LESSON 3: DEPRECIATION

Lesson Rationale:
This lesson contains the definitions and uses of depreciation and depletion, an understanding of depreciation cost, types of
depreciation, and methods of determining depreciation cost.

Lesson Outcomes:
At the end of the lesson, you are expected to:
1. Familiarize the basic definition of depreciation and depletion;
2. Understand the types of depreciation,
3. Apply different formulas of depreciation; and
4. Analyze the samples problems

Lesson Content/s:

3.1 What is depreciation?

Depreciation (𝑫) is defined as the decrease in the value of a property, such as machinery, equipment, building, or other
structure, due to the passage of time. (Matias Arreola)
Excluded from this definition are properties whose values increase with time, such as antiques, paintings of the masters, rare
stamps, rare coins, and in most cases, land.

Depreciation must always be included in the cost of production of any product or the rendering of any service where equipment is used
for the following reasons:
(1) To provide for the replacement of the equipment either at the end of its physical or economic life or at the time when its
operation no longer results in a satisfactory profit.
(2) To provide for the maintenance of capital to replace the decrease in the value of equipment caused by physical or
functional causes.

3.2 Types of Depreciation

Decreases in the value of the property with time are due mainly to the following:
(1) Physical depreciation caused by the following:
a. Deterioration due to the effects of various chemical and mechanical factors on the materials composing the property.
Included in this are rusting of metal parts, the decay of wooden parts of a structure, and the discoloration and cracking of
plastic parts.
b. Wear and tear due to abrasion, friction between moving parts of equipment, impact, vibration, or fatigue of the materials in
the property. It is determined by the use rather than the age. Sudden physical damage to a property due to accidents and
disasters, such as fire, flood, earthquake, tidal waves, and other unforeseen acts of nature are excluded from the
determination of a decrease in value.
(2) Functional depreciation which is due to a decrease in the demand for the function of the equipment for which it was designed. Such
depreciation is caused by the following:
a. Inadequacy of the equipment.
b. Obsolescence caused by the invention of more efficient equipment and machines to perform the same task.
c. Changes in methods of production.
d. Changes in style and designs of the goods produced on the equipment.
e. Transfer of the population due to various causes.
(3) Changes in the price levels of similar properties. If the price level rise during the life of a property, even if the original investment has
been recovered through proper depreciation procedure, the recovered capital will be insufficient to provide an identical replacement.
Thus, it is the capital that has depreciated and not the property.
3.3 Depreciation Cost

The depreciation cost depends upon the physical or economic life of the equipment and its first cost.

1. The physical life of the equipment is the length of time during which it is capable of performing the function for which it
was designed and manufactured.
2. The economic life of the equipment is the length of time during which it will operate at a satisfactory profit. Thus, even
though the equipment can still perform its function, if it can only operate at a loss, then it is considered economically dead.
3. The life of any property is usually difficult to determine accurately. In many cases, the determination of life is dependent
to a great extent upon the experience of the men managing the enterprise in the use of similar equipment.
4. The first cost (𝑪𝑶 ) of any property includes the original purchase price, freight and transformation changes to the site,
installation expenses, initial taxes, permits to operate, and all other expenses needed to put the equipment into operation.
The amount to be recovered, equal to the depreciation cost, is the difference between the first cost and the salvage or
scrap value of the equipment.
5. Salvage value(𝑪𝒏 ), sometimes called second-hand value is defined to be the amount for which the equipment or
machine can be sold as second hand. It implies that the machine can still perform its function.
6. Scrap or junk value is the amount the equipment can be sold for when disposed of as junk. This implies that the
equipment cannot be used anymore for the function for which it was designed.
7. Book value(𝑪𝒎 ) present value or current value of the asset

3.4 Requirements for a Depreciation Method

A depreciation method should fulfill the following requirements:

1. Payments to the depreciation fund should be equal to the loss in value due to depreciation.
2. The method should be due to depreciation.
3. Prior to its adoption, approval for the method should be secured from the Bureau of Internal Revenue.
4. To be satisfactory, the actual value of the equipment should, at all times, be equal to the book value. It will be necessary
from time to time to check the actual value against the book value, and in case the two values are not in agreement,
adjustments should be made.

3.5 Properties of Different Depreciation Methods

3.5.1 The Straight-Line Methods- a method that is simple and most widely used than any other method. Also, a method of calculating
depreciation assumes that an asset will lose an equal amount of value each year. In short, it is assumed that the loss in value is directly
proportional to the age of the equipment or asset or uniform amount.

 Annual cost of Depreciation (d) 𝑪𝒐 − 𝑪𝒏

𝒅=
𝒏
 Depreciation after “m” years (𝑫𝒎 ) 𝑪𝒐 − 𝑪𝒏
𝑫𝒎 = 𝒅 ∗ 𝒎 = ( )∗𝒎
𝒏
 Book value after “m” years (𝑪𝒎 ) 𝑪𝒎 = 𝑪𝒐 − 𝑫𝒎
Sample Problems:
Example 1: A machine costs ₱8,000 and have an estimated life of 10 years with a salvage value of ₱500. What is its book
value after 8 years using the straight-line method?

Given: 𝐶𝑜 = ₱8,000 𝑛 = 10 𝑦𝑟𝑠.

𝐶𝑛 = ₱500 𝑚 = 8 𝑦𝑟𝑠.

Required: Book value (𝐶𝑚 )

Solution: Solving for annual depreciation charge, (d):

𝐶𝑜 − 𝐶𝑛 ₱8,000 − ₱500
𝑑= = = ₱750
𝑛 10

Depreciation after “m” years(Dm ):

𝐷8 = 𝑑 ∗ 𝑚 = (₱750)(8) = ₱6,000

Book value after “m” years(Cm ):

𝐶8 = 𝐶𝑜 − 𝐷𝑚 = ₱8,000 − ₱6,000 = ₱𝟐, 𝟎𝟎𝟎

Example 2: A machine was brought for ₱50,000 with an estimated useful life of 10 years and a salvage value of ₱5,000.
What is its annual depreciation using the straight-line method?

Given: 𝐶𝑜 = ₱50,000 𝑛 = 10 𝑦𝑟𝑠.

𝐶𝑛 = ₱5,000

Required: annual depreciation charge, (d):

Solution: Solving for annual depreciation charge, (d):

𝐶𝑜 − 𝐶𝑛 ₱50,000 − ₱5,000
𝑑= = = ₱𝟒, 𝟓𝟎𝟎
𝑛 10

Example 3: A brand new oscilloscope is estimated to have a salvage value of ₱10,000 after 10 years and a book value of
₱30,000 after 5 years, what is the initial cost of the machine? (Assume straight-line depreciation)

Given: 𝐶𝑚 = ₱30,000 𝑛 = 10 𝑦𝑟𝑠.

𝐶𝑛 = ₱10,000 𝑚 = 5 𝑦𝑟𝑠

Required: Initial or First cost(𝐶𝑜 ):

Solution: Solving for initial/first cost (𝐶𝑜 ):

𝐶𝑚 = 𝐶𝑜 − 𝐷𝑚
𝐶𝑚 = 𝐶𝑜 − 𝑑 ∗ 𝑚
𝐶𝑜 − 𝐶𝑛
𝐶𝑚 = 𝐶𝑜 − ( )∗𝑚
𝑛
𝐶𝑜 − ₱10,000
₱30,000 = 𝐶𝑜 − ( )∗5
10

𝑪𝒐 = ₱𝟓𝟎, 𝟎𝟎𝟎
3.5.2 Sinking Fund Method- a method of depreciation that assumes that there is a savings account set up to replace an asset at the
end of its life. In this method, it is assumed that a sinking fund is established in which funds will accumulate for replacement purposes.
It is relatively simple, though it will require the use of annuity tables in the absence of the electronic calculator.

 Annual cost of Depreciation (d) (𝑪𝒐 − 𝑪𝒏 ) ∗ 𝒊

𝒅=
(𝟏 + 𝒊)𝒏 − 𝟏
 Depreciation after “m” years (𝑫𝒎 ) 𝒅 ∗ [(𝟏 + 𝒊)𝒎 − 𝟏]
𝑫𝒎 =
𝒊
 Book value after “m” years (𝑪𝒎 ) 𝑪𝒎 = 𝑪𝒐 − 𝑫𝒎

Where; 𝑖= interest rate in percent

𝒊
(𝟏 + 𝒊)𝒏 − 𝟏

Sample Problems:
Example 1: Equipment has a useful life of 3 years and a salvage value of ₱20,000 was bought for ₱135,000. If the owner
decides to sell after using it for 2 years, how much should the selling price be so that he will not lose or gain if the interest is 5%?

Given: 𝐶𝑜 = ₱135,000 𝑛 = 3 𝑦𝑟𝑠. 𝑖 = 5%

𝐶𝑛 = ₱20,000 𝑚 = 2 𝑦𝑟𝑠.

Required: Book value (𝐶𝑚 )

Solution: Solving for annual depreciation charge, (d):

(𝐶𝑜 − 𝐶𝑛 ) ∗ 𝑖 (₱135,000 − ₱20,000) ∗ 0.05
𝑑= = = ₱36,478.98
(1 + 𝑖 )𝑛 − 1 (1 + 0.05)3 − 1

Depreciation after “m” years(Dm ):

𝑑 ∗ [(1 + 𝑖)𝑚 − 1] (₱36,478.98)[(1 + 0.05)2 − 1]
𝐷𝑚 = = = ₱74,741.91
𝑖 0.05

Solving for the book value after 2 years:

𝐶𝑚 = 𝐶𝑜 − 𝐷𝑚 = ₱135,000 − ₱74,741.91 = ₱𝟔𝟎, 𝟐𝟏𝟖. 𝟎𝟖

Example 2: A piece of machinery costs of ₱20,000 and has an estimated life of 8 years and a scrap value of ₱2,000. What
uniform annual amount must be set aside at the end of each 8 years for replacement if the interest rate is 4%?

Given: 𝐶𝑜 = ₱20,000 𝑛 = 8 𝑦𝑟𝑠. 𝑖 = 4%

𝐶𝑛 = ₱2,000 .

Solution: Solving for annual depreciation charge, (d):

(𝐶𝑜 − 𝐶𝑛 ) ∗ 𝑖 (₱20,000 − ₱2,000) ∗ 0.04
𝑑= = = ₱𝟏, 𝟗𝟓𝟑. 𝟓𝟎
(1 + 𝑖 )𝑛 − 1 (1 + 0.04)8 − 1
 Example 3: A company purchased equipment costing ₱60,000. The equipment has a guaranteed useful life of 16 years with
a salvage value of ₱6,000. Using the sinking fund method, what is the book value of the equipment after 12 years? Money is worth
12% per annum.

Given: 𝐶𝑜 = ₱60,000 𝑛 = 16 𝑦𝑟𝑠. 𝑖 = 12%

𝐶𝑛 = ₱6,000 𝑚 = 12 𝑦𝑟𝑠.

Required: Book value (𝐶𝑚 )

Solution: Solving for annual depreciation charge, (d):

(𝐶𝑜 − 𝐶𝑛 ) ∗ 𝑖 (₱60,000 − ₱6,000) ∗ 0.12
𝑑= = = ₱1,263.06
(1 + 𝑖 )𝑛 − 1 (1 + 0.12)16 − 1

Depreciation after “m” years(Dm ):

𝑑 ∗ [(1 + 𝑖)𝑚 − 1] (₱1,263.06)[(1 + 0.12)12 − 1]
𝐷𝑚 = = = ₱30,481.60
𝑖 0.12

Solving for the book value after 2 years:

𝐶𝑚 = 𝐶𝑜 − 𝐷𝑚 = ₱60,000 − ₱30,481.60 = ₱𝟐𝟗, 𝟓𝟏𝟖. 𝟒𝟎

3.5.3 Declining Balance Method -a method of depreciation that assumes that annual depreciation is a fixed percentage of the growing
value of the property per year. This method is sometimes known as the Constant Percentage Method or Matheson Formula.
In addition to the previous symbols for the Straight Line Method formula;
Let 𝒌 = ratio of the depreciation in any one year to the book value at the beginning of that year.
This is constant throughout the life of the property. The k must be a decimal or value less than 1.

The formulas are:

 Matheson Formula or Rate of

𝒏 𝑪𝒏 𝒎 𝑪𝒎
Depreciation 𝒌 =𝟏− √ 𝒐𝒓 𝒌 = 𝟏 − √
𝑪𝒐 𝑪𝒐
 Depreciation during m” years (𝑫𝒎 )
𝑫𝒎 = 𝒌(𝑪𝒐 )(𝟏 − 𝒌)𝒎−𝟏

 Salvage value at the end of its useful

life (𝑪𝒏 ) 𝑪 𝒏 = 𝑪 𝒐 (𝟏 − 𝒌 )𝒏

 Book value after “m” years (𝑪𝒎 ) 𝑪 𝒎 = 𝑪 𝒐 (𝟏 − 𝒌) 𝒎

𝒎
𝑪𝒏 𝒏
𝑪 𝒎 = 𝑪𝒐 ( )
𝑪𝒐
 Table 3.5.3 Derivation of Formulas for Declining Balance Method

Year Book Value at the beginning of Depreciation during the year Book value at the end of the year
the year
1 𝑪𝒐 𝒌𝑪𝒐 𝑪𝟏 = 𝑪𝒐 (𝟏 − 𝒌)
2 𝑪𝒐 (𝟏 − 𝒌) 𝒌𝑪𝟏 𝑪𝟐 = 𝑪𝒐 (𝟏 − 𝒌)𝟐
3 𝑪𝟐 = 𝑪𝒐 (𝟏 − 𝒌)𝟐 𝒌𝑪𝟐 𝑪𝟐 = 𝑪𝒐 (𝟏 − 𝒌)𝟑
… … … …
m 𝑪𝒐 (𝟏 − 𝒌)𝒎−𝟏 𝒌𝑪𝒎−𝟏 𝑪𝒎 = 𝑪𝒐 (𝟏 − 𝒌)𝒎
… … … …
n 𝑪𝒐 (𝟏 − 𝒌)𝒏−𝟏 𝒌𝑪𝒏−𝟏 𝑪𝒏 = 𝑪𝒐 (𝟏 − 𝒌)𝒏

Sample Problems:
Example 1: A device costs ₱720,000 is estimated to have a life of 10 years. If the annual rate of depreciation is 25%, find the
salvage value using declining balance method.

Given: 𝐶𝑜 = ₱720,000 𝑛 = 10 𝑦𝑟𝑠. 𝑘 = 25%

Required: Salvage value (𝐶𝑛 )

Solution: Solving for salvage value of the device:

𝑛 𝐶
𝑘 = 1 − √𝐶𝑛 or
𝑜

10 𝐶𝑛
0.25 = 1 − √
₱720,000

𝐶𝑛 = ₱𝟒𝟎, 𝟓𝟒𝟓. 𝟕𝟑

Example 2: A printing machine has a selling price of ₱4,000. If it’s selling price is expected to decline at a rate of 10% per
annum due to obsolescence, what will be its book value and depreciation after 5 years?

Given: 𝐶𝑜 = ₱4,000 𝑚 = 5 𝑦𝑟𝑠. 𝑘 = 10%

Required: Book value (𝐶𝑚 ) and depreciation (d):

Solution: Solving for book value of the device:

𝐶𝑚 = 𝐶𝑜 (1 − 𝑘)𝑚 = ₱4,000(1 − 0.10)5 = ₱𝟐, 𝟑𝟔𝟏. 𝟗𝟔

The depreciation of the device:

𝐷𝑚 = 𝑘(𝐶𝑜 )(1 − 𝑘)𝑚−1 = 0.10(₱4,000)(1 − 0.10)5−1 = ₱𝟐𝟔𝟐. 𝟒𝟒

3.5.4 Sum of the Years-Digit (SYD) Method- this method is based on the assumption that assets are generally more productive when
they are new and their productivity decreases as they become old.

The steps in the method are:

1. Determine the sum of the years (∑Years) of the life of the property. If 𝑛 is the life of the property in years, and noting that
the digits 1, 2, 3,......(n-1), 𝑛 form an arithmetic progression, then

𝒏
𝑺𝒀𝑫 =
(𝒏 + 𝟏)
𝟐
𝑆𝑌𝐷 = ∑ 𝑌𝑒𝑎𝑟𝑠 = ∑(1 + 2 + 3 + 4 + 5 … … + 𝑛)

2. Determine the loss in value due to depreciation, 𝑪𝒐 − 𝑪𝒏

3. The respective annual depreciation charges are:

𝒏
 For the first year, 𝒅𝟏 = (𝑪𝒐 − 𝑪𝒏 )
𝑺𝒀𝑫
𝒏−𝟏
 For the 2nd year, 𝒅𝟐 = (𝑪𝒐 − 𝑪𝒏 )
𝑺𝒀𝑫
𝒏−𝟐
 For the 3rd year, 𝒅𝟑 = (𝑪𝒐 − 𝑪𝒏 ) 𝑺𝒀𝑫
𝒏−𝟑
 For the 4th year, 𝒅𝟒 = (𝑪𝒐 − 𝑪𝒏 ) 𝑺𝒀𝑫
𝒏−𝟒
 For the 5th year, 𝒅𝟓 = (𝑪𝒐 − 𝑪𝒏 ) 𝑺𝒀𝑫 ………….and so on

4. The annual depreciation charge during the 𝑚𝑡ℎ years:

(𝒏−𝒎+𝟏)
𝒅𝒎 = (𝑪𝒐 − 𝑪𝒏 )
𝑺𝒀𝑫

5. Total depreciation after 𝑚 years;

𝒎(𝟐𝒏 − 𝒎 + 𝟏)
𝑫𝒎 = (𝑪𝒐 − 𝑪𝒏 )
𝟐(𝑺𝒀𝑫)

6. Note that the annual depreciation charge gradually decreases as the property gets older.

Sample Problems:
Example 1: A certain machine costs ₱5,000 and has an expected resale value of ₱1,000 at the end of 5 year useful life.
Compute the annual depreciation charge on the 4th year using SYD Method.

Given: 𝐶𝑜 = ₱5,000 𝐶𝑛 = ₱1,000 𝑛 = 5 𝑦𝑟𝑠.

Required: depreciation (d):

Solution: First, compute the SYD of the machine:

𝑛 5
𝑆𝑌𝐷 = (𝑛 + 1) = (5 + 1) = 𝟏𝟓
2 2
Solving for the depreciation on the 4th year:
𝑛−3 5−3
𝑑4 = (𝐶𝑜 − 𝐶𝑛 ) = (₱5,000 − ₱1,000) = ₱𝟓𝟑𝟑. 𝟑𝟑
𝑆𝑌𝐷 15
 Example 2: ABC Corporation makes it a policy that for any new equipment purchased; the annual depreciation cost should
not exceed 20% of the first cost at any time with no salvage value. Determine the length of service life necessary if the depreciation
used is the SYD method.

Solution:
In SYD method, the largest depreciation is on first year. So, analyze first year depreciation 𝒅𝟏 :
𝑛 𝑛
𝑑1 = (𝐶𝑜 − 𝐶𝑛 )
𝑆𝑌𝐷
; where: 𝐶𝑛 = 0 𝑆𝑌𝐷 = 2 (𝑛 + 1)

𝑛
𝑑1 = (𝐶𝑜 − 0) 𝑛
(𝑛 + 1)
2
2
𝑑1 = (𝐶𝑜 − 0)
(𝑛 + 1)
But, 𝑑1 = 0.20𝐶𝑜
2
0.20𝐶𝑜 = (𝐶𝑜 − 0)
(𝑛 + 1)
2
0.20𝐶𝑜 = 𝐶𝑜 ( )
(𝑛 + 1)

Cross multiply both sides where in the two 𝐶𝑜 were cancelled out. Then,

0.20(𝑛 + 1) = 2
0.20𝑛 + 0.20 = 2
0.20𝑛 = 2 − 0.20
1.8
𝑛= = 𝟗 𝒚𝒆𝒂𝒓𝒔
0.20

Example 3: An asset is purchased for ₱9,000. Its estimated economic life is 10 years after which it will be sold for ₱1,000.
Find the total depreciation in the first two years using SYD method.

Given: 𝐶𝑜 = ₱9,000 𝐶𝑛 = ₱1,000 𝑛 = 10 𝑦𝑟𝑠.

Required: Depreciation in the first two years 𝑫𝟐 :

Solution: First, compute the SYD of an asset:

𝑛 10
𝑆𝑌𝐷 = (𝑛 + 1) = (10 + 1) = 𝟓𝟓
2 2
Solve for depreciation on 1st year:
𝑛 10
𝑑1 = (𝐶𝑜 − 𝐶𝑛 ) = (₱9,000 − ₱1,000) ( ) = ₱1,454.55
𝑆𝑌𝐷 55

Solve for depreciation on 2nd year:

𝑛−1 9
𝑑2 = (𝐶𝑜 − 𝐶𝑛 ) = (₱9,000 − ₱1,000) ( ) = ₱1,309.09
𝑆𝑌𝐷 55

Depreciation in the first two years 𝑫𝟐 :

𝐷2 = 𝑑1 + 𝑑2 = ₱1,454.55 + ₱1,309.09 = ₱𝟐, 𝟕𝟔𝟑. 𝟔𝟒