Depreciation

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 Definition
 Depreciation is the part of the original cost of the fixed
asset consumed during its period of use by the firm.
 It is an expense for services consumed in the same way
as expenses for items such as wages, rent and
electricity.
 Since depreciation is an expense, it will be charged to the
profit and loss account.
– The allowance for wear and tear on equipment and
machinery

– Amount of decreasing value in a capital asset

allowed to be deducted from a business tax return

– Cost Recovery

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 Definition
 Depreciation is defined as an artificial (non-cash) accounting entry
intended to systematically capture the consumption of a capital asset

over its economic life.

 Depreciation increases after tax profit, so firms desire to

depreciate assets as fast as possible (depreciation schedule
has major tax implications).

 Depreciation basis is that part of the asset’s purchase price

that is spread over the depreciation period (service life).

 Depreciation basis is cost minus expected salvage value at

the end of the service period.

 IRD regulations spell out the types of depreciation schedules

and bases for most business assets.

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 Definition
 Decrease in the value of an asset

 Decline in market value

– appraisal
– replacement
– reporting aggregate value to SEC and shareholders

 Systematic allocation of cost

– cost of products
– taxes

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 Main Causes of Depreciation

 Wear and tear (i.e. loss of value arising from use)

 Rust, rot and decay

 Obsolescence (i.e. new technology)

 Inadequacy

 Time factor (i.e. lease on premises or a patent)

 Depletion (i.e. extraction of raw materials)

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 What can be depreciated?
 You can depreciate property only if it meets the following
requirements:
– It is used in business or held for the production of income.

– It must be expected to last for more than one year. In other

words, it must have a useful life that extends substantially
beyond the year it was placed in service.
– It is property that wears out, decays, gets used up, becomes
obsolete, or looses value from natural causes.

 Depreciable property can be either tangible or intangible

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 Tangible Depreciable Property

 Purchased property you can see or touch

– Livestock (purchased)
– Machinery
– Buildings and improvements, fences
– Dams, ponds, or terraces
– Irrigation systems and water wells
– Partial business use
• You can claim depreciation on the part of a vehicle
used in the business (ex - 1/2 business value of a
truck)

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 Intangible Depreciable Property

 Purchased property that has value that you cannot readily

see or touch
– Computer Software
– Copyrights, patents, etc

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 What cannot be depreciated?

 Property placed into service and disposed of in the same year.

 Land (land can never be depreciated)
 Inventory
– You cannot depreciate property held for resale in the normal
course of business
 Leased property
– The value of the lease is already showing up as a rental
expense
 Raised Market Livestock (Because there is no cost to recover)

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 When depreciation begins & ends?

 Begins  Ends
– When you “place the – When the cost of the
property in service”. item has been
– When it is ready and recovered or when it is
available for a specific retired from service,
use in the business whichever happens
first

 Example  Example
– When it was bought for – When it is sold or is not
the business longer useable

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 Depreciation methods

 Straight line (SL)

 Sum-of-years digits (SOYD)

 Declining balance (DB or %DB)

 Switching from straight line to declining balance

 Units-of-production (UOP)

 Modified Accelerated Cost Recovery (MACRS)

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Book value (BV) = Original cost – Accumulated depreciation

Three items are important in determining depreciation schedule:

 Cost of the property, P
 Depreciation life in years, n
 Salvage value of the property at the end of its depreciation life, S

Example:
• Initial cost (P) = RM9000
• Salvage value (S) = RM700
• Life (n) = 5 years
• Note that over the five-year period the value is reduced from
RM9000 to RM700. In other words the total depreciation we
take over that period is $9000-700 = RM8300 which is P-S.
• Book value (BV) at the end of five year = ?? (RM 700)
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 Straight Line (SL)
Depreciation

• Annual depreciation charge is (P-S)/n

• P-S = RM9000 - 700 = 8300
• (P-S)/n = 8300/5 = 1660

Beginning book Ending

Year Depreciation
value book value
1 9000 1660 7340

2 7340 1660 5860

3 5860 1660 4200

4 4020 1660 2360

5 2360 1660 700

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 Sum-of-years digits (SOYD)
Depreciation

• Depreciation charge is: remaining life  P  S 

SOYD

• where SOYD is 1 + 2 + 3 + … + n = n/2(n + 1) = 5/2(5+1) = 15

Beginning Ending
Year Depreciation
book value book value
1 9000 2767 6233

2 6233 2213 4020

3 4020 1660 2360

4 2360 1107 1253

5 1253 553 700

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 Declining balance (DB)
Depreciation

• Depreciation charge is: some % (remaining book value)

n
• Usually 200% “double declining balance” 200DB
• can be 150% 150DB
• or 175% 175DB

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 200% DB example

Beginning Ending
Year Depreciation Depr Cal.
book value book value
1 9000 3600 2/5(9000) 5400

2 5400 2160 2/5(5400) 3240

3 3240 1296 2/5(3240) 1944

4 1944 778 2/5(1994) 1166

5 1166 466 2/5(1166) 700!

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 200% DB example
(changed a bit)

(salvage value changed to RM300)

Beginning Ending
Year book Depreciation book
value value
1 9000 3600 5400
2 5400 2160 3240
3 3240 1296 1944
4 1944 778 1166
5 1166 466 Still 700!
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 200DB example
changed again

(salvage value changed to RM1000)

Beginning Ending
Year Depreciation
book value book value
1 9000 3600 5400
2 5400 2160 3240
3 3240 1296 1944
4 1944 778 1166
not 466
5 1166 1000
but 166
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 Three cases for DB

• You depreciate to exactly the salvage value in exactly n

years. (improbable)

• You depreciate to the salvage value before year n but you

quit whenever you get there.

• You don’t get down to the salvage value at or before year n.

– switch

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 Switch to Straight Line
1
• Take remaining life (remaining book value-salvage) in
each of the remaining years.

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 Switch to straight line
If you were to use DDB depreciation for an asset which cost
RM100,000 and had an estimate salvage value of RM5000 and an 8-
year useful life, which year would you switch to straight line
depreciation?
Year DDB Deprec Straight Line Remaining Summary
Deprec BV EOY Deprec Schedule

1 2/8(100,000)=25,000 (100,000-5,000)/8=11,875 75,000 25,000

2 0.25(75,000)=18,750 (75,000-5,000)/7=10,000 56,250 18,750
3 0.25(56,250)=14,063 (56,250-5,000)/6=8,542 42,188 14,063
4 0.25(42,118)=10,547 (42,188-5,000)/5=7,438 31,641 10,547
5 0.25(31,641)=7,910 (31,641-5,000)/4=6,660 23,731 7,910
6 0.25(23,731)=5,933 (23,731-5,000)/3=6,244 17,487 6,244
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8  (17,487-5,000)/2=6,244
(11,263-5,000)/1=6,244
11,243
0
6,244
6,244
Total ~ 95,000
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Don’t need to compute
 Units of production (UOP)
• Allocate depreciation charges by the proportion of the life
(measured in tons, hours, etc.) actually used that year times (P-S).
It is sometimes ok to depreciate below the salvage value.
• Not a predictive model.
• In our example assume 1000 hours per year or 5000 hours total
life.
Hours
Year Depreciation Book value
used
1 1000 1660 7340
2 1500 2490 4850
3 500 830 4020
4 2000 3320 700

Total = 5000 8300

= 1000/5000(9000-700)

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