Depreciation Methods PDF

Depreciation Methods ESECON230  Definition of Terms Depreciation - the decrease in the value of physical property with the passage of time. - is an accounting concept that establishes an annual deduction against before tax income such that the effect of time and use on the asset’s...

Depreciation Methods ESECON230  Definition of Terms Depreciation - the decrease in the value of physical property with the passage of time. - is an accounting concept that establishes an annual deduction against before tax income such that the effect of time and use on the asset’s value can be reflected in a firm financial statement Value - in a commercial sense, is the present worth of all future profits that are to be received through ownership of a particular property.  Definition of Terms Market Value of a property - the amount which a willing buyer will pay to a willing seller for the property where each has equal advantage and is under no compulsion to buy or sell. Utility (Use value of a property) - property is what the property is worth to the owner as an operating unit. Fair Value - the value which is usually determined by a disinterested third party in order to establish a price that is fair to both seller and buyer.  Definition of Terms Book Value - sometimes called depreciated book value, is the worth of a property as shown on the accounting records of an enterprise. Salvage/Resale Value - the price that can be obtained from the sale of the property after it has been used. Scrap Value - the amount the property would sell for, if disposed off as junk.  Definition of Terms Initial Investment (cost) – the cost of acquiring an asset (purchase price plus any asset taxes), including transportation expenses and other normal costs of making the asset serviceable for its intended use. Book Value – worth of property or an asset as shown on the accounting records of the company. It is the original cost of the property less all allowable depreciation deductions. Market Value – the amount that will be paid by a willing buyer to a willing seller for a property where each has equal advantage and is under no compulsion to buy or sell.  Definition of Terms Useful Life – the expected (estimated) period that a property will be used in trade or business to produce income. It is not how long the property will last, but how long the owner expects to productively use it Physical life of a property is the length of time during which it is capable of performing the function for which it was designed and manufactured. Economic life is the length of time during which the property may be operated at a profit.  The Purpose of Depreciation 1. To enable the cost of depreciation to be included as a cost in the production of goods and services. 2. Annual cost of depreciation are being put in a fund called depreciation reserve for replacement of the property. 3. To recover the capital invested in the property. 4. Provide as an additional capital termed as depreciation reserve  Types of Depreciation 1. Normal Depreciation a.)Physical b.)Functional 2. Depreciation due to changes in price levels 3. Depletion  Types of Depreciation Physical depreciation is due to the lessening of the physical ability of a property to produce results. Its common causes are wear and deterioration. Functional depreciation is due to the lessening of the demand for the function which the property was designed to render. Its common causes are inadequacy, changes in styles, population- center shifts, saturation of markets or more efficient machines are produced (obsolescence)  Types of Depreciation Depreciation due to changes in price levels is most impossible to predict and therefore is not considered in economy studies. Depletion refers to the decrease in the value of a property due to the gradual extraction of its contents.  Properties of Depreciable Assets 1. It must have a determinable life and the life must be greater than 1 year. 2. It must be something used in business or held to produce income. 3. It must be something that gets used up, wears out decays, become obsolete, or loses its value due to natural causes. 4. It must not be an inventory or stock in trade or investment  Requirements of a Depreciation Method 1. It should be simple. 2. It should be recover capital. 3. The book value will be reasonably close to the market value at any time. 4. The method should be accepted by the Bureau of Internal Revenue.  Depreciation Methods Straight Line Method (SLM) Sinking Fund Method Declining Balance Method Sum Of The Years Digit Method (SYD) Inflation  Depreciation Methods Use the following symbols for the different depreciation methods: L useful life of the property in years Co the original cost CL the value at the end of the life, the scrap value (including gain or loss due to removal) d the annual cost of depreciation Cn the book value at the end of n years Dn depreciation up to age n years  I. Straight Line Method (SLM) The method assumes that the loss in value is directly proportional to the age of the property. Is the simplest depreciation method. It assumes that a constant amount is depreciated each year over the depreciable (useful) life of the asset. 𝐶𝑂 − 𝐶𝐿 Annual cost of Depreciation: 𝑑= 𝐿 Depreciation up to age n years: 𝑛 𝐶𝑂 − 𝐶𝐿 𝐷𝑛 = = 𝑛𝑑 𝐿 Book Value at the end of n years: 𝐶𝑛 = 𝐶𝑂 – 𝐷𝑛  Straight Line Method (SLM) Example #1: An electronic balance costs P90,000 and has an estimated salvage value of P8,000 at the end of 10 years life time. What would be the book value after three years, using the straight line method in solving for the depreciation?  Sinking Fund Method This method assumes that a sinking fund is established in which funds will accumulate for replacement. (A sinking fund is a fund containing money set aside or saved to pay off a debt or bond.) The sinking fund method is a technique for depreciating an asset while generating enough money to replace it at the end of its useful life. The total depreciation that has taken place up to any given time is assumed to be equal to the accumulated amount in the sinking fund at that time Sinking Fund Method Annual Cost of Depreciation, d 𝐶𝑜 − 𝐶𝐿 𝑑= 1+𝑖 𝐿−1 𝑖 Depreciation, 𝐷𝑛 1+𝑖 𝑛−1 𝐷𝑛 = 𝑑 𝑖 Book Value, 𝐶𝑛 𝐶𝑛 = 𝐶𝑜 − 𝐷𝑛  Sinking Fund Method Example #2: A broadcasting corporation purchased an equipment for P53,000 and paid P1,500 for freight and delivery charges to the job site. The equipment has a normal life of 10 years with a trade-in value of P5,000 against the purchase of a new equipment at the end of the life. A. Determine the annual depreciation cost by the straight line method. B. Determine the annual depreciation cost by the sinking fund method. Assume interest at 6.5% compounded annually.  Sinking Fund Method Example #2: A broadcasting corporation purchased an equipment for P53,000 and paid P1,500 for freight and delivery charges to the job site. The equipment has a normal life of 10 years with a trade-in value of P5,000 against the purchase of a new equipment at the end of the life. A. Determine the annual depreciation cost by the straight line method. B. Determine the annual depreciation cost by the sinking fund method. Assume interest at 6.5% compounded annually.  Sinking Fund Method Example #3: A firm bought an equipment for P56,000. Other expenses including installation amounted to P4,000. The equipment is expected to have a life of 16 years with a salvage value of 10% of the original cost. Determine the book value at the end of 12 years by (a) the straight line method and (b) sinking fund method at 12% interest.  Sinking Fund Method Example #3: A firm bought an equipment for P56,000. Other expenses including installation amounted to P4,000. The equipment is expected to have a life of 16 years with a salvage value of 10% of the original cost. Determine the book value at the end of 12 years by (a) the straight line method and (b) sinking fund method at 12% interest.  Declining Balance Method Constant Percentage Method Matheson Formula It is assumed that the annual cost of depreciation is a fixed percentage of the salvage value at the beginning of the year.  Declining Balance Method The ratio of the depreciation in any year to the book value at the beginning of that year is constant throughout the life of the property and is designed by k, the rate of depreciation This method does not apply , if the salvage value is zero, because k will be equal to one and d1 will be equal to C0.  Declining Balance Method Deprecation during nth year: dn = C0(1-k)n-1k Year Book Value Depreciation Book Value at the end Book Value: at during the year of the year 𝑛 beginning 𝐶𝐿 𝐿 of year Cn = C0(1-k)n = 𝐶0 𝐶0 1 C0 d1= kC0 C1= C0 – d1= C0(1-k) 2 C0(1-k) d2= kC1 C2= C1 – d2= C0(1-k)2 End of Life Value: 3 C0(1-k)2 d3= kC2 C3= C2 – d3= C0(1-k)3 CL = C0 (1-k)L n C0(1-k)n-1 dn= kCn-1 Cn= Cn-1 – dn= C0(1-k)n Rate of Depreciation: 𝑛 𝐶𝑛 𝐿 𝐶𝐿 L C0(1-k)L-1 dL-1= kCL CL= CL-1 – dL= C0(1-k)L k=1- =1− 𝐶0 𝐶0  Double Declining Balance Method Similar to the declining balance method except that k = 2/L 𝑛−1 2 2 𝑑𝑛= 𝐶0 1− 𝐿 𝐿 2 𝑛 𝐶𝑛= 𝐶0 1 − 𝐿 𝐿 2 𝐶𝐿= 𝐶0 1− 𝐿 When the DDB method is used, the salvage value should not be subtracted from the first cost when calculating the depreciation charge.  Example #4: Determine the rate of depreciation, the total depreciation up to the end of the 8th year and the book value at the end of 8 years for an asset that costs P15,000 new and has an estimated scrap value of P2,000 at the end of 10 years by (a) the declining balance method and (b) the double declining balance method.  Example #4: Determine the rate of depreciation, the total depreciation up to the end of the 8th year and the book value at the end of 8 years for an asset that costs P15,000 new and has an estimated scrap value of P2,000 at the end of 10 years by (a) the declining balance method and (b) the double declining balance method.  Double Declining Balance Method Example #4: Determine the rate of depreciation, the total depreciation up to the end of the 8th year and the book value at the end of 8 years for an asset that costs P15,000 new and has an estimated scrap value of P2,000 at the end of 10 years by (a) the declining balance method and (b) the double declining balance method. Declining Balance Method Example #5: A certain type of machine loses 10% of its value each year. The machine costs P2,000 originally. Make out a schedule showing the yearly depreciation, the total depreciation and the book value at the end of each year for 5 years. Year Book value at Depreciation during Total depreciation Book value at end beginning of year the year (k=10%) at end of year of year 1 2 3 4 5  Declining Balance Method Example #5: A certain type of machine loses 10% of its value each year. The machine costs P2,000 originally. Make out a schedule showing the yearly depreciation, the total depreciation and the book value at the end of each year for 5 years. Year Book value at Depreciation during Total depreciation Book value at end beginning of year the year (k=10%) at end of year of year 1 2 3 4 5  Declining Balance Method Example #5: A certain type of machine loses 10% of its value each year. The machine costs P2,000 originally. Make out a schedule showing the yearly depreciation, the total depreciation and the book value at the end of each year for 5 years. Final Answer: Year Book value Depreciatio Total Book value at n during the depreciatio at end of beginning year 10% n at end of year of year year 1 P2,000.00 P200.00 P200.00 P1,800.00 2 P1,800.00 P180.00 P380.00 P1,620.00 3 P1,620.00 P162.00 P542.00 P1,458.00 4 P1,458.00 P145.80 P687.80 P1,312.20 5 P1,312.20 P131.22 P819.02 P1,180.98  Sum of Years’ Digit Method (SYD) the depreciation charge is computed For a property whose life is 5 years based on the reverse digit and sum of Year Year in Depreciation Depreciation digits Reverse Factor during the Order year Let dn = depreciation charge during the nth year 1 5 5/15 (5/15)(C0 - CL) dn = (depreciation factor)(total depreciation) 2 4 4/15 (4/15)(C0 - CL) 𝑟𝑒𝑣𝑒𝑟𝑠𝑒 𝑑𝑖𝑔𝑖𝑡 3 3 3/15 (3/15)(C0 - CL) dn = 𝐶0 − 𝐶𝐿 4 2 2/15 (2/15)(C0 - CL) 𝑠𝑢𝑚 𝑜𝑓 𝑑𝑖𝑔𝑖𝑡𝑠 5 1 1/15 (1/15)(C0 - CL) Sum of digits = 15  Sum of Years’ Digit Method (SYD) Example #6: A structure costs P12,000 new. It is estimated to have a life of 5 years with a salvage value at the end of life of P1,000. Determine the book value at the end of each year of life. Year Year in Depreciation Depreciation during the year Book value at the end of year reverse factor order 1 2 3 4 5  Sum of Years’ Digit Method (SYD) Example #6: A structure costs P12,000 new. It is estimated to have a life of 5 years with a salvage value at the end of life of P1,000. Determine the book value at the end of each year of life. Year Year in Depreciation Depreciation during the year Book value at the end of year reverse factor order 1 2 3 4 5  The Service-Output Method This method assumes that the total depreciation that has taken place is directly proportional to the quantity of output of the property up to that time. This method has the advantage of making the unit cost of depreciation constant and giving low depreciation expense during periods of low production. The Service-Output Method Sample Problem A television Company purchased machinery for P100,000 on July 1,1979. It is estimated that it will have a useful life of 10 years; scrap value of P4,000, production of 400,000 units and working hours of 120,000. The company uses the machinery for 14,000 hours in 1979 and 18,000 hours in 1980. The machinery produces 36,000 units in 1979 and 44,000 units in 1980. Compute the depreciation for 1980 using: a. Straight Line Method b. Working hours c. Service Output Method.  Inflation -It is the decrease in the value of a currency due to the increase in volume of currency circulated that will eventually increase the price of the commodities. CPI - Consumer Price Index