eering Economy.: DEPRECIATION 5.1. DEFINITION Depreciation may be defined as "the lessening in value of physical asset with use, and/or the passage of time". All manufacturing and Producing facilities are consumed in the production process. With the Possible exception of land, this phenomenon is a characteristic of all physical assets. 5.2. SIGNIFICANCE i) Amortization of Capital Depreciation provides the concept of amortizing the cost of an asset. In any enterprise, physical capital (in the form of machines, buildings, and This results in a systematic way to spread or distribute the capital cost, and anticipated loss in value, throughout the life of the asset, rather than charging the entire cost as an expense at the time the asset is purchased. This concept, of amortizing the cost of an asset, makes the profit and loss statement a more accurate reflection of capital consumption. Also, depreciation provides a continuous Monetary measure of the value of an enterprise’s unexpended physical value or ‘book value' at any time, both: collectively (for the whole plant), and individually (for specific machines and units). * However, it should be noted here that, these book values can only be approximated with the accuracy with which the future life of the asset, and the effect of deteriorations can be estimated. ii) Determination of Production Cost ; . An understanding of the depreciation concept is essential; as it has to be included as an integral part of any engineering economy analysis. The overall economy of a process must be sufficient to absorb the reduction in value of production facilities due to depreciation. ; The lost capital needs to be accounted for ; in order to determine Production costs, Therefore, without depreciation consideration, it will be ‘mpossible to determine the true production cost, and the profitability. 417.Chapter (5) > Classification a8, 5.3 CLASSIFICATION The common types of depreciation can be classified as: a) Physical Depreciation This is the deterioration, or physical impairment of an asset. It results in the lowering of the ability of a physical asset to render its intended service. It may be due to: i) Natural Causes: e.g. corrosion of pipes, rotting of timbers, chemical decomposition, bacterial action, ...etc. ) Through use: e.g. wearing of pistons and cylinders of a car engine, wearing out of tires, ...ctc. b) Functional Depreciation , 7 This is a depreciation resulting from a change in the need for the service. It is associated with external changes, and may be due to: i) Obsolescence: This is a loss in valuc duc to technological advance. Each technological advance produces improvements, that result in the obsolescence of the existing assets. An asset becomes obsolete, or out-of-date, when it becomes more profitable to use a more efficient unit, or when it is uneconomical to continue using the original asset. * A disposition to replace machines when it becomes profitable to do so, instead of when they are worn out, has probably been an important factor in the rapid development of human civilization, e.g. , the sailing ship has given way to the steamship, one generation of computer is rapidly being replaced by the next, and so on. ii) Inadequacy: This is the inability of an asset to meet the demand placed upon it. An asset becomes inadequate, when changes in demand for its service result in a demand beyond its scope or capability. This situation arises from changes in demand not contemplated when the asset was acquired. * Usually, replacement of a small unit may cost less, in the long run, than supplementing the present unit with another unit to meet the new ) Accidental Depreciation This is the sudden depreciation due to an accident,ster (5) > Depreciation Accounting and Models 419 .4 DEPRECIATION ACCOUNTING AND MODELS )) The Value-Time Function: The value-time function is a curve that represents the lessening in value f an asset, over time, as shown in Figure 5.1. It is used to predict the attern of the future value, or the book-value of an asset, at any point in me, t, during its service life. The value-time function is a general expression, that represents the y0k-value of an asset, By as a function of time, t. The book-value of any set, B,, is given by the following equation: t reg y Dj 5.4-1 A here: B, =the book-value value at the end of any year, t. B,, = the book-value at the end of the year (t-1), or at the beginning of the year (t). D, =the deprecation charge during the year 't'. P =Bo = the first cost of the asset. D,+D, + ... + D, = the accumulated depreciation. In words, the above equation says that, the book-value at the end of 'y year, is equal to the book-value at the beginning of that year, less the preciation expense charged during that year. Or, the book-value at any ‘int in time, t, is equal to the original value of the asset, P, minus the cumulated depreciation up to that point in time, Yj_, D, - ) Depreciation Models The evaluation of the depreciation charge, D,, during any year, t, and e determination of the value-time function are based on the depreciation odel. Several models are available, The most common ones are: ). The Straight-Line Model. The Sum-of-the-Y ears-Digits Model. ii) The Declining-Balance Model.chapter (vy) ~ Vepreciation Accounting and Models Qa = aaa nEInaeErneneneeeeemenee ae ) The Straight-Line Model: SL-Model This model assumes that the value of an asset decreases at a constant ‘ate as shown in Figure 5.1-(i). According to this model: P-F D, = = = constant 5.4-2 where: the depreciation charge during any year, t . the first cost of the asset. the estimated salvage value. the estimated service life of the asset. amu oooud Using Eq. 5.4-1, the book-value, B, , at the end of any year, t, is given by: 5 P—F B.=P-)> D, Spee | 54-3 fad n j= ii) The Sum-of-the-Years-Digits Model: SYD -Model The Straight-Line Model is a simple model, but it does not indicate the general trend of depreciation. Most assets depreciate more rapidly during the early part of their life, and this fact is reflected by the Sum-of- the-Years-Digits model, which assumes that the value of an asset decreases at decreasing rates. According to this model, the asset depreciates about three-fourth of its depreciable cost (P-F) during the first half of its life. If an asset has a first cost, P, of $5,000, and an estimated salvage value, F, of $1,000 after n = 5 years, then the sum of the years digits will De : a 14+2+3+4+5 =15 ja According to this model, the depreciation charges during the first, second... and fifth years are given by: D= = GS, 000 - $1,000) = $1,333.33 = Fa (P-F) Dz = ($5,000 - $1,000) = $1,066.67 = aa eee Ds = 35 ($5,000 - $1,000) = $267,00 = a7 @=-F) [he depreciation charge during any year, t, is given by:apter (5) > Depreciation Accounting and Models __ (aa 5.4-4 The sum-of-the-years-digits for any number of years 'n', can be computed from the expression: n Dyait2+a+—4@—yina WtD eee fot From Eqs. 5.4-4 & 5.4-5, we have: 2 Gets =| De = Ga 5.4-6 From Eq. 5.4-1, the book-value, B; , at the end of any year 't' is given by: n >) sa jai Substitute Eq. 5.4-6 into Eq. 5.4-1: t eae eral: oes 54-7 t SMesti-o = nt+(n—-1)+(n—-2)4+--+(m+1-1t) ti =[1+24+3+ ...¢n]-[1+2+...+(@0] n@M+1)_ @-H)@-tt+) Darin = : 5.4-8 t=1 Substitute Eq. 5.4-8 into Eq. 5.4-7: ie gh Gueh) a (a. Gas 8 Coe) (na toed) Pe ts Fata pare yay «ere 2 -pm-t+1 re e-n+e-7.(Sea®)>hapter (5) > Depreciation Accounting and Models 5.49 B, ar+@-[S—|[So oY n (n+ 1) ii) The Declining-Balance Model: DB-Model The declining-balance model of depreciation assumes that, an asset lecreases at a faster rate in the early portion of its service life than in the atter portion of its life. Mathematically this model is represented by the ollowing equation: D=R.Bu 5.4-10 where: D, = the depreciation charge during any year 't’. B,. = the book-value at the end of the year (t-1), or at the beginning of the year 't’. R =the depreciation rate, which is a fixed percentage, or a fraction. 'R' is a constant. According to this model, a fixed percentage, R, is multiplied times the book value of the asset at the beginning of the year, to determine the depreciation charge for that year. * Since the book-value of the asset decreases through time, so does the size of the depreciation charge. * As: Bat > Dat From Eq. 5.4-1, we have : B, = Bu -D, 5.4-1 Substituting for 'D,’ from Eq. 5.4-10 , Eq 5.4-1 reduces to: B, = Bu - RB = (1-R) Bu 54-11 3q. 5.4-11 is a recursive relation, that relates 'B,' to 'B,.;'. For various values of 't' , Eq. 5.4.11 gives: B,= (1-R) Bo= (1-R) P B= (1-R) B,= (1-R)’ P B,= (1-R) B,= (1-R)’ P B,= (-RY P 5.412chapter ( 5) > Depreciation Accounting and Models 423 rrom Eqs: 5.4-10 and 5.4-12, we have: D, = R(-R)*P 5.4-13 Also Eq. 5.4-12 can be written in the following form : r= 1- ‘fe P $.4-14 Eq. 5.4.14 is used to calculate the depreciation rate, R, that will result n a particular book-value, B; , at some point in time, t , i.e. it is used to jetermine the rate, R, that makes the model passes through any given point. B,, t). Jepreciation Rate, R If the declining-balance model of depreciation is utilized for income ax purposes, the maximum rate that may be used is double the straight-line ate. Thus for an asset with an estimated life at SV = 0.0 of 'n” years, the naximum rate, Rmax, that may be used with this method is given as: + 2 Panic) S25 Gre) eres 5.415 senerally: -o = RS = vhere: 1 _ @=Bi) _ @r-1=Be) es P P rom similar triangles , it can be shown that : a P 54-16 lh i (og v) The Double-Declining-Balance Model: DDB-Model Many firms and individuals choose to depreciate ee ee eclining-balance depreciation, with the maximum ® . hown in Figure 5.1 below. tion, is commonly referred to as the Such a method of deprecia ati Double-Declining-Balance" Model of depreciation.shapter (5) > Depreciation Accounting and Models ee, s s P Asset Asset | Value Value nor) t Service life Service life | (@ Straight Line Model (ii) SYD - Model | 0 € Servicelife om) ° t Servicelife " ™ (iii) DB-Model with R2 >Ri (iv) DDB-Model R= Ras= 2/n"= 2(P-F) /(nP) Figure 5.1: Value-Time Function for the Various Depreciation Models.Chapter (5) > Summary of Depreciation Models l 5.5 SUMMARY OF DEPRECIATION MODELS: 5.5.1 General Relationships The following relationships hold for all depreciation models, as indicated in Figure 5.1. t Bere Ss yy a 5.5-1 ja D, = Br-1 — B, 5.5-2 where: B, = book-value at the end of year 't' . B,.= book-value at the end of year 't-1', or at the beginning of year 't’. P =Bo= first cost, or original value of the asset . D, = depreciation charge during any year 't’ , t D; = accumulated depreciation. j= Eq. 5.5-1 points out that the book-value of an asset, at the end of any year 't' is equal to the first cost minus the accumulated depreciation during all the previous years (1—t), while Eq 5.5-2 indicates simply that the depreciation during any year 't' is the difference between the book-values at he beginning and at the end of that particular year. 5.5.2 Straight Line Model : SL-Model @-F) n De = = constant # f(t) oa B= P - = @-F) 5.5-4 Where 'F' is the salvage value, or the book-value at end of the n" year. .5.3 Sum- of- the- Years- Digit Model : SYD-Model 2m+1-t) t = E = Sten = Gren sss B= F + G-DGH=) (p_ F) 55-6 n(n+1)Chapter (5) > Summary of Depreciation Models aad nani eeeereneete se 5.5.4 Decline-Balance Model : DB-Model D= R. Bi = R(1-R)'.P 5.5-7 By = (eR). P 5.5-8 From Eq. 5.5-8, the deprecation rate of the model, R, is defined as: 5.5-9 5.5-10 where 'n" is the limiting value of the service life 'n', for which the book-value, B,, becomes zero. Using Straight-Line Model, the value ' n*' can be determined as follows: ee i ED 5.5-11 5.5.5: Double-Declining-Balance Model : DDB Model DDB-Model is the particular case of DB-Model, when the depreciation rate, R, gets its maximum value, i.e. Roos = Rmx = = entiseha > The various models of depreciation are shown in Figure 5.1. ‘napter | BESET AS OU &Xample. .6 WORKED-OUT EXAMPLES The depreciation models, discussed in the previous section, are justrated through Examples: 5.1 and 5.2, given below. An asset has a first cost of $10,000, with a salvage value of $1,000 after 5 years. a) Determine its book-value, B,, during its service life, using the flowing depreciation models: i) Straight-line ii) Sum-of-the-Years Digits. iii) Declining-Balance | b) If the salvage value is assumed to be zero, how does this affect the general shape of the book-value curves? - - solution Part (a) ) For Straight-Line Model , the book-value , B,, is given as: Bo et ec n the present case : B, = $10,000 — t (Snneanesn ne) @ or as B, = $10,000 - $1,800t (ii) ii) For the Surn-of-the-Years-Digits Model, we get = nated es “ren Ga me ‘ni values in Eq. (iii) results in: (iv) = $1,000 + $9,000 (5) (=) ili) For the nese Model, we have: eh yr 2 or 0.18 < R < 0.36 ne i. Particular value of 'R' that makes the model passes through the given Salvage value, SV =F = Bs = $1,000, is determined as: eS ESS428 n/p 1,000 Rai. Jak ms i. ! pa 9 Z P 40,000 ~ 0-369 ™ Thus the model can be solved for these 3 values of 'R'. In those cases, the book-value, B,, is given as : B, =(1-R)'. P, for R = 0.2 , 0.369 and 0.4 . B, = $10,000(0.8)' , or $10,000 (0.631)', or $10,000 (0.6)' (vi) Egs.: (ii),(iv) & (vi) are solved for values of: t = 1,2...5. The corresponding book-values are tabulated below in Table 5.1, and shown diagrammatically in Figure 5.2. Time t St-Line Model SYD - Model Declining-Balance Model B, (S) | or) | BS) | Bs Ruin = 0.2 R= 0.369 | Riax = 0-4 } 1 8,200 7,000 8,000 6,310 6,000 ee 6,400 4,600 | 6,400 3,982 3,600 | 3 4,600 2,800 5,120 2,512 2,160 4 | __2,800 __1,600 4,096 | 1,585 _|_1,296 5 1,000 1,000 3,277 1,000 778chapter (5) > Worked-out itariipies (as s T ) An asset with a present worth of i value of $500 after 8 years, dapreciaten ind is epee ene for 4.5 years, then depreciates 1i i 25 , inearly until the end of i life. Sketch the book-value, B, versus servi i ae ee genie a Tvice life, t, for O Worked-out Examples U_430 B, = (1 -0.25)*($ 5,000) = $1,582.03 Part (b) The depreciation charge , D,,, is given by DB-Model as: D, =R.Bui (ii) For t= 1 year, Eq. (ii) gives : D, =R. Bo= R.P = (0.25) ($ 5,000) = $1,250 Alternatively, 'D;' can be obtained as: D =P -B (ii) where 'B;' is obtained through Eq.(i) as: = (1 - 0.25) ($ 5,000 ) = $ 3,750 Substituting this value of 'B,' into Eq. (iii) results in: = $5,000 —$ 3,750 =$ 1,250 which is the same value as that obtained before . Now 'Ds' can be defined as: Ds= Bs—Bs (iv) 'B,' is known, but Bs falls within the range of straight line model. To define this model, it is necessary to specify its terminal point, Bs; , which can be obtained through Eq. (i) as: Bas= (1 - 0.25)**($ 5,000) = $ 1,370.08 The straight line model starts at t = 4.5 years; hence this point represents the relative zero of this model, while the corresponding value, B,.s, stands for the first cost , P . The book value, B, , at any time, t, (where t > 4.5yrs), is given by: B, = P'-£ @-F) ~ Based on the above discussion, the following values are evident: P=Bas = $1,370.08 F=Bs = $ 500.00 wi B=B—45. = 35 voars Substituting these values, aca Eq. (v) to: meu eee aChapter (5) > Worked- out Examples co B, = $ 1,370.08 — 35 ¢ $ 1,370.08 - $ 500.00 ) or B, = $1,370.08 — $248.594t (vi) Note * Itshould be noted here that, the time 't' in Eq. (vi) is the time after the starting of model, or it is the time relative to the model zero at t= 4.5 . Therefore the book-value at the end of the fifth year, Bs, is given hrough Eq. (vi), bearing in mind the above note as: Bs = Bos = $1,370.08 — $ 248.594 (0.5) = $ 1,245.783 ubstituting this value into Eq. (iv) yields: Ds = Bs—Bs = $ 1,582.03 - $ 1,245.783 = $ 336.247 FED WE{ ) Chapter (5) > Problems (C432) PROBLEMS 5-1 a) Show that the depreciation charge, D, , that takes place during any year 't’ is given by various depreciation models as indicated below: i) The Straight Line Model, SL-Model : —F ii) Sum-of-the-Y ears-Digits model , SYD-Model : n+1-t Daerncupem 5 iii) Declining-Balance Model, DB-Model: D, = R(-R)".P b) The Golden Star Company purchased 3 types of machines: X, Y and Z, three years ago, for its production activity. The first cost 'P', service life 'n' , salvage value 'F' and, the depreciation model for each machine are indicated in the table below: | First cost ($) | Service life (years) Salvage value ($) Depreciation Model Sketch the book-value, B,, vs. time, t, for each machine, then determine: i) The depreciation charge, for each machine, during next year i.e. Ds. ii) The double-declining-balance model rate, R, for each machine. iii) Use the double-declining-balance model to determine the salvage value of each machine. 5-2 a) Show that for Sum-of-the-Years-Digi iation, ¥: igits Model of depreciation, the book-value at the end of the year 't', Br, is given by: Bre B =F +(P-F))(F n+. P = first cost F = salvage value n = service life aChapter (5) > Problems (C433) b) The first cost of an asset is $ 25,000, and its salvage value after 10 $ 6,000. If the asset depreciates according to the Sum-of-the- Digits Model, sketch its book-value, B,, vs time, t, and determine its book-value at the end of each year, during the first five years of its service life, c) An asset has a first cost of $900,000, an estimated life of 15 years, and an estimated salvage value of %15 of the first cost. i) Using the Straight-Line Model, find the annual depreciation charge, expressed as a percentage of first cost, and the book-value at the end of the 10" year. ii) Using the Sum-of-the-Years-Digits Model determine the depreciation charge during the 7" year, and the book value at the end of the 10" years. 5-3 A new asset is purchased for $1,200, and is estimated to have a life of 10 years, and a scrap value of $200 at the end of that time. a) Determine the book-value at the end of the sixth year, using: Straight Line Model, and Sum-of-the-Years-Digits Model. b) Determine the declining-balance rate 'R’, that results in the same book-value as that given by the Sum-of-the-Years-Digits Model. 5-4 a) Define mathematically 'Declining-Balance Model of depreciation’ b) Prove that, for this model : Bua GR) ae where: B, = book-value at end of year 't'. P first cost of the asset . R = model rate . c) Determine the book-value of an asset at the end of the fifth year if it has a first cost of $20,000, and a salvage value of $5,000 after 9 years, and it depreciates according to the Declining- Balance Model, a) When Double-Declining-Balance Model is used the book-value of an asset, at the end of the fifth year, was found to be $4,260. If the first cost atthe asset is $13,000, determine its book-value at the end of the 3™ year. >) Ifthe Straight Line Model is used, what would be the book-value of the asset at the end of the 5" year?lL 434 ] Chapter (5) > Problems ©) Sketch on the same graph 'B;' vs. ‘t! for the two models, and indicate all numerical values, you obtained in previous parts, on your graph. d) When the two models predict the same book value? i.e. the intersection point on your graph. i a osts $45,000, and it has an estimated life 5-6 A certain heat-exchanger costs Beemer uae tic 10° of 10 years, with a salvage value of $10,000 ar: 5 Determine the book-value, B, , of the heat exchanger, at the end of the 5" year, using the following depreciation models: i) Straight Line Model, SL-Model. if) Sum-of-the-Years-Digits, SYD-Model. iii) Double-Declining-Balance, DDB- Model. Sketch 'B,' vs. 't’, in each case, on the same graph. b) What is the rate 'R', that should be used with the Declining- Balance Model in order to predict the same book-value, Bs, as that of SYD-Model? Is it possible to use this rate for tax purpose? Why? What will be the salvage value at the end of the 10" year if this rate 'R' is used? c) Which depreciation model do you recommend for your company? Why? 5-7 An asset has a first cost of $ 9,000, an estimated life 'n' of 12 years , and an estimated salvage value of $ 1,200. This asset is to be depreciated with a declining-balance rate of 0.14 for 6 years, then it depreciates linearly. Sketch the book-value, B,, vs. time, t, then determine: a) The depreciation charge in the 3" and the 7 yrs: D3 & D>. b) The declining-balance rate that will give a book-value of 15% of the first cost at the end of the 10" year. Is it permitted to use this rate for tax calculation? Why? 5-8 An asset with a first cost of $100,000, has an estimated salvage v: ,000, alue of $12,000 at the end of the 8" year. If this asset depreciates anes to the Sum-of-the-Years-Digits Model for the first five years, then eas, to depreciate linearly for the rest of its service life the book-value at the end of the 3", 5" and the 7" years, then sketch its book-value, B,, in the time interval (0-+8) years assuming a smooth value-time function. ; RS