Kathmandu University

Engineering Economy MGTS 301

Chapter-7
Depreciation
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Today’s class

Depreciation Concepts and Terminology

The Classical Depreciation Methods

2
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The objective of Chapter 7 is to explain

how depreciation affects income taxes
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Depreciation is the decrease in value of physical properties with the

passage of time and use. More specifically, depreciation is an
accounting concept that establishes an annual deduction against
before Tax Income such that the effect of time and use on as asset’s
value can be reflected in a firm’s financial statements.

• It is an accounting concept, a non-cash cost, that establishes an

annual deduction against before-tax income.
• It is intended to approximate the yearly fraction of an asset’s value
used in the production of income.
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Property is depreciable if
• it is used in business or held to produce income.
• it has a determinable useful life, longer than one year.
• it is something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.
• it is not inventory, stock in trade, or investment property.
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Depreciable property is
1) Tangible (can be seen or touched): It includes two main types of property
a) Personal property: it includes assets such as machinery, vehicles, equipment, furniture&
fixtures etc.
b) Real property: it includes land and generally anything that erected on, growing on , or
attached to land. Land itself, however, is not depreciable, because it does not have a
determinable life.
2) Intangible (such as copyrights, patents, or franchises).

• Depreciated, according to a depreciation schedule, when it is put in service for use in the
business and for the production of income
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Method of Depreciation

1. The Classical/Historical Method of Depreciation

 Straight line (SL) Method

 Declining balance (DB) Method
 Double Declining balance Method
 DB with Switchover to SL
 Units of Production Method
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Straight line (SL): It is the simplest depreciation method. It assumes that a

constant/fixed amount is depreciated each year over the depreciable (useful)
life of the assets.

d  k* = k
BVk = B- dk*
• N = depreciable life • BVk = book value at end of k
• B = cost basis • SVN = salvage value
• dk = depreciation in k
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Pause and solve

Acme purchased a coordinate measurement machine (CMM). The
cost basis is $120,000 and it has a seven year depreciable life.
Acme estimates a salvage value of $22,000 at the end of seven
years. Determine the annual depreciation amounts using SL
depreciation. Tabulate the annual depreciation amounts and book
value of the CMM at the end of each year.
 Solutions
EOY,k dk ($) BVk($)
0 - 120,000
1 14,000 106,000
𝑑  𝑘 =( 𝐵 − 𝑆𝑉𝑁 )/ 𝑁
2 14,000 92,000
𝑑  𝑘 =( $ 120,000 − $ 22,000)/ 7 3 14,000 78,000
𝑑  𝑘 =$ 14,000 4 14,000 64,000
5 14,000 50,000
𝑑  ∗𝑘 =𝑘 . 𝑑𝑘 𝑓𝑜𝑟 1≤ 𝑘 ≤ 𝑁 , 6 14,000 36,000
$ 120,000 − $ 22,000 7 14,000 22,000
𝑑  ∗5=5 ( 7 )
¿  $ 70,000

𝐵𝑉
  5=$ 120,000 − $ 70,000=$ 50,000
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Pause and solve

A laser surgical tool has a cost basis of $200,000 and a five year
depreciable life. The estimated SV of the laser is $20,000 at the end
of five years. Determine the annual depreciation amounts using the
SL method. Tabulate the annual depreciation amounts and the
book value of the laser at the end of each year.
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Declining-balance (DB): It is called a constant-percentage method or the

Matheson formula. It is assumed that the annual cost of depreciation is a fixed
percentage or the BV at the beginning of the year. The ratio of the depreciation in
any one year to the BV at the beginning of the year is constant throughout the life
of the asset and designated by R (0 ≤ R ≤ 1)

 𝑑 𝑘 ∗= 𝐵 [ 1− ( 1− 𝑅 ) 𝑘 ]

The constant percentage is determined by R, where R = 2/N when 200%

declining balance is being used, R = 1.5/N when 150% declining balance is being
used.
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Declining Balance-Depreciation rate, R= 100%/5= 20%

Case I: If salvage value is not given,
Q) A machine costs Rs 100,000 now. Calculate depreciation and corresponding book value in each year for 5 years

EOY Depreciation Book Value

0 100,000
1 100,000*20%= 20,000 100,000-20,000=80,000
2 80,000*20%= 16,000 80,000-16,000= 64,000
3 64,000*20%= 12,800 51200
4 10,240 40960
5 8192 32768
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Declining Balance-Depreciation rate, R= 100%/N

Case I: If salvage value is given,

Q) A machine costs Rs 100,000 now and salvage value at the end of year is 20,000. Calculate depreciation and
corresponding book value in each year for 5 years
20,000
 

EOY Depreciation Book Value

0 100,000
1 100,000* 27.52%=27520 72480
2 72480*27.52%= 19946.5 52,533.5
3 52,533.5*27.52%=14,
4
5 20,000.0756
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Pause and solve

A new electric saw for cutting small pieces of lumber in a furniture
manufacturing plant has a cost basis of $4,000 and a 10-year depreciable life.
The estimated salvage value of the saw is zero at the end of 10 years. Use the
DB method to calculate the annual depreciation amounts when,
a) R=2/N (200% DB method)
b) R=1.5/N (150% DB method)
Tabulate the annual depreciation amount and BV for each year.
 Annual depreciation, cumulative depreciaiton, and BV are
200% DB Method determined by using formula respectively. Sample calculations
EOY,k dk BVk for year seven are as follows: =
  0.15,
0 - $4000 =  0.2,
1 $800 3200
2 640 2,560
 
3 512 2,048  
4 409.6 1,638.4
5 327.68 1,310.72
  𝑘 ∗=𝐵[ 1− ( 1− 𝑅 ) 𝑘 ]
𝑑
6 262.14 1,048.58 𝑑  𝑘 ∗=𝐵[ 1− ( 1− 𝑅 ) 𝑘 ]
7 209.72 838.86   7 ∗=$ 4,000 [1 − ( 1 −0.15 ) 7]
𝑑
8 167.77 671.09 𝑑  7 ∗=$ 4,000 [1 − ( 1 −0.2 ) 7]
9 134.22 536.87 ¿  $ 2,717.69
¿  $ 3,161.14
10 107.37 429.50
𝐵𝑉
  𝑘 =𝐵 ( 1− 𝑅 ) 𝑘
𝐵𝑉
  𝑘 =𝐵 ( 1− 𝑅 ) 𝑘
𝐵𝑉
  7=$ 4,000 ( 1 −0.15 ) 7
𝐵𝑉
  7=$ 4,000 ( 1 −0.2 ) 7
¿  $ 1282.31
¿  $ 838.86
EOY,k 200% DB Method SL-Method Type of Book Value at EOY
Depreciation
0 $4,000
1 $4,000×20%=$800 $(4,000-0)/10=$400 DB>SL 4,000-800=3,200
2 $3,200×20%=$640 $(3,200-0)/9=$355.56 DB>SL 3,200-640= 2,560
3 $2,560×20%=$512 $(2,560-0)/8=$320 DB>SL 2,560-512=2,048
4 $2,048×20%=$409.6 $(2,048-0)/7=$292.57 DB>SL 2,048-409.6=1,638.4
5 $1,638.4×20%=$327.68 $(1638.4-0)/6=$273.07 DB>SL 1,638.4-327.68=1,310.72
6 $1,310.72×20%=$262.14 $(1,310.72-0)/5=$262.14 DB=SL 1310.72-262.14= 1,048.58
7 =209.72 $262.14 DB<SL 1,048.58-262.14=786.44
8 =167.77 $262.14 DB<SL 786.44-262.14=524.3
9 =134.22 $262.14 DB<SL 524.3-262.14=262.16
10 =107.37 $262.14 DB<SL 262.16-262.14=000
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The units-of-production method can be used when

the decrease in value of the asset is mostly a function
of use, instead of time. The cost basis is allocated
equally over the number of units produced over the
asset’s life. The depreciation per unit of production
is found from the formula below.
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Pause and solve

A piece of equipment used in business has a basis of
$50,000 and is expected to have a $10,000 SV when
replaced after 30,000 hours of use. Find its depreciation
rate per hours of use, and find its BV after 10,000 hours of
operation.
Solution

  𝐵 − 𝑆𝑉𝑁
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛=
( 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑖𝑓𝑒𝑡𝑖𝑚𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑢𝑛𝑖𝑡𝑠)

  $ 50,000 − $ 10,000
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛=
30,000 h𝑜𝑢𝑟𝑠
 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛=$ 1.33 𝑝𝑒𝑟 h𝑜𝑢𝑟
  After 10,000 hours, BV

  BV
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Pause and solve

The “Big deal” company has purchased new furniture for their
offices at a retail price of $100,000. An additional $20,000 has
been charged for insurance, shipping, and handling. The
company expects to use the furniture for 10 years and then
sell it at a salvage (market) value of $10,000. Use the SL
method for depreciation to answer these questions.
a) What is the depreciation during the second year?
b) What is the BV of the asset at the end of first year?
c) What is the BV of the asset after 10 years?
 Solution

 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒇𝒖𝒓𝒏𝒊𝒕𝒖𝒓𝒆 = 𝑹𝒆𝒕𝒂𝒊𝒍 𝒑𝒓𝒊𝒄𝒆+𝒊𝒏𝒔𝒖𝒓𝒂𝒏𝒄𝒆 , 𝒔𝒉𝒊𝒑𝒑𝒊𝒏𝒈 , 𝒂𝒏𝒅 𝒉𝒂𝒏𝒅𝒍𝒊𝒏𝒈

 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒇𝒖𝒓𝒏𝒊𝒕𝒖𝒓𝒆 =$ 𝟏𝟎𝟎 ,𝟎𝟎𝟎+ $ 𝟐𝟎 , 𝟎𝟎𝟎
¿  $ 𝟏𝟐𝟎 ,𝟎𝟎𝟎
𝒅
  𝒌 =( 𝑩 − 𝑺𝑽𝑵 )/ 𝑵

𝒅
  𝒌 =( $ 𝟏𝟐𝟎 , 𝟎𝟎𝟎 −$ 𝟏𝟎 ,𝟎𝟎𝟎)/ 𝟏𝟎

𝒅  𝒌 =$ 𝟏𝟏 ,𝟎𝟎𝟎
BVk = B- dk*

𝑩𝑽
  𝟏=$ 𝟏𝟐𝟎 , 𝟎𝟎𝟎 − $ 𝟏𝟏 , 𝟎𝟎𝟎=$ 𝟏𝟎𝟗 , 𝟎𝟎𝟎
𝑩𝑽
  𝟏𝟎=$ 𝟏𝟐𝟎 ,𝟎𝟎𝟎 − $ 𝟏𝟏 , 𝟎𝟎𝟎 ×𝟏𝟎=$ 𝟏𝟎 ,𝟎𝟎𝟎
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Pause and solve

Cisco system is purchasing a new bar code scanning device for its
service center in San Francisco. The table that follows lists the relevant
cost items for this purchase. The operating expenses for the new
system are $10,000 per year, and the useful life is 5 years. The SV for
depreciation purposes is equal to 25% of the hardware cost. Hardware
cost is $160,000, training cost $15,000 and installation cost $15,000.
a) What is the BV of device at the end of year three, by using SL?
b) Suppose that after depreciating the device for 2 years with SL, the
firm decides to switch to the DB for the remainder of the device’s
life. What is the device’s BV at the end of four year?
 Solution

 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒅𝒆𝒗𝒊𝒄𝒆=𝑯𝒂𝒓𝒅𝒘𝒂𝒓𝒆 𝒄𝒐𝒔𝒕 +𝑻𝒓𝒂𝒊𝒏𝒊𝒏𝒈 + 𝑰𝒏𝒔𝒕𝒂𝒍𝒍𝒂𝒕𝒊𝒐𝒏

 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒅𝒆𝒗𝒊𝒄𝒆=$ 𝟏𝟔𝟎 ,𝟎𝟎𝟎+ $ 𝟏𝟓 , 𝟎𝟎𝟎+ $ 𝟏𝟓 ,𝟎𝟎𝟎
¿  $ 𝟏𝟗𝟎 ,𝟎𝟎𝟎
𝒅
  𝒌 =( 𝑩 − 𝑺𝑽𝑵 )/ 𝑵

𝒅
  𝟑=( $ 𝟏𝟗𝟎 ,𝟎𝟎𝟎 − $ 𝟒𝟎 , 𝟎𝟎𝟎)/ 𝟓

𝒅  𝟑=$ 𝟑𝟎 , 𝟎𝟎𝟎
BVk = B- dk*
𝑩𝑽
  𝟑=$ 𝟏𝟗𝟎 ,𝟎𝟎𝟎 − $ 𝟑𝟎 , 𝟎𝟎𝟎 ×𝟑=$ 𝟏𝟎𝟎 ,𝟎𝟎𝟎
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Declining Balance with Switchover to Straight Line

• Because the DB method never reaches a BV of zero, it is
permissible to switch from this method to the SL method so
that an asset’s BVN will be zero
• Switching occurs when next period’s SL depreciation
amount on the undepreciated balance of the asset exceeds
the next period’s declining balance (DB) depreciation
charge. The switch is occur at the beginning of period t,
where first.
• DB depreciation < SL depreciation on undepreciated
balance.
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Pause and solve

Cost of equipment= $10,000, useful life=5 years and

salvage value=$2,000, find the depreciation of end of each
year by using declining method. (R=2/5=0.4)
Dep. amount BV
0 $10,000
1 4,000 6,000
2 2,400 3,600
3 1,440 2,160
4 160 2000
5 0 $2,000
Rate of depreciation using DB=200/5=40%

Year Depreciation charge Book Value at the EOY

($) ($)
0 10,000
1 10,000×40%= 4,000 10,000-4000=6,000
2 6,000×40%= 2400 6,000-2,400=3,600
3 3,600×40%= 1440 3,600-1,440=2,160
4 2,160×40%= 864 $2,000
5 0 $2,000
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Pause and solve

Cost of equipment= $10,000, useful life=5 years and

salvage value=$0, find the depreciation of end of each year
by using declining method switching to SL. (R=2/N)
Using DB Using SL Adopted method BV
0 $10,000
1 4,000 2000 10,000-
4000=6000
2 2400
3
4
5 0 0
Rate of depreciation using DB=200/5=40%

Depreciation charge
Year Using DB ($) Using SL Method Type of Book Value at the EOY
($) Depreciation ($)
0 10,000
1 10,000×40%= 4,000 (10000-0)/5=2,000 DB 10,000-4000=6,000
2 6,000×40%= 2400 (6000-0)/4=1,500 DB 6,000-2,400=3,600
3 3,600×40%= 1440 (3600-0)/3=1,200 DB 3,600-1,440=2,160
4 2,160×40%= 864 (2160-0)/2=1,080 SL 2,160-1,080=1,080
5 - 1,080 SL 0