SECTION 8 - DEPRECIATION

8.1 DEFINITIONS

Depreciation is a way of accounting for the cost of an asset when income is determined for tax
purposes. The cost, including any delivery or installation charges, is treated as a prepayment for
future services; and depreciation consists in amortizing this prepayment over the period of use of the
asset.

The annual depreciation is the amount of the asset's cost that is charged off in a given year; the
total of the annual depreciations to date is the accumulated depreciation. The salvage value or scrap
value of an asset is the estimated proceeds that will be realized from its sale or disposition when it is
retired. Under federal tax law, the net salvage value is either zero or the salvage value minus the
cost of removing the asset from the premises, whichever is greater. The adjusted cost of an asset is its
original cost less its net salvage value.

The useful life, over which an asset is depreciated, may not be the same as its service life, physical
life, economic life, market life, etc. The U.S. government publishes guidelines for most equipment,
showing the ranges of useful lives allowed in tax computations.

Depreciable And Non-depreciable Assets

The current tax laws permit only assets with a useful life or more than one year to be
depreciated. Depreciation is allowed only for assets used in a business, trade or profession, or held
for the production of income. Personal property, such as a family residence or automobile used for
pleasure, is not depreciable; however, that portion of an automobile or other property which is used
in business may be depreciable. Depreciation is not permitted on land (or on its upkeep), even when
it is used for business purposes or income generation. However, buildings and equipment which
occupy that land are depreciable if used in a business or to generate income. Inventories of goods used
in a business, other stock in trade, and short-term assets that will be consumed during a normal year's
operation of the business are not depreciable.

Purpose of Depreciation
The purpose of depreciation is to match the cost of a productive asset, that has a useful life of more than a year, to the
revenues earned by using the asset. The asset’s cost is usually spread over the years in which the asset is used. Over the
asset’s useful life, depreciation systematically moves the asset’s costs from the balance sheet to expenses on an income
statement.

Depreciation cost
Physical life is the length of time that it takes for an asset to become fully depreciated, at which point it has zero financial
value. While the Economic life is the expected period of time during which an asset remains useful to the average owner.

DEFINITON OF TERMS
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, telephone, 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.
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
COMPUTATION METHODS
8.2 STRAIGHT-LINE METHOD

8.2 STRAIGHT-LINE METHOD

The straight-line method writes off the cost of an asset uniformly over a given recovery period. The recovery period (n) is
just the length of time over which you’re going to use depreciation to reduce your taxes. Uniform depreciation means
you’re writing off the same amount every year until you’ve recovered the entire cost of the asset. This method is
frequently used because it is simple and easy to calculate. The straight line method is based on the asset’s number of
years of useful life.

If an asset has a basis B and a salvage value S and will be written off over n years, then the
annual depreciation amount is just

b−s
D t=
n
The book value of the asset at any time t can be calculated recursively:

BVt=BVt – 1 – Dt

or, since Dt is a constant, it can be calculated directly from the first cost as

BVt=B – t Dt

8.3 SINKING FUND FORMULA

In the sinking fund method of repaying a loan, the borrower agrees to make periodic interest payments on the complete
loan amount and to repay the loan principal at the end of the loan term. In order to repay the principal at the end, the
borrower is required to make periodic deposits in an interest earning account (called a sinking fund) sufficient to accrue
the original loan amount at the end of the loan term.
C o−C L
d=
(1−i) L−1
i
Dn=d (F / A , i% , n)
Dn=(C ¿ ¿ O−C L )¿ ¿ ¿
C n=C o−Dn

Where: d = annual cost of depreciation

 Dn=depreciation up ¿ age∧ years

C o=Original Cost

C L =scrap value

C n=Book Value at the end of the years

L=Useful life

8.4 DECLINING-BALANCE METHOD

Instead of writing off a fixed amount each year, the declining-balance method writes off a

fixed percentage of the remaining book value each year:

Dt=d ∙ BV t −1

Note that the depreciation rate (d) doesn’t change over time, but the depreciation amount (Dt) does. It’s relatively large
in the early years and gets smaller toward the end of the recovery period. This allows the company to recover its capital
costs more quickly than it would using straight-line depreciation. Why would a company want to do this? Remember, the
company wants to recover its initial investment in as few years as possible. A reduction in taxes is the same as putting
money in your pocket; the tax savings effectively increase the company’s annual revenue and therefore can reduce the
payback period for the project.

Under declining-balance depreciation, the book value at any point in time can be calculated recursively as

BV t=BV t−1−D t=BV t−1−d ∙ BV t −1=(1−d )BV t−1

Note that BVt–1 = (1 – d) BVt–2 so we can also write this as

2
BV t=(1−d)BV t =(1−d )(1−d )BV t−2=(1−d) BV t −2

This calculation can be continued all the way back to BV0 which is the original basis, B. So the book value at the end of
any year can be calculated directly from the basis as
t
BV t=(1−d) B

Using this equation, we can calculate the book value at the end of the recovery period as
n
BV n=(1−d ) B
8.5 DOUBLE DECLINING-BALANCE METHOD
Double-declining balance (DDB) results in relatively large amounts of depreciation in early years of asset life and smaller
amounts in later years. This method can be justified if the quality of service produced by an asset declines over time, or if
repair and maintenance costs will rise over time to offset the declining depreciation amount. With this method, a fixed
percentage of the straight-line rate (i.e., 200% or “double”) is multiplied times the remaining book value of an asset (as
of the beginning of a particular year) to determine depreciation for a particular year. As time passes, book value and
annual depreciation decrease.

This method is very similar to the declining balance method except that the rate of depreciation k is replaced by 2/L.
n−1
2 2
d n=Co (1− )
L L
n
2
C n=C o (1− )
L
L
2
C L =C o (1− )
L

8.6 SUM-OF-THE-YEAR’S-DIGITS (SYD) METHOD

Sum-of-the-years' digits (SYD) is an accelerated method for calculating an asset's depreciation. This method takes the
asset's expected life and adds together the digits for each year; so if the asset was expected to last for five years, the sum
of the years' digits would be obtained by adding: 5 + 4 + 3 + 2 + 1 to get a total of 15. Each digit is then divided by this
sum to determine the percentage by which the asset should be depreciated each year, starting with the highest number
in year 1.

Sum-of-the-years' digits is an accelerated method for determining an asset's expected depreciation over time.
Depreciation is an accounting technique that involves pairing the cost of using a tangible asset with the advantage gained
over its useful life. Accelerated depreciation differs from standard depreciation by assuming higher depreciation costs
initially and lower costs in later years, reflecting the fact that the benefit of using an asset will be diminished as the asset
ages. Standard depreciation, or straight-line depreciation, utilizes the same monetary cost every year of the asset's useful
life. It is best to use an accelerated depreciation method, such as the SYD method, when an asset will lose most of its
value toward the beginning of its useful life.

For sum of the years-digits depreciation, the depreciation rate for year k using a useful life of n years is given by dividing
(n + 1 − k) by the sum of the years of useful life digits.

n+1−k
Depreciation rate for year k=
∑ of the years of useful life digits
To find the depreciation, multiply this rate by the difference between the purchase price and the salvage value.

dn=depreciation charge duringthe nth year

reversedigit
dn= ( C −C )
∑ of digits o L
L
∑ years= 2 ( L+1)
EXAMPLE OF A PROPERTY WHOSE LIFE IS 5 YEARS
 YEAR YEAR IN REVERSE ORDER DEPRECIATION FACTOR DEPRECIATION DURING

THE YEAR
1 5 5/15 (5/15) (CO-CL)
2 4 4/15 (4/15) (CO-CL)
3 3 3/15 (3/15) (CO-CL)
4 2 2/15 (2/15) (CO-CL)
5 1 1/15 (1/15) (CO-CL)
15=∑ DIGITS

8.7 SERVICE-OUTPUT METHOD

Service output method of depreciation is a technique used in engineering economics to calculate the
depreciation of an asset based on its expected service life and output. This method is particularly useful for assets that
have varying levels of output or use over time, such as machinery or equipment.

The service output method of depreciation is based on the assumption that the value of an asset is directly related to
the amount of output or service that it provides over its useful life. Under this method, depreciation is calculated by
dividing the total cost of the asset by its expected total output or service.

To calculate depreciation using the service output method, the following steps are typically followed:

1. Estimate the total cost of the asset, including any installation or delivery costs.
2. Determine the expected total output or service life of the asset. This can be measured in units such as hours of
use, miles traveled, or products manufactured.
3. Calculate the annual output or service life of the asset by dividing the expected total output or service by the
expected useful life of the asset. For example, if a machine is expected to produce 10,000 units over a useful life
of 5 years, its annual output would be 2,000 units per year.
4. Calculate the depreciation per unit of output by dividing the total cost of the asset by the expected total output
or service. For example, if the total cost of the machine is $100,000 and it is expected to produce 10,000 units,
the depreciation per unit would be $10 per unit.
5. Calculate the annual depreciation by multiplying the depreciation per unit by the annual output or service life. In
the example above, if the annual output is 2,000 units, the annual depreciation would be $20,000 ($10 per unit x
2,000 units). In this method, it is assumed that the total depreciation that has taken place is directly proportional
to the quantity of the output of the property up to that time.

(CO −C L )
d= Qn
T
COMMON ERRORS

Even after learning the computation methods of depreciation. You can still make mistakes or common Error. Here are the
common errors that you can encounter when studying depreciation.

One of the common mistakes that students make when using the declining balance method is using the wrong
depreciation rate. The depreciation rate is the percentage used to calculate the amount of depreciation expense in each
period. It is important to choose the correct rate based on the asset's useful life, salvage value, and the method used. For
example, if a business uses a 20% depreciation rate for an asset with a useful life of 10 years, it will result in over-
depreciation, which will affect the accuracy of the financial statements.

Another common mistake is failing to adjust the salvage value. The salvage value is the estimated value of the asset at
the end of its useful life. It is important to adjust the salvage value based on the actual value of the asset at the end of its
useful life. If the salvage value is not adjusted, it can result in under or over-depreciation, which will affect the accuracy
of the financial statements.

To avoid these common mistakes, students should ensure that they have a proper understanding of the declining balance
method and its applications. They should also have a clear understanding of the asset's useful life, salvage value, and the
depreciation rate used. By avoiding these mistakes, businesses can achieve accurate cost recovery and maintain the
accuracy of their financial statements.

When it comes to double declining balance method, the common errors that students can encounter is Using the wrong
salvage value: The salvage value is the estimated value of the asset at the end of its useful life. Some students use a
salvage value that is too high or too low, which can affect the accuracy of the depreciation calculation. For instance, if the
salvage value is too high, it will result in less depreciation and a higher net income. Conversely, if the salvage value is too
low, it will result in more depreciation and a lower net income. To avoid this mistake, it is important to use a realistic
salvage value that reflects the actual value of the asset at the end of its useful life.

Also, another mistake is incorrect calculation of the depreciation rate: The depreciation rate is the percentage of the
asset's value that is depreciated each year. Some businesses make the mistake of using the wrong depreciation rate,
which can lead to inaccurate financial statements. To calculate the depreciation rate, you need to divide the number 2 by
the useful life of the asset. For example, if the useful life of the asset is five years, the depreciation rate would be 40%
(2/5). It is important to use the correct depreciation rate to ensure accurate financial.

Lastly in DDBM Failing to consider the half-year convention: The half-year convention is a rule that requires businesses to
assume that an asset is purchased in the middle of the year, regardless of when it was actually purchased. This means
that businesses can only depreciate half of the asset's value in the first year of use. For instance, if an asset costs $10,000
and has a useful life of five years, the depreciation expense in the first year would be $2,000 (10,000 40% 50%). Failing to
apply the half-year convention can lead to inaccurate financial statements.
PRACTICE PROBLEMS

1. An equipment is bought for P20,000. Its salvage value is P5,000. Assume that its lifetime is 5 years. Determine its
depreciation cost after 3 years. Use double declining balance method.
2. A man bought a machine for P60,000 which has useful life of 5 years. It has a salvage value of P20,000. Using the
Sinking Fund Method with i = 10% cpd. annually, find the annual depreciation and the book value at year 3.
3. A used piece of depreciable property was bought for P20,000. If it has a useful life of 10 years and a salvage
value of P5,000, how much will it be depreciated in the 9thyear. Use declining balance method.
4. An equipment costs P50,000 and it can last up to 6 years. The equipment was transported from Singapore to
Philippines which costs P2,000 for the delivery fee. The equipment was taxed by 10% of its purchase cost. If its
salvage value is P7,000, find the depreciation cost in year 3. Use Sum of Year’s Digits Method. Solution: Co
=50,000+2,000+50,000(0.10) Co =P57,000 CL=P7,000
5. A commercial building has a salvage value of Php 1 million after 50 years. Annual depreciation is Php 2 M. Using
the Straight Line Method, how many years after should you sell the building for Php 30 M?
6.
SOLUTIONS