DEPRECIATION AND DEPLETION

3.1 OBJECTIVES

At the end of this chapter, the students are expected to be able to:

 Understand the basic terminologies of depreciation.

 Apply the different depreciation methods.
 Differentiate the physical and economic life.
 Differentiate tangible and intangible factors; and
 Identify the different types of depreciation.

3.2 INTRODUCTION

The capital investments of a corporation in tangible assets—equipment, computers,

vehicles, buildings, and machinery—are commonly recovered on the books of the corporation
through depreciation. Although the depreciation amount is not an actual cash flow, the process of
depreciating an asset, also referred to as capital recovery or amortizing, accounts for the decrease
in an asset’s value because of age, wear, and obsolescence.
Why is depreciation important to engineering economy? Depreciation is a tax allowed
deduction included in tax calculations in virtually all industrialized countries. Different types of
depreciation are discussed in this chapter.
Purpose of Depreciation:

1. To provide for the recovery of capital which has been invested in physical property

2. To enable the cost depreciation to be changes to the cost of producing products or

services that results from the use of the property.

3.3 TERMINOLOGIES

Depreciation - is the method by which a taxpayer deducts the cost of a capital asset over a
period of time. It is also the decrease in the value of physical property due to the passage of time.
The deterioration of the physical and functional utility of a fixed asset due to its passage of time.

Value – in a commercial sense, is the present worth of all future amounts that to be receive
through ownership of a particular property. Designates the worth that a person attaches to an
object or service.

Market Value – of a property, is the amount which a willing buyer will pay to a willing seller
for the property where each has equal advance and is under no compulsion to buy or sell. The
market value lies between what the seller wishes to obtain for this property and what the buyer
would like to pay for it. It is the estimated amount realizable if the asset were sold on the open
market.
Utility Value – is what the property is worth to the owner as an operating unit.

Fair Value – is the value which is usually determined by a disinterested third party in order to
established a price that is fair to both seller and buyer. (Usually done by the assessor)

Book Value – sometimes called “depreciated book value”. It represents the remaining,
undepreciated capital investments on the books after the total amount of depreciation charges to
date has been subtracted from the basis.
- Is the worth of a property as shown on the accounting records of an enterprise.
- It is equal to the original cost minus the amounts which have been charged to
depreciation

Salvage Value or Resale Value - is the price that can be obtained from the sale of the property
as second hand.

Scrap Value – is the amount the property would sell for if disposed off as a junk. The utility of
the machine is considered to be zero.

Valuation or Appraisal – is the process of determining the value of certain property for specific
reasons. The person engaged in the task of valuation is called an appraiser.

3.4 TYPES OF DEPRECIATION

1. Normal Depreciation
a. Physical Depreciation- is due to the lessening of the physical ability of a property to
produce results. Its common causes are wear and deterioration.
b. Functional Depreciation – is due to the lessening in the demand for the function which
the property was designed to render. Its common causes are inadequacy, changes in
styles, saturations of market, or more efficient machines are produced.
2. Depreciation due to changes in price levels – is almost impossible to predict and therefore is
not considered in economy studies. The capital has depreciated, and not the
property.
3. Depletion – is a book method (noncash) to represent the decreasing value of a natural
resources as it is recovered, removed or felled. The two methods of depletion for
book or tax purposes are used to write off the first cost, or value of the estimated
quantity, of resources in mines, wells, quarries, geothermal deposits, forests, and the
like. refers to the decrease in the value of a property due to the gradual extraction of
its contents. It is the actual physical reduction of natural resources by companies
such as mines, quarries, oil and gas well, timber lands are called “wasting” or
“depleting”. Two methods of depletion are:
 a. Cost Depletion - Sometimes referred to as factor depletion, cost depletion is
based on the level of activity or usage, not time, as in depreciation. Cost depletion
may be applied to most types of natural resources and must be applied to timber
production.
b. Percentage Depletion - This is a special consideration given for natural
resources. A constant, stated percentage of the resource’s gross income may be
depleted each year provided it does not exceed 50% of the company’s taxable
income. Using percentage depletion, total depletion charges may exceed fi rst cost
with no limitation.

3.5 TWO TYPES OF LIFE

Physical life of a property – is the length of time during which it is capable of performing the
function for which it was designed and manufactured.
- The time that it takes for the machine to function normally.
Economic life - is the length of time during which the property may be operated at a profit.
- A function that has something to do with revenue.

3.6 TWO TYPES OF FACTORS THAT AFFECT ECONOMIC STUDIES

In many economic studies, there are two basic types of factors to be considered. These
are: tangible and intangible factors.

1. Tangible factor – are those which can be expressed in terms of monetary values.
- Are those which can be expressed in terms of monetary values.

2. Intangible factor – are those which are difficult or impossible to express definitely in
terms of monetary values. Intangible factors are also called irreducible factors.
- Are those which are difficult to express definitely in terms of monetary values that cannot
be measured.
Examples of Intangible Assets:
- Goodwill - patents - licenses
- leaseholds
- Copyrights - franchise - trademarks/brand name

INTANGIBLE VALUES
- Values of an asset that can not be seen or touched or physically measured. intangible
assets rarely have any relation to economic value
In the determination of the value of industrial property or equipment, 4 intangible items
are often encountered.
1. Goodwill – is that element of value which a business has earned through the favourable
consideration and patronage of its customers arising from its well-known and well conducted
policies and operation.
- an intangible asset valued according to the advantage or reputation a business has
acquired. It's simply the premium paid over and above the net value of the assets in the
acquisition of a company. Goodwill presumably reflects the value of things such as employee
talent, market reputation and technology

2. Franchise – is an intangible item of value arising from the exclusive right of the company to
provide specific product or service in a stated region of the company. Franchise have a real
value and are to be considered.

3. Going Value – is an intangible value which an actually operating concern has due to its
operation. It is also considered as the difference between the value of the property as it stands
ready for operation and its value as it would stand at completion of construction as an inert
assembly of physical parts.

4. Organization cost – is the amount of money spent in organizing a business and arranging for
its financing and building.

DEPRECIATION METHODS

A. STRAIGHT LINE METHOD – derives its name from the fact that the book value
decreases linearly with time. This method assumes that the loss in value is directly
proportional to the age of the property. No interest is assumed to be paid on the amounts
set aside in the depreciation fund.
Symbols:
n = age of the property at any time less than or equal to L (n L)
L = useful life of the property in yrs; economic life
FC or Co = original cost; first cost
SV or CL = value at the end of the life, the scrap value
BV or Cn = Book value at the end of n th yrs; appraisal value; salvage or scrap value as the
case maybe (Cn = CL)
Dn = depreciation up to age nth yr; total depreciation after n yrs
d = annual cost of depreciation; depreciation charge

d= eqn. 1 ** uniform all through out

 Dn = OR = nd eqn. 2

Cn = Co - Dn OR
Cat the end = Book value at the beginning - depreciation eqn. 3

Depreciation rate = eqn. 4

Salvage rate = x 100%

Sunk Cost = Cn – actual resale value Money already spent and permanently lost. Sunk
costs are past opportunity costs that are partially (as salvage, if any) or totally
irretrievable and, therefore, should be considered irrelevant to future decision making.
This term is from the oil industry where the decision to abandon or operate an oil well is
made on the basis of its expected cash flows and not on how much money was spent in
drilling it. Also called embedded cost, prior year cost, stranded cost, or sunk capital.

Illustrative Example:
1. A factory equipment has an initial cost of 200,000.00. It’s salvage value after 10yrs is
20,000. As a percentage of initial cost, what is the straight line depreciation rate?
Given:
Co = P200,000 CL = P20,000 L = 10yrs
Solution:

Depreciation rate = but; d = = = P18,000

Therefore; Depreciation rate = = 0.09 //ans.

2. An air conditioning unit was bought 30,000 six years ago. It will have a salvage value of
3,000 4 years from now. It is sold now for 10,000.00. Using straight line, determine
sunk cost.

Given:
C0 = 30,000 CL = 3,000.00 L = 6+4=10 Resale = 10,000 n=6
Solution:

d= = = P2,700.00

Solving present value: D = (nd)

 C6 = C0 – D6 = 30,000 – 6(2700) = 13,800.00

Sunk Cost = C6 – Resale Value = 13,800 – 10,000 = 3,800.00 ans.

3. A tax and duty free importation of a 30HP sand mill(for paint manufacturing) cost
360,000, CIF Mla. Bank charges, arrastre and brokerage cost 5,000. Foundation and
installation costs were 25,000. Other incidental expenses amounted to 20,000. Salvage
value of the mill is estimated to be 60,000 after 20yrs. Find the appraisal value of the
mill, using straight line depreciation at the end of
a. 10yrs.
b. 15 yrs
Given:
C0 = 360,000+5,000+25,000+20,000 = 410,000 Cl = 60,000 L = 20 n = 20
Solution:

a. d = = = P17,500.00

Apparaisal value, Cn = C0 – Dn = 410,000 – 10(17,500) = 235,000.00 ans

b. n = 15yrs

C15 = Co – D15 but: D15 = = = P262,500

= 410,000 – 262,500 = 147,500.00 ans

Arrastre charge – is the amount which the owner, consignee, or agent has to pay for the baggage
handling, receiving and custody of the imported or exported article or the baggage of the
passenger.

4. An engineer bought an equipment for P500,000. He spent an additional amount of P30,000

for installation and other expenses. The salvage value is 10% of the first cost. If the book
value at end of 5 years will be P291,500 using straight line method of depreciation, compute
the useful life of the equipment in years.
Given:
C0 = 500,000 + 30,000 = 530,000 CL = 10%(530,000) = 53,000.00
C5 = 291,500.00 L=?
Solution:

a. d =
 but: Dn = OR = nd D5 = nd Therefore: d =

Also: C5 = C0 – D5 Therefore:D5 = C0 – C5 = 530,000-291,500 = 238,000

d= = = 47,700.00

47,700 =

L = 10 yrs.

5. An electronic balance costs P90,000 and has an estimated salvage value of P8,000 at the
end of its 10 years life time. What would be the book value after three years, using
straight line method in solving for the depreciation?
Given:
C0 = 90,000 CL = 8,000 L = 10 C3 = ?

Solution:

C3 = C0 – D3 Also: D3 = nd and d= = = 8,200

Therefore: D3 = nd = 3(8,200) = 24,600

C3 = 90,000 – 24,600

C3 = 65,400.00

6. An asset is purchased for P500,000. The salvage value in 25 years is P100,000. What are the
depreciation in the first three years using straight line method?

Given:

C0 = 500,000 CL = 100,000 L = 25 D3 = ?
Solution:

D3 = nd but: d= = = 16,000
 D3 = 3(16,000)
D3 = 48,000.00

B. 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. Presence of interest rate in this method. Finally, all amounts in the
sinking fund earn interest.

Symbols:
n = age of the property at any time less than or equal to L (n L)
L = useful life of the property in yrs; economic life
FC or Co = original cost; first cost ; it is uniform all through out
SV or CL = value at the end of the life, the scrap value
BV or Cn = Book value at the end of nth yrs; appraisal value;
Dn = depreciation up to age nth yr; total depreciation after n yrs
d = annual cost of depreciation; depreciation charge

n prds Dn Co - C L

0 1 2 3 n L
d d d d d

L prds

d= = Annual cost of depreciation

Dn = d(F/A, i%, n) = d[ Depreciation up to age nth yrs

Cn = Co - Dn Book value after n years

Sunk Cost = Cn – Actual resale value

Illustrative Example:

1. A firm bought an equipment for P56,000.00. Other expenses including installation amounted
to P4,000.00. The equipment is expected to have a life for 16 yrs with a salvage value of 10%
of the original cost. Determine the book value at the end of 12 yrs by:
 a. straight line method; and b. sinking fund method at 12% interest

Given:
Co = P56,000+P4,000= P60,000 L = 16yrs CL = .10(P60,000) = P6000
n = 12yrs i= 10%
Solution:
a.)Straight line method

C12 = Co – D12 but: D12 = = = P40,500

Therefore: C12 = P60,000 – P40,500 = P19,500 (book value at 12yrs after)//ans.

b.) Sinking fund method

C12 = Co – D12 1 but: Dn = d[

Also; d = = = P1,263.06

From eqn 2:

D12= P1,263.06 [ = P30,481.62

From eqn. 1
C12 = 60,000 – 30,481.62 = P29,518.38 //ans.

2.A boiler has a first cost of 700,000 and has a salvage value of 75,000 10 yrs from now.
Find the book value after 6 yrs with 12% interest.
Given:

C0 =700,000 Cl = 75,000 L = 10yrs n=6 i = 12%

Solution:
C6 = Co – D6

but D6 = d[ also: d = = = P35,615.10

Therefore: D6 = d[ = P35,615.10 [ = 289,023.29

C6 = Co – D6 = 700,000 - 289,023.29 = Php 410,976.71 ans

3. An evaporator cost 45,000 5 yrs ago with an estimated life of 8 yrs. Its salvage value is
2,500. Find the book value if it can sell the old unit for 20,000 with 12% interest rate.
Given:
 C0 =45,000 Cl = 2,500 L = 8yrs n=5 i = 12%
Resale = 20,000

Solution:
C5 = Co – D5

but D5 = d[ also: d = = = P3455.37

Therefore: Dn = d[ = P3455.37 [ = 21,951.44

C5 = Co – D5 = 45,000 – 21,951.44 = 23,048.55 ans

4. A dump truck was bought for 30,000 6 yrs ago. It will have a salvage value of 3000 4 yrs
from now. It is sold now for 8,000. What is its sunk cost if the sinking fund method with
6% interest is used.

Given:
C0 =30,000 Cl = 3,000 L = 6+4 = 10yrs n=6 i = 6%
Resale value = 8,000.00

Solution:

d= = = P2,048.44

D6= d[ = 2,048.44 [ = 14,288.48

C6 = Co – D6 = 30,000 – 14,288.48 = 15,711.5

Sunk cost = 15,711.5 – 8,000 = 7,711.51 ans

5. The original cost of a certain piece of equipment is 150,000 and it is depreciated by a

10% sinking fund method. Determine the annual depreciation charge if the book value of
the equipment after 10 yrs is the same as if it had been depreciated at 14,000 each year by
straight line method.
C0 = 150,000 i = 10% L = 10

Total depreciation in 10yrs by the straight line formula;Dn = nd

d= C L = C n = C0 - D n

= 150,000 – 10(14,000)
= 10,000
d=

d = 8784.36 //ans