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Depreciation

Terminology
Depreciation is the reduction in value of an asset.
Usually the annual depreciation is tax deductible i.e. it is subtracted from income when calculating the amount of taxes due each year.

First cost (or unadjusted basis) is the delivered and installed cost of the asset including purchase price.

Depreciation Terminology
Book value (BV)
represents the remaining, undepreciated capital investment on the books after the total amount of depreciation charges to date have been subtracted from the basis. BV is usually determined at the end of each year, which is consistent with the end-of-year convention.

Depreciation Terminology
Recovery period (n)
is the depreciable life, n of the asset in years.

Salvage value (S)


is the estimated trade-in or market value at the end of the assets useful life.

Depreciation rate or recovery rate (dt)


is the fraction of the first cost removed by depreciation each year. This rate may be same (straight line method) or different for each year of the recovery period.

Depreciation Methods
Straight Line (SL) Depreciation
derives its name from the fact that the book value decreases linearly with time. Depreciation rate (dt = 1/n = d)is the same each year of the recovery period, n. Straight line is considered the standard against which any depreciation model is compared.

Straight Line (SL) Depreciation


The annual SL depreciation is determined by multiplying the first cost minus salvage value by d. In equation form,

where, t = year (t=1,2,n) Dt= annual depreciation charge B = first cost or unadjusted basis S = estimated salvage value n = recovery period d = depreciation rate = 1/n

BS Dt ( B S ) d n

B B o o k v a l u e S

t
time

Straight Line (SL) Depreciation


Since the asset is depreciated by the same amount each year, the book value after t years of service (BVt) will be equal to the first cost B minus the annual depreciation times t. BVt = B tDt Earlier we defined dt as a depreciation rate for a specific year t. However, the SL model has the same rate for all years, that is d = dt = 1/n Excel function is SLN(B,S,n)

Straight Line (SL) Depreciation


Example 16.1
If an asset has a first cost of $50,000 with a $10,000 estimated salvage value after 5 years, (a) calculate the annual depreciation and (b) compute and plot the book value of the asset after each year, using straight line (SL) depreciation Solution (a) The depreciation each year for 5 years can be found by

Example 16.1
Dt ( B S )d BS n
= (50,000 10,000)/5 = $8000 Enter SLN(50000,10000,5) in any cell to get Dt of $8000 (b) The book value after each year t is computed by using the equation BVt = B tDt.

The BVt values for years 1 and 5 are


BV1 = 50,000 1(8,000) = $42,000 BV5 = 50,000 5(8,000) = $10,000 = S

Example 16.1
The BVt values are plotted for years 1 and 5 as
50

B V , x $ 1 0 0 0

Dt=$8,000
40 30 20 10

S=$10,000
0 1 2 3 4 5

Year t

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation


The declining balance method is commonly applied. This method is also known as the fixed percentage or uniform percentage method. DB depreciation accelerates the writeoff of asset value because
the annual depreciation is determined by multiplying the book value at the beginning of a year by a fixed (uniform) percentage d.

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation


If d = 0.1 then 10% of the book value is removed each year. So, the depreciation amount decreases each year. The maximum annual depreciation rate for the DB method can be twice the straight line rate, that is dmax = 2/n In this case, the method is given a special title called double declining balance (DDB) method.

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation


If n = 10 years, the DDB rate is 2/10 = 0.2 of the book value is removed each year. The depreciation for year, t is the fixed rate d times the book value at the end of the previous year. Dt = (d)BVt-1 The actual depreciation rate for each year t, relative to the first cost B, is dt = d(1-d)t-1.

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation


If BVt-1 is not known, the depreciation in year t can be calculated using B and d, Dt = dB(1-d)t-1 Book value in year t is determined in one of two ways:
(1) by using the rate d and the first cost B or (2) by subtracting the current depreciation charge from the previous book value.

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation The equations are BVt = B(1-d)t and BVt = BVt-1 - Dt Note that the book value for DB method never goes to zero. Why?

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation The implied salvage value after n years is BVn amount. Thus, implied salvage value = Implied S = BVn = B(1-d)n If a salvage value is estimated for the asset, this estimated S value is not used in the DB or DDB method to calculate annual depreciation.

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation However, if the implied S < estimated S, it is correct to stop charging further depreciation. So stop depreciating when the book value is at or below the estimated salvage value. In most cases, the estimated S is in the range of zero to the implied S value.

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation If the fixed percentage d is not stated, it is possible to determine the implied fixed rate using the estimated S value, if S > 0. The range for d is 0 < d < 2/n. Implied d = 1- (S/B)1/n [as we
know, Implied S = BVn = B(1-d)n]

Declining Balance (DB) and Double Declining Balance (DDB) Depreciation


Example 16.2 A fiber optics testing device is to be DDB depreciated. It has a first cost of $25,000 and an estimated salvage value of $2500 after 12 years. (a)Calculate the depreciation and book value for years 1 and 4. (b)Calculate the implied salvage value after 12 years.

Example 16.2
Solution (a)The DDB fixed depreciation rate is d = 2/n = 2/12 = 0.1667 per year. So, for year 1, D1 = dB(1-d)1-1 = (0.1667)(25000)(1-0.1667)1-1 = $4167 BV1 = B(1-d)1 = 25,000(1-0.1667)1 = $20,833 and for year 4, D4 = dB(1-d)4-1 = (0.1667)(25000)(1-0.1667)4-1 = $2411 BV4 = B(1-d)4 = 25,000(1- 0.1667)4 = $12,054.

Example 16.2

Solution (contd)
(a)DDB function for D1 and D4 are respectively, DDB(25000,2500,12,1) and DDB(25000,2500,12,4) Assignment: Check with Excel (b)The implied salvage value after 12 years is Implied S = B(1-d)n = 25,000(1-0.1667)12 = $2803

Example 16.3
A mining company has purchased a computer-controlled gold ore grading unit for $80,000. The unit has an anticipated life of 10 years and a salvage value of $10,000. Use DB and DDB methods to compare the schedule of depreciation and book values for each year.

Example 16.3
Solution An implied DB depreciation rate is d = 1 (S/B)1/n = 1 (10,000/80,000)1/10 = 0.1877 Note: 0.1877 < 2/n = 0.2. So the DB model does not exceed twice the straight line rate.

Example 16.3:Schedule of depreciation and Book values


Declining Balance
Year t 0 Dt -BVt $80,000

Double Declining
Dt -BVt $80,000

1
2 3 4

$15,016
12,197 9,908 8,048

64,084
52,787 42,879 34,831

$16,000
12,800 10,240 8,192

64,000
51,200 40,960 32,768

5
6 7 8

6,538
5,311 4,314 3,504

28,293
22,982 18,668 15,164

6,554
5,243 4,194 3,355

26,214
20,972 16,777 13,422

9
10

2,846
2,318

12,318
10,000

2,684
737

10,737
10,000

Example 16.3
Assignment: Eng Economy Solve the following problems manually and by using computer and submit by /1/2011. Straight line Depreciation
Problem # 16.6, 16.7 and 16.8

Declining Balance Depreciation


Problem # 16.11, 16.12, 16.14, 16.15

Another problem
[#16.14 Ref: Blank]

Equipment for immersion cooling of electronic components has an installed value of $182,000 with an estimated trade-in value of $50,000 after 18 years. Determine the annual depreciation charge using DDB and DB depreciation for the years 2 and 18. Ans: We need to determine the implied salvage value to verify whether the implied S is less than the estimated S (50,000) For DDB, d = 2/n = 2/18 = 0.1111 Implied S = Book value after useful life = B(1- d)n = 182,000(1- 0.1111)18 = $21,848

Using DDB
It is found that the implied S (21,848) < estimated S (50,000). So it will be correct to stop charging depreciation beyond $50,000. For DDB, depreciation charge, Dt = dB(1-d)t-1 For this case, d = 2/n = 2/18 = 0.1111 Depreciation charge for year 2, D2=(0.1111)(182,000)(1-0.1111)2-1 =$17,973.74

Using DDB
Similarly, D18=(0.1111)(182,000)(1-0.1111)18-1 =$2,730.77 So since after 18 years the implied salvage value is lower than the estimated salvage value, D18 should not be charged.

Using DB
For DB, d = 1/n = 1/18 = 0.05555 or We can also use d = 1- (S/B)1/n = 1- (50000/182000)1/18 = 0.0693 Implied S = B(1-d)n = 182,000(1-0.05555)18 = $65,057
Since the implied S (65,057) > estimated S (50,000), it will be correct to continue charging further depreciation.

Using DB
Given, B=182,000 S=50,000 For DB, we know Dt = dB(1-d)t-1 Now d = 1/n = 1/18 = 0.055555 Depreciation charge for year 2, D2=(0.05555)(182,000)(1-0.05555)2-1 =$9,549 Similarly, D18=(0.05555)(182,000)(1-0.05555)18-1 =$3,827 It should also be correct if someone answers by using implied d = 0.0693