Module 11: Depreciation

Introduction
 Asset will eventually loss its value due to age, wear
(physical depreciation) and obsolescence (functional
depreciation) over its useful life.
 The loss of value through the time must be considered in
economic evaluation of (asset) investment .
 Thus, the loss in capital investment (equipment, building,
machinery, vehicle) must be recovered through tax-allowed
expense deduction, called deprecation.
 The act of recovery loss of value of asset is known as
(cost) capital recovery.
 EXAMPLE:
 It is common to consider loss of value of an investment as part of
expenses that would be recovered from revenue (volume x unit price)
Introduction
Depreciation (in relation to business and tax purposes)
 Is an artificial (non cash) accounting entry intended to capture the
consumption of a capital asset over its economic life.
 Depreciation increases after-tax profit
What can be depreciated?
Property that meets the following criteria:
 Used in business and/or held for the production of income
 Must expected to last for more than one year (must be substantially beyond the year
it was placed in service)
 It losses on values caused by natural causes.
What cannot be depreciated?
 Property put in placed into service and disposed in the same year
 Land (can never be depreciated)
 Inventory (property held for resale during the normal course of business)
 Leased property (in accounting this was placed under expenses)
Terminology
 Depreciation (D) aka Capital Recovery
 reduction in value of asset
 Book Value (BV)
 represents the remaining un-depreciated value of investment as recorded in company’s book
 Market Value aka Realized Value
 the actual value that could be realized if an asset is to be sold in an open market
 Basis Cost aka First Cost (B)
 represents the installed cost of an asset (incl. purchase price, delivery, installation and other
depreciable cost); - unadjusted basis → new asset ; - adjusted basis →
 Recovery Period aka Depreciable Life (n)
 the life of asset for depreciation and tax purposes
 Depreciation Rate aka Recovery Rate (d)
 fraction at which an asset is depreciated in each year (period)
 Salvage Value (SV)
 represents the expected market value (or trade-in value) at the end of asset useful life
Depreciation

BV B

BV1
D
Book Value

BV2

BV3

SV

0 1 2 3 4 Time n
Straight Line Depreciation
B − SV
BV B Dt =
n
1
dt = d =
n
SV BVt = BVt −1 − Dt
 B − SV 
BVt = B − t  
0 1 2 3 4 n  n 
Where:
t = year (t = 1, 2, 3, …n)
n = estimated service life
Dt = annual depreciation
dt = depreciation rate (the same for each year)
B = first cost / basis cost
BVt = book value at end of year t
SV = salvage value = BVn
Declining Balance Depreciation
 In this method, an asset is depreciated faster early than in
the latter portion of its service life
 The depreciation is calculated based on a fixed
percentage of the book value at the beginning of any year
of the service life D =  .BV
t t −1

since BVt = BVt −1 − Dt

then BVt = BVt −1 − BVt −1 = (1 −  )BVt −1

Dt =  (1 −  ) B
t −1
therefore,
BVt = (1 −  ) B
t
Double Declining Balance Depreciation
 Under the US tax law, an asset can only be
depreciated at the maximum rate of twice the rate 0f
straight line depreciation method.
 Double declining balance method:
2
=
n
Sum-of-Year-Digits Depreciation
 Under this method, an asset is depreciated faster on the
first one-third of the recovery period.
 The depreciation value at any end of the year:
 n − t +1
Dt =  (B − SV )
 S 
where n (n + 1)
S= = dt
2

 thus  t (n − t / 2 + 0.5)
BVt = B −   (B − SV )
 S 
Graphical Representation of Depreciation
Methods

B
Book Value

SLD

SYD

DDB

SV

0 1 2 3 4 5 6 n
Exercise
A man just bought a Mercedes for Rp 675.000.000,-. He expects to use that
car for 6 years after which he hopes to sell it for Rp 450.000.000,-
Calculate the book value of that piece of car each year for the next six years
using SLD, DB @ 175%, and SYD methods

SLD DB@175% SYD

EOY
Dt BVt Dt BVt Dt BVt
0
1
2
3
4
5
6
Other Reduction in Values of Asset
UNITS-OF-PRODUCTION DEPRECIATION
 Sometimes calculating recovery of capital cost in accordance to theoretical value-
time approach is undesirable.
 Alternatively, it can be assumed that depreciation occurs based on unit of production
 example:
A tractor was bought 3 years ago for $ 2,400,000. The owners has estimated the equipment to be
used for another 4 years, and to be sold for $ 950,000. During 7 years of ownership the tractor
is expected to help moving 6 million cm of dirt. If in its 3 years of operation that tractor has
excavated 2.5 millions cm of dirt, what is the current book value?
 answer:
dv = (B-SV)/Volume = ($2,400,000 - $ 950,000)/6.000.000 = $ 0.24/cm
D2.5m = dv x Vol = $ 0.24 x 2,500,000 = $ 0.6 millions
BV2.5m = B – dv x Vol = $ 2,400,000 - $ 0.24 x 2.5 m = $ 1.8 millions
Other Reduction in Values of Asset
DEPLETION
This term refers to activity that tends to exhaust a supply (of resources)

COST METHOD:
 This method is similar to the units-of-product depreciation method, where the depletion charge is based on the amount
of resources consumed and the initial investment.
 example:
 A coal mining site worth $ 3.5 billions is estimated to produce 20 million tons of coal. Last year the mine produce 2,2
million ton of coal.
 The unit depletion rate = $ 3.5 billions/20 million tons = $ 175 / ton
 Depletion charge = 2.2 million to x $ 175/ton = $ 33 millions

PERCENTAGE METHOD:
 This method is based on the application of a fixed percentage of depletion rate for individual type of natural resource,
e.g., oil, gas. copper, etc. (max charge is 50%)
 example:
 The fixed percentage of depletion for coal is 10%. The coal can be sold for $ 195 /ton.
 The gross depletion income = 2.2 million tons x $ 195 /ton = $ 429 millions.
 Depletion rate = 10% x $ 429 millions = $ 42.9 millions
Other Reduction in Values of Asset
REDUCED BALANCE METHOD
 This method assumes assets are used more in early years, thus larger depreciation
charges made in early years
 Depreciation is calculated by applying a fixed rate to the “net book value” (reduced
balance) of the asset. Where:
R
r = 1− n r = depreciation rate
C n = estimated service life
R = residual value (BVt)
C = historic cost (B)
 example:
 The installed cost of an asphalt mixing plant is $ 1,150,000 and is estimated to serve
for 12 years. After 5 years in service this piece of plant has recorded book value of
$ 725,000. Calculate the book value at the end of 7th, 10th, and 12th year
Exercise/Homework
1. A scraper was bought for $ 1,375,000. Service life was estimated at 12 years, and
would then be resold for 485,000. Compute the annual depreciation charge for 4th,
7th, and 10th year using a) straight line and b) double declining balance method.
Compare the book value of both method.
2. A gold mine that is estimated to produce 300,000 ounces of gold is purchased for
$45 million. The gold can sold for $620 per ounce. If 28,500 ounce was produced
this year, what will be the depletion for a) cost depletion, and b) percentage
depletion where the fixed percentage for gold is 22,5%? For what price should the
gold be sold so that percentage depletion will be advantageous than cost depletion?
3. A truck bought for Rp 675,000,000 was to be used for 6 years on an average of
2,000 hours per year. So far the truck has accumulated 5,400 operating hours.
What was the depreciation charge?
4. An investor is considering to choose applying depreciation method between DDB
and SYD for an asset he bought 2 years ago for Rp 1,175 million. At that time he
estimated the service life of 9 years and salvage value of Rp 210 millions . Compare
both metjdo and give suggestion with the rationales.