.00 20,000.00

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Note that the book value at the end of the depreciable life is equal to the salvage
value used to calculate the yearly depreciation amount.

2. The Sinking Fund Method

This method assumes that a sinking fund is established in which funds will
accumulate for replacement .The total depreciation that has taken place up to
any given time is assumed to be equal to the accumulated amount in the sinking
fund at that time.
The annual cost of depreciation
𝐶𝑜 − 𝐶𝐿 𝐶𝑜 − 𝐶𝐿
𝑑= 𝑁 =
(1 + 𝑖) − 1 𝐹/𝐴, 𝑖%, 𝐿
[ ]
𝑖
The total depreciation up to age of year N, D N
(1 + 𝑖)𝑁 − 1
𝐷𝑁 = 𝑑 [ ]
𝑖
The book value at the end of year N
𝐶𝑁 = 𝐶𝑜 − 𝐷𝑁

Example. A firm bought an equipment for 56,000.Other expenses including

installation amounted to 4,000.00. The equipment is expected to have a life of
16 years with a salvage value of 10% of the original cost. Determine the book
value at the end of 10 years at 12% interest.
𝐶𝑜 − 𝐶𝐿 60,000 − 6,000
𝑑= = = 1,263.061
(1 + 𝑖)𝑁 − 1 (1 + .12)16 − 1
[ ] [ ]
𝑖 . 12
(1 + 𝑖)𝑁 − 1 (1 + .12)10 − 1
𝐷𝑁 = 𝑑 [ ] ; 𝐷10 = 1,263.061 [ ] = 22,165.122
𝑖 . 12

𝐶𝑁 = 𝐶𝑜 − 𝐷𝑁 ; 𝐶10 = 60,000.00 − 22,165.122 = 37,834.878

3. Declining-Balance (DB) Method

In the DB method, sometimes called the constant-percentage method or the
Matheson formula, it is assumed that the annual cost of depreciation is a fixed
percentage of the book value at the beginning of the year. The ratio of the
depreciation in any one year to the book value at the beginning of the year is
constant throughout the life of the asset and is designated by k, the rate of
depreciation.
The following relationships hold true for the DB method:

𝑁 𝐶𝑁 𝐿 𝐶𝐿
𝑘 =1− √ = 1− √ ;
𝐶𝑜 𝐶𝑜

𝑑𝑁 = 𝐶𝑜 (1 − 𝑘)𝑁−1 𝑘

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𝑁
𝐶 𝐿
𝐶𝑁 = 𝐶𝑜 (1 − 𝑘 )𝑁 = 𝐶𝑜 [𝐶𝐿 ]
𝑜

𝐶𝐿 = 𝐶𝑜 (1 − 𝑘)𝐿
This method does not apply , if the salvage value is zero, because k will
be equal to one and 𝑑1 will be equal to 𝐶𝑜 .

5. Double Declining-Balance (DB) Method

This method is very similar to the declining balance method except that
the rate of depreciation k is replaced by 2/L.
The following relationships hold true for the DDB method:
2 𝑁−1 2
𝑑𝑁 = 𝐶𝑜 (1 − ) 𝑥
𝐿 𝐿
2 𝑁
𝐶𝑁 = 𝐶𝑜 (1 − 𝐿 )

2 𝐿
𝐶𝐿 = 𝐶𝑜 (1 − 𝐿 )

Example. A new electric saw for cutting small pieces of lumber in a furniture
manufacturing plant has a cost basis of 40,000 and a 10-year depreciable life.
The estimated salvage value of the saw is 1,000.00 at the end of 10 years.
Calculate the annual depreciation amounts using
a. Declining Balance Method
b. Double Declining Balance Method
Tabulate the annual depreciation amount and book value for each year.
Solution:
𝐿 𝐶 10 1,000
a) 𝑘 = 1 − √ 𝐶𝐿 = 1 − √40,000 = 0.308
𝑜

Sample calculations for year six are as follows:

𝑑𝑁 = 𝐶𝑜 (1 − 𝑘)𝑁−1 𝑘 = 40,000(1 − .308)6−1 𝑥 0.308 = 1,951.107
The depreciation and book value amounts for each year, when k=0.308 are shown
in the following table:
EOY,N Depreciation ,d Book Value, CN
0 -------- 40,000.00
1 12,339.880 27660.12
2 8,533.065 19127.055
3 5900.640 13,227.055
4 4,080.309 9146.746
5 2,821.546 6325.2
6 1951.107 4374.093
7 1,349.196 3024.897
8 932.973 2091.924

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9 645.153 1446.771
10 446.126 1000

b) For double declining balance method, k=2/L.

Sample calculations for year six are as follows:
2 𝑁−1 2 2 10−1 2
𝑑𝑁 = 𝐶𝑜 (1 − 𝐿) 𝑥 𝐿 = 40,000.00 (1 − 10) 𝑥 10 = 2,621.440

The depreciation and book value amounts for each year, when k=2/L or 0.2 are
shown in the following table:

EOY,N Depreciation ,d Book Value, CN

0 -------- 40,000.00
1 8,000.00 32,000.00
2 6,400.00 25,600.00
3 5,120.00 20,480.00
4 4,096.00 16,384.00
5 3,276.800 13,107.20
6 2,621.440 10,485.76
7 2,097.162 8,388.598
8 1,677.722 6,710.876
9 1,342.177 5,368.699
10 1,073.742 4,294.957

6. The Sum-of-the Year –Digits (SYD) Method

The SYD method is a classical accelerated depreciation technique that removes
much of the basis in the first one-third of the recovery period; however, write-
off is not as rapid as for DDB. This technique may be used in an engineering
economy analysis in the depreciation of multiple asset accounts ( group and
composite depreciation).
The mechanics of the method involve the sum of the years digits from 1
through the recovery period L. The depreciation charge for any given year is
obtained by multiplying the basis of the asset, less any salvage value, by the
ratio of the number of years remaining in the recovery period to the sum of the
year’s digit SUM.
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑦𝑒𝑎𝑟𝑠 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔
𝑑𝑁 = (𝐶𝑜 − 𝐶𝐿 )
𝑠𝑢𝑚 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑑𝑖𝑔𝑖𝑡
𝐿−𝑁+1
𝑑𝑁 = (𝐶𝑜 − 𝐶𝐿 )
𝑆𝑈𝑀

Where the sum of the digits 1 through L

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𝐿(𝐿+1)
𝑆𝑈𝑀 = 2

The book value for any year N is calculated as

𝑁
𝑁(𝐿− +0.5)
𝐶𝑁 = 𝐶𝑜 − 2
(𝐶𝑜 − 𝐶𝐿 )
𝑆𝑈𝑀

Example. Calculate the SYD depreciation charge for year 2 and the book value
at the end of year 2 for electro-optics equipment with initial cost of 250,000.00,
salvage value of 40,000.00, and an 8-year recovery period.
8(8+1)
𝑆𝑈𝑀 = = 36
2

The SYD depreciation charge for year 2 is

8−2+1
𝑑2 = (250,000 − 40,000) = 40,833.333
36

The book value at the end of year 2,

2
2(8− +0.5)
2
𝐶2 = 250,000 − (250,000 − 40,000) = 155,500.00
36

7. The Service –Output Method or Production Units Method

This method assumes that the total depreciation that has taken place is
directly proportional to the quantity of output of the property up to that time.
This method has the advantage of making the unit cost of depreciation constant
and giving low depreciation expense during periods of low production.
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 𝐶𝑜 − 𝐶𝐿
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 = =
𝑇𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑢𝑝 𝑡𝑜 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑙𝑖𝑓𝑒 𝑇

Depreciation for Nth year;

𝐶𝑜 − 𝐶𝐿
𝑑𝑁 = (𝑄𝑁 )
𝑇
Where: T=total units of output up to the end of life
𝑄𝑁 =total number of units of output during the nth year.

Example. A manufacturing company purchased machinery for 500,000.00. It is

estimated that it will have a useful life of 12 years, scrap value of 10,000.00,
and an estimated total production of 600,000 units. Compute the book value of
the machine after producing 50,000 units in 3 years of operation.
Solution:
The accumulated depreciation for 3 years is
500,000−10,000
𝐷3 = (50,000) = 40,833.333
600,000

The book value at the end of year 3 is

𝐶3 = 𝐶𝑜 − 𝐷3 = 500,000 − 40,833.333 = 459,166.667

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8. Working Hours Method

This method assumes that the total depreciation that has taken place is
directly proportional to the number of hours of use of the property up to that
time.
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟 = 𝑁𝑜.𝑜𝑓 𝐻𝑜𝑢𝑟𝑠 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦

depreciation during year N, dN

𝑑𝑁 = 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟 𝑥 ℎ𝑜𝑢𝑟𝑠 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑑𝑢𝑟𝑖𝑛𝑔 𝑦𝑒𝑎𝑟 𝑁

Example. A piece of equipment used in a business has a basis of 50,000 and is

expected to have a 10,000 salvage value when replaced after 30,000 hours of
use. Find its depreciation rate per hour of use, and find its book value after
10,000 hours of operation.
50,000−10,000
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟 = = 1.333
30,000

The book value after 10,000 hours of operation, 𝐶𝑁

𝐶𝑁 = 𝐶𝑜 − 𝐷𝑁
𝐷𝑁 = 1.333𝑥 10,000 = 13,333.333
𝐶𝑁 = 50,000 − 13,333.33 = 36,666.667

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Learning Activity

1. An asset purchased for 50,000 has a depreciable life of 5 years, and it

has a terminal book (salvage) value of 5,000 at the end of its
depreciable life. With the straight-line method of depreciation, what is
the asset’s book value at the end of year 3?

2. The “Big-Deal” Company has purchased new furniture for their offices at
a retail price of 125,000. An additional 20,000 has been charged for
insurance, shipping, and handling. The company expects to use the
furniture for 10 years (useful life = 10 years) and then sell it at a salvage
(market) value of 15,000. Use the SL method of depreciation to answer
these questions.
a. What is the depreciation during the second year?
b. What is the book value of the asset at the end of the first year?
c. What is the book value of the asset after 10 years?

3. An asset for drilling was purchased and placed in service by a petroleum

production company. Its cost basis is 600,000, and it has an estimated
market value of 120,000 at the end of an estimated useful life of 14
years. Compute the depreciation amount in the third year and the book
value at the end of the fifth year of life by each of these methods:
a. Straight line method
b. Sinking fund method at i=10%
c. Declining Balance method
d. Double Declining Balance method
e. SYD method

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Summative Test

1. What conditions must a property satisfy to be considered depreciable?

2. A machine has a n initial cost of P60,000.00 and a salvage value of

P12,000.00 after 10 years. What is the straight-line method
depreciation rate as a percentage of the initial cost?

3. A dump truck was bought for P40,000.00 six years ago. It will have a
salvage value of P4,000.00 four years from now. It is sold now for
P10,000.00. What is its sunk cost if the depreciation method used is
Sinking Fund Method at 7%.

4. An equipment costs P8,000.00 has an economic life of 8 years and a

salvage value of P400.00 at the end of 8 years. The first year
depreciation amounts to P1688.89. What method is used in the
calculation of the depreciation? Show solution.

5. A machine costing P780,000.00 is estimated to have life of 15 years.

If the annual rate of depreciation is 26%, determine the total
depreciation using a constant percentage of the declining balance
method.

6. A VOM has a current selling price of P500.00. If its selling price is

expected to decline at the rate of 11% per annum due to absolence,
What will be its selling price after 4 years?

7. A certain equipment which cost P500,000.00 when brand new has a

salvage value of x pesos and is expected to last for 23000 hrs. in a
period of 5 years. In the first year of service it was used for 7000
hours. If the book value of the equipment is P360,000.00 at the end
of the first year, What is the value of “x”?

8. An asset is purchased for P9,000.00. Its estimated life is 10 years after

which it will be sold for P1200.00 Find the book value during the first
year if sum-of-the-year’s-digit (SOYD) depreciation is used.

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 MODULE SUMMARY

In module III, depreciation can be defined in three senses like physical

depreciation, which is caused due to physical decay. Economic depreciation is
the loss of value of an asset due to outdated technology and in accounting sense
depreciation is the estimated value of fall in the worth of an asset. Depreciation
is a permanent continuing and gradual shrinkage in the book value of a fixed
asset.

Congratulations! You have just studied Module III.

Module III