DEPRECIATION

Depreciation is defined as the decrease in the value of a

property such as machinery, equipment, building or other structure due
to passage of time.
Excluded from this definition are properties whose value
increases with time, such as antiques, paintings, rare stamps, rare coins
and in most cases, land.
Depreciation must always be included in the cost of production
of any product or rendering of any service where equipment is used for
the following reasons.
(1) To provide for the replacement of the equipment either at the end
of its physical life or economic life or at the time when its operation no
longer results in satisfactory manner.
(2) To provide for the maintenance of capital to replace the decrease in value of
the equipment caused by physical or functional causes.

TYPES OF DEPRECIATION

(1) Physical depreciation caused by the following:

(a) deterioration due to the effects of various chemical and mechanical
factors on the materials (rusting of metal parts, decay of wooden parts,
discoloration and cracking of plastic parts)
(b) wear and tear due to abrasion, friction between moving parts, vibration
etc.
(2) Functional depreciation
- inadequacy of equipment
- obsolescence caused by invention of more efficient machine
 - changes of methods of production
- changes in styles and designs of the good produced on the equipment

Physical Life vs Economic Life of Properties

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 which the property maybe operated at a
profit.
Symbols:

𝒏 = useful life of the property in years

𝒎 = age of the property at any time less than or equal to n (𝒎 ≤ 𝒏)
𝒅 = annual cost of depreciation
𝑫𝒎 = accrued or total depreciation up to age m years
𝑪𝒐 = original or first cost of the property
𝑪𝒎 = book value of the property at the end of m years
𝑪𝒏 = book value at the end of life, n years,(salvage or scrap value, as the case maybe)
Depreciation Methods:

1. ) The Straight - Line Formula

- in this method the loss in value is considered to be directly proportional to
the age of the property/structure. No interest is assumed to be paid on the amounts
set aside in the depreciation fund.

𝐶𝑜 − 𝐶𝑛
𝑑=
𝑛
𝐷𝑚 = 𝑚𝑑
𝐶𝑚 = 𝐶𝑜 − 𝐷𝑚
2.) Sinking – Fund Method
- In this method it is assumed that a sinking fund is established in
which fund will accumulate for replacement purposes and will bear
interest. The total depreciation which has occurred up to any given
time is assumed to equal the accumulated value of the sinking fund at
that time.
1
𝑑 = 𝐶𝑜 − 𝐶𝑛 ∙
𝐹
(𝐴 . 𝑖%, 𝑛)
𝐹
𝐷𝑚 = 𝑑 , 𝑖%, 𝑚
𝐴
𝐶𝑚 = 𝐶𝑜 − 𝐷𝑚
3.) Matheson Formula (Declining Balance Method)
This method assumes that the annual cost of depreciation is a
fixed percentage of the book value at the beginning of the year.
let: k = ratio of the depreciation in any one year to the book value at
the beginning of that year. This is constant throughout the life of the
property.
This method does not apply if the salvage value is zero, because k will
be unity or 100% and 𝑑1 will equal to 𝐶𝑜
𝑛 𝐶𝑛
𝑘 =1− 𝐶𝑜
𝑑𝑚 = 𝑘𝐶𝑚−1
𝐶𝑚 = 𝐶𝑜 1 − 𝑘 𝑚
𝐶𝑛 = 𝐶𝑜 1 − 𝑘 𝑛
𝐷𝑚 = 𝐶0 − 𝐶𝑚
4.) Double Declining Balance Method
- this method is similar to the declining balance method except that
the rate of depreciation k is replaced by 2/n
let: k = 2/n
𝑚−1 𝑚−1
2 2 2𝐶𝑜 2
𝑑𝑚 = 𝐶𝑜 1 − = 1−
𝑛 𝑛 𝑛 𝑛
𝐶𝑚 = 𝐶𝑜 1 − 𝑘 𝑚
𝐷𝑚 = 𝐶0 − 𝐶𝑚

5.) The Sum-of-the Years-Digit (SYD) Method

Steps:
1. Determine the sum of the years (σ 𝑦𝑒𝑎𝑟𝑠) of the life of the property. If n is
the life of the property in years, and noting that the digits 1,2,3….,(n-1), n
forms an arithmetic progression, then
 𝑛
෍ 𝑦𝑒𝑎𝑟𝑠 = 𝑛 + 1
2
2.) Determine the loss in value due to the depreciation, Co – Cn.
3.) The respective annual depreciation charges are as follows:

𝑛
For the first year, 𝐶𝑜 − 𝐶𝑛 ∙ σ
𝑦𝑒𝑎𝑟𝑠
𝑛−1
For the second year, 𝐶𝑜 − 𝐶𝑛 ∙ σ 𝑦𝑒𝑎𝑟𝑠
………………………………………………………..
1
For the nth year, 𝐶𝑜 − 𝐶𝑛 ∙ σ 𝑦𝑒𝑎𝑟𝑠
For any year m, m≤n, the annual depreciation
 2 𝑛−𝑚+1
𝑑𝑚 = 𝐶𝑜 − 𝐶𝑛 ∙
𝑛 𝑛+1
Note the annual depreciation charge gradually decreases as the
property gets older. The depreciation for the first year is n times the
depreciation charge for the last year n.
6.) Straight – Line Depreciation Plus Average Interest Formula
- in this method it is assumed that the amount of capital
recovered each year is on a straight – line basis. The investment is
recovered each year by an annual amount equal to (Co –Cn)/n. Thus
the annual interest charges are not equal, and we have to determine
the average annual interest cost in order to have equal annual costs.
Interest paid at the end of the first year
𝑪𝒐 · 𝒊 + (𝑪𝒐 – 𝑪𝒏) · 𝒊
Interest paid at the end of the last year
𝑪𝒏 · 𝒊 + {(𝑪𝒐 – 𝑪𝒏)/𝒏} · 𝒊
The average of these interest is:
½{𝑪𝒐 · 𝒊 + (𝑪𝒐 – 𝑪𝒏) · 𝒊 + 𝑪𝒏 · 𝒊 + {(𝑪𝒐 – 𝑪𝒏)/𝒏} ∙ 𝒊
= (𝑪𝒐 – 𝑪𝒏) {(𝒏 + 𝟏)/𝒏} · 𝒊/𝟐 + 𝑪𝒏 · 𝒊
Thus, the annual cost (AC) is the sum of the annual depreciation plus
the average interest:
𝑨𝑪 = (𝑪𝒐 – 𝑪𝒏)/𝒏 + (𝑪𝒐 – 𝑪𝒏) {(𝒏 + 𝟏)/𝒏} 𝒊/𝟐 + 𝑪𝒏 · 𝒊

7.) Service – Output Method

In this method it is assumed that the total depreciation that has
taken place is directly proportional to the amount 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 little production. In actual practice its application
is difficult due to the uncertainty in the estimate of the economic life of
the property and its total output during that life.
Let:
𝑇 = total units of output produced during the life of the property
𝑚 = age in years of the property at any time
𝑄m = total units of output during year m
𝐷𝑚 = depreciation charge during year m
𝐶𝑜 = original cost of the property
𝐶𝑛 = book value at the end of life
𝑑1 =(Co – Cn)/T
𝐷𝑚 = Qm · d1 = (Co – Cn) · Qm/T
Problems:
1.) The original cost of a certain piece of equipment is $100,000 and it
is depreciated by a 6% sinking fund method. Determine the annual
depreciation charge if the book value of the equipment after 8 years is
the same as if it had been depreciated at $3,000 each year by straight
line formula.

2.) A company makes it the policy that for any new equipment the
annual depreciation cost should not exceed 10% of the original cost at
any time with no salvage or scrap value. Determine the length of
service life necessary if the depreciation method used is (a) straight line
formula (b) sinking fund method at 8% and (c) SYD method
3.) Julie’s Bakeshop bought a bread machine for $500,000 on June 1,
2010. It is estimated that it will have a useful life of 10 years, a scrap
value of $10,000, production of 400,000 loaves of bread and working
hours of 150,000. The company uses the machine for 15,000 hours in
2010 and 50,000 loaves in 2011. Compute the depreciation in 2011
using service-output-method.

4.) A backhoe machine was bought for $200,000 and used it for 10
years. What is the book value of the machine after 5 years if the
salvage value is $20,000 using (a) declining balance and (b) double
declining balance
3.) A contractor imported a bulldozer for his job paying $100,000 to the
manufacturer. Freight and insurance charges amounted to $18,000;
custom’s broker’s fees and other services $19,500; taxes, permits and
other initial expenses, $82,500.
If the contractor estimates the life of the bulldozer to be 10 years
with a salvage value of $12,000, determine the book value at the end
of 5 years, using (a) straight line method (b) sinking fund at 8% (c)
Matheson formula and (d) SYD method (e) Double Declining Balance.
Prepare a depreciation schedule for each.
DEPRECIATION SCHEDULE FOR STRAIGHT – LINE METHOD
YEAR BOOK VALUE AT DEPRECIATION BOOK VALUE AT END OF
BEGINNING OF YEAR YEAR

1 $220,000 $20,800 $199,200

2 199,200 20,800 178,400
3 178,400 20,800 157,600
4 157,600 20,800 136,800
5 136,800 20,800 116,000
6
7
8
9
10 $12,000
DEPRRECIATION SCHEDULE FOR SINKING FUND METHOD
YEAR BOOK VALUE AT ACCRUED DEPRECIATION BOOK VALUE AT END OF
BEGINNING OF YEAR (Dm) YEAR (Co – Dm)
(Co)
1 $220,000 $14,358.1336 $205,641.8664
2 29,864.9179 190,135.0821
3 46,612.2449 173,387.7551
4 64,699.3581 155,300.6419
5 84,233.4404 135,766.5956
6
7
8
9
10 $12,000
DEPRECIATION SCHEDULE FOR MATHESON - FORMULA
YEAR BOOK VALUE AT DEPRECIATION DURING BOOK VALUE AT END OF
BEGINNING OF YEAR THE YEAR YEAR
(Cm) (kCm) (Cm-kCm)
1 $220,000 $55,528 164,472
2 164,472 41,512.7328 122,959.2672
3 122,959.2672 31,034.9190 91,924.3482
4 91,924.3482 23,201.7055 68,722.6427
5 68,722.6427 17,345.5950 51,377.0477
6
7
8
9
10 $12,000
DEPRECIATION SCHEDULE FOR SYD METHOD
YEAR BOOK VALUE AT Factor DEPRECIATION BOOK VALUE AT
BEGINNING OF DURING THE YEAR THE END OF YEAR
YEAR FACTOR x (Co – Cn)

1 $220,000 10/55 $40,000 $180,000

2 180,000 9/55 36,000 144,000
3 144,000 8/55 32,000 112,000
4 112,000 7/55 28,000 84,000
5 84,000 6/55 24,000 60,000
6 5/55
7 4/55
8 3/55
9 2/55
10 1/55 $12,000
DEPRECIATION SCHEDULE FOR DOUBLE DECLINING BALANCE
YEAR BOOK VALUE AT ANNUAL DEPRECIATION BOOK VALUE AT END OF
BEGINNING OF YEAR k x Cm YEAR
Cm Cm - kCm
1 $220,000 $44,000 $176,000
2 176,000 35,200 140,800
3 140,800 28,160 112,640
4 112,640 22,528 90,112
5 90,112 18,022.4 72,089.6
6 72,089.6 14,417.92 57,671.68
7 57,671.68 11,534.336 46,137.344
8 46,137.344 9,227.4688 36,909.8752
9 36,909.8752 7,381.9750 29,527.9002
10 29,527.9002 5,905.58 23,622.3202
5.) An industrial plant bought a generator set for $90,000. Other
expenses including installation amounted to $10,000. The generator set
is to have a life of 13 years with a salvage value at the end of life of
$5,000. Determine the depreciation charge during the 11th year and
the book value at the end of 13 years using. Make a depreciation
schedule for each of the following:
(a) declining balance method
(b) double declining balance method
(c) sinking fund at 12%
(d) SYD