Chapter 5

Depreciation

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  Depreciation is the decrease in value of physical
properties with the passage of time.

 Depreciation: the decline in the value of the asset.

 As time elapses, every asset undergoes a progressive

loss of value resulting from:

1) Physical factors: wear and tear,

2) Functional factors: technological change

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Introductory points
 Asset: property that is acquired and exploited for monetary
gain such as machines, vehicles, office building, planes, ships,
boats, computers, etc.
 First Cost of an Asset: total expenditure required to place
an asset in operating condition.
 E.g. If an asset is purchased, it includes the purchase price

related and all incidental expenses such as transportation,

tax, assembly, expert advice, etc.
 Salvage Value or Residual Value: the price at which a
fixed asset is expected to be sold at the end of its useful life.

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 Book Value: the value of an asset displayed on the

documents of the firm.

 E.g. if the first cost of an asset is $20,000 and the depreciation

charges to date total $14,000 the current book value is $6,000

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An Asset is Depreciable If

1.The asset is used for business purposes in the production

of income.

2.The asset has a useful life that can be determined, and the
useful life is longer than one year.

3.The asset decays, gets used up, wears out, becomes

obsolete or loses value from natural causes.

4.It is not inventory, stock in trade, or investment property.

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Depreciation and Expenses
 Expenses - subtracted from business revenues as they
occur (time frame < one year).
 Labor

 Utilities

 Materials

 Insurance, etc.

 Depreciation - subtracted from business expenses over

time as the asset is used up (applies to assets with > 1
year useful life).
 Machinery

 Installation and Maintenance costs

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Classification of Assets
 Tangible - can be seen, touched, and felt.

 Real - land, buildings, and things growing on, or

attached to the land.

 Personal - equipment, furnishings, vehicles, office

machinery, or not defined as real property.

 Intangible - has value but cannot be seen or touched,

examples include patents, copyrights, and trade marks.

In general buildings and equipment are

depreciable; land is not.

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 Depreciation for Tax Purposes
 Depreciation is used to allocate an asset’s loss of value over time.

 Depreciation is deducted from revenue and reduces the taxable

income of a business over time which produces a cash flow on an
after tax-basis.

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 Tax Effects of Depreciation

 Since depreciation is a recognized business expense, it

reduces the taxes the firm is required to pay.

 Thus, every depreciation charge creates a tax savings for that

year, and amount of the savings is the function of the
amount of the depreciation charge and the rate at which the
firm's profits are taxed.

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 Depreciation Methods

 There are several methods of accounting depreciation

fund. These are as follows:
 Straight line method of depreciation

 Declining balance method of depreciation

 Sum of the years—digits method of depreciation

 Sinking-fund method of depreciation

 Service output method of depreciation

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Straight Line Method of Depreciation

 In this method of depreciation, a fixed sum is

charged as the depreciation amount throughout
the lifetime of an asset such that the accumulated
sum at the end of the life of the asset is exactly
equal to the purchase value of the asset.

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 Here, we make an important assumption that inflation is
absent.

Let

P= first cost of the asset,

F= salvage value of the asset,

n = life of the asset,

B t = book value of the asset at the end of the period t,

D t = depreciation amount for the period t.

The formulae for depreciation and book value are as follows:

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 Example: A company has purchased an equipment
whose first cost is Birr. 100,000.00 with an
estimated life of eight years. The estimated salvage
value of the equipment at the end of its lifetime is
Birr. 20,000. Determine the depreciation charge
and book value at the end of various years using
the straight line method of depreciation.

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....Straight Line Depreciation
Solution

P= Birr. 100,000 F= Birr. 20,000 n = 8 years

D t = (P– F)/n = (100,000 – 20,000)/8 = Birr. 10,000

In this method of depreciation, the value of D t is the same for all the years.

The calculations pertaining to B t for different values of tare summarized in

Table 1.

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...Straight Line Depreciation
Table 1: D t and B t Values under Straight line Method of Depreciation

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Declining Balance Method of Depreciation

 In this method of depreciation, a constant percentage of the

book value of the previous period of the asset will be charged as
the depreciation amount for the current period. This approach is
a more realistic approach, since the depreciation charge
decreases with the life of the asset which matches with the
earning potential of the asset. The book value at the end of the
life of the asset may not be exactly equal to the salvage value of
the asset. This is a major limitation of this approach.


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Let;
P= first cost of the asset,

F= salvage value of the asset,

n= life of the asset,

B t = book value of the asset at the end of the period t,

K= a fixed percentage, and

D t = depreciation amount at the end of the period t.

The formulae for depreciation and book value are as follows:

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 The formulae for depreciation and book value in terms of P
are as follows:

While availing income-tax exception for the depreciation

amount paid in each year, the rate K is limited to at the most
2/n. If this rate is used, then the corresponding approach is
called the double declining balance method of depreciation.

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 ….. Declining Balance Method of Depreciation

 Example: Consider the previous example and demonstrate the

calculations of the declining balance method of depreciation by
assuming 0.2 for K.

 Solution

P= Birr. 1,00,000 F= Rs. 20,000 n= 8 years K= 0.2

The calculations pertaining to D t and B t for different values of tare

summarized in Table 2 using the following formulae:

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…Declining Balance Method of Depreciation
Table 2: D t and B t according to Declining Balance Method of Depreciation

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Cont.

 Also we can calculate the depreciation and book value For

specific period. For example take period five and calculate the
depreciation and book value at this period.
 Solution
P= Birr. 1,00,000 F= Birr. 20,000 n= 8 years K= 0.2

=Birr. 8,192

= Birr. 32,768

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 Sum-of-the-Years-Digits Method of Depreciation

 In this method of depreciation also, it is assumed that the book

value of the asset decreases at a decreasing rate. If the asset has
a life of eight years, first the sum of the years is computed as
Sum of the years = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 = 36 = n(n+ 1)/2
 The rate of depreciation charge for the first year is assumed as
the highest and then it decreases. The rates of depreciation for
the years 1–8, respectively are as follows: 8/36, 7/36, 6/36,
5/36, 4/36, 3/36, 2/36, and 1/36.
 For any year, the depreciation is calculated by multiplying the
corresponding rate of depreciation with (P– F).

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 Cont. ..

 The formulae for D t and B t for a specific year t are as follows:

Example: Consider the previous example and demonstrate the

calculations of the sum-of-the-years-digits method of depreciation.

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 Solution

 P= Birr. 1,00,000 F= Birr. 20,000 n= 8 years

 Sum = n(n+ 1)/2 = 89/2 = 36

 The rates for years 1–8, are respectively 8/36, 7/36, 6/36,
5/36, 4/36, 3/36, 2/36 and 1/36.

 The calculations of D t and B t for different values are

summarized in Table 3. using the following formulae:

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Table 3: D t and B t under Sum-of-the-years-digits Method of Depreciation

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 Sinking Fund Method of Depreciation
 In this method of depreciation, the book value decreases at
increasing rates with respect to the life of the asset. Let

 P= first cost of the asset,

 F=Future value

 S= Salvage value of the asset,

 n= life of the asset,

 i = rate of return compounded annually,

 A= the annual equivalent amount,

 B t= the book value of the asset at the end of the period t, and

 D t = the depreciation amount at the end of the period t.

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 The loss in value of the asset (P– F) is made available and the
form of cumulative depreciation amount at the end of the life
of the asset by setting up an equal depreciation amount (A) at
the end of each period during the life time of the asset.

 A= (P– S) [A/F, i, n]

 The fixed sum depreciated at the end of every time period

earns an interest at the rate of i% compounded annually, and
hence the actual depreciation amount will be in the increasing
manner with respect to the time period. A generalized formula
for D t is

 D t = (P– S) (A/F, i, n) (F/P, i, t– 1)

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 The formula to calculate the book value at the end of period t
is

 B t = P– (P– S) (A/F, i, n) (F/A, i, t)

 The above two formulae are very useful if we have to calculate

D t and B t for any specific period. If we calculate B t and D t

for all the periods, then the tabular approach would be better.

 Example: Consider the previous example and give the

calculations regarding the sinking fund method of depreciation
with an interest rate of 12%, compounded annually.

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 Solution

 P= Birr. 1,00,000 S= Birr. 20,000 n= 8 years i = 12%

 A= (P – S) [A/F, 12%, 8] = (100,000 – 20,000) X 0.0813 = Birr.

6,504

 In this method of depreciation, a fixed amount of Rs. 6,504

will be depreciated at the end of every year from the earning
of the asset. The depreciated amount will earn interest for the
remaining period of life of the asset at an interest rate of 12%,
compounded annually. For example, the calculations of net
depreciation for some periods are as follows:

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 Depreciation at the end of year 1 (D1) = Birr. 6,504.

 Depreciation at the end of year 2 (D2) = 6,504 + 6,504 X 0.12 =

Birr. 7,284.48

 Depreciation at the end of the year 3 (D3) = 6,504 + (6,504 +

7,284.48) X 0.12 = Birr. 8,158.62

 Depreciation at the end of year 4 (D4) = 6,504 + (6,504 +

7,284.48 + 8,158.62) X 0.12 = Birr. 9,137.65

 These calculations along with book values are summarized in

Table 4.

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 Cont. …
• Table 4: D t and B t according to Sinking Fund Method of Depreciation
 Service Output Method of Depreciation or Unit Production Method

• In some situations, it may not be realistic to compute

depreciation based on time period. In such cases, the
depreciation is computed based on service rendered by an
asset. Let

• P= first cost of the asset

• S= salvage value of the asset

• X= maximum capacity of service of the asset during its lifetime

• x= quantity of service rendered in a period.

• Then, the depreciation is defined per unit of service rendered:

• Depreciation/unit of service = (P– S)/X

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 Cont …

Example: The first cost of a road laying machine is Birr.

8,000,000. Its salvage value after five years is Birr. 50,000. The
length of road that can be laid by the machine during its lifetime
is 75,000 km. In its third year of operation, the length of road
laid is 2,000 km. Find the depreciation of the equipment for that
year.

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 Cont …

• Solution
• P= Birr. 80,00,000 S= Birr. 50,000 X= 75,000 km x= 2,000 km

= Birr. 212,000

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Read about MACR and
Depletion

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 END

all the best…….