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Chapter 16

Depreciation Methods

May ,2023 Dr. Mansour Abou Gamila 1

LEARNING OBJECTIVES
This chapter will help you to:
• Understanding and use the basic terminology of depreciation.
• Apply the straight line model of depreciation.
• Apply the declining balance and double declining balance
models of depreciation.
• Apply the Modified Accelerated Cost Recovery System
(MACRS) of depreciation for U.S. corporations.
• Select the recovery period of an asset for MACRS
depreciation.
• Utilize the cost depletion and percentage depletion

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Factors to Consider in Asset

Depreciation

• Depreciable life (how long?)

• Salvage value (disposal value)

• Cost basis (depreciation basis)

• Method of depreciation (how?)

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Depreciation is the decrease in value of

physical properties with the passage of time.

• 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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16.1 Depreciation Terminology

Depreciation: is the reduction in value of asset.

• The depreciation may be performed for two reasons:

– Recording asset reduction in the internal financial
accounting (called Book depreciation).
– Use in tax calculations per government regulations. This is
tax depreciation.

• First Cost or Unadjusted Basis (B)

– Initial purchase price + all costs incurred in placing the
asset in service (Installation the asset: including purchase
price, delivery, installation fees, and other depreciable
direct costs incurred to prepare the asset of use.
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16.1 Depreciation Terminology

• Book Value (BV): The remaining un-depreciated capital
investment on the book after the total amount of depreciation
charges to date have been subtracted from the basis.
• Recovery Period (n): is the depreciable life n of the asset in years.
• Market Value (MV): is the estimated amount realizable if the
asset were sold on open market.
• Salvage Value (S): is the estimated trade-in value or market value
at the end the asset’s useful life.
• Depreciation Rate (dt): is the fraction of the first cost removed by
depreciation each year.
• Personal Property: one of the two types of property for which
depreciation is allowed, is the income producing, tangible
possessions of a corporation used to conduct business. e.g.
machinery, equipment, vehicles, telephone, computers, furniture,
etc..
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16.1 Depreciation Terminology

 Real Property: include real estate and all improvements, e.g.
office building, manufacturing structure, test facilities, warehouses,
etc.
 Half-year convention: Assumes the assets are placed in service or
disposed off in midyear.

• Depreciation Models
 Straight line (SL) depreciation model : Asset’s value decrease
linearly with time.

 Declining balance (DB) depreciation model : Asset’s value

decrease according to a fixed percentage.

 Sum of year digits (SYD) : An accelerated depreciation

technique that includes an arithmetic gradient.
 Modified accelerated cost recovery system (MACRS): is a
modified version of accelerated cost recovery system that is used
to calculate the depreciation for tax deduction in the USA law.
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16.1 Depreciation Terminology

• General shape of Book value Curves for Different Depreciation

Models

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16.2 Straight Line (SL) Depreciation

 Straight Line (SL) term is derived from the fact that the book value
decreases linearly with time.
 The depreciation rate d = 1/n is the same each year up to the period
of recovery n.
 Therefore, the annual depreciation amount is calculated by
multiplying the first cost minus the salvage value by d:
Notation:
t = year (t = 1,2,...,n)
BS
D t = annual depreciation charge Dt  ( B  S ) d 
n
B = first cost or unadjusted basis BVt  B  tDt
S = Estimated salvage value 1
d dt 
n
n = recovery period
d t = depreciation rate

Using excel function the annual depreciation amount is calculated by:

SLN(B,S,n)
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16.2 Straight Line (SL) Depreciation

Example 16.1, Page 418
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) calculate and plot the book value of the asset after each
year, using straight line depreciation.

B = $50,000; “n” = 5 years;

S = $10,000 at t = 5;

(a) The annual depreciation amount Dt is:

B  S 50,000  10,000
Dt     $8,000
n 5
Using Excel function:
– Enter the function SLN(50000,10000,5) in any cell to display
$8,000/year
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16.2 Straight Line (SL) Depreciation

Example 16.1 Cont.
(b) The book value amount BVt is:
• BV1 = $50,000 -1($8000) = $42,000
• BV5 = $50,000 -5($8000) = $10,000 = S

BS 1
Dt  , d  dt 
n n
EOY,t Dt BVt
1 $8,000 $42,000
2 8,000 34,000
3 8,000 26,000
The book values
4 8,000 18,000 decline at the same
rate down to
5 8,000 10,000 $10,000

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16.2 Straight Line (SL) Depreciation

Example 16.1 Cont.

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16.2 Straight Line (SL) Depreciation

Example :
B = $200,000; “n” = 5 years; S = $ 20,000 at t = 5;
(a) The annual depreciation amount dk is:
($200,000 - $20,000)/5 = $36,000/year

b) The book value amount BVt is:

BV1 = $200,000 -1($36000) = $164,000
BV5 = $200,000 -5($36000) = $20,000 =S
EOY,t Dt BVt
0 -- $200,000
1 $36,000 $164,000
2 $36,000 $128,000
3 $36,000 $92,000
4 $36,000 $56,000
5 $36,000 $20,000
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16.2 Straight Line (SL) Depreciation

Example
Air handling equipment that costs $12,000 has a life of 8 years with a $2000 salvage value.
(a) Calculate the straight line depreciation amount for each year. (b) Determine the book
value after 3 years. (c)What is the rate of depreciation?
B = $12,000; “n” = 8 years; S = $ 2,000
a. The annual depreciation amount dk is: ($12,000 - $2,000)/8 = $1,250/year
b. BV3 = $12,000 -3($1250) = $8,250
c. d =1/n = 1/8 = 0.125
EOY,t Dt BVt
0 -- $12,000
1 $1,250 $10,750
2 $1,250 $9,500
3 $1,250 $8,250
4 $1,250 $7,000
5 $1,250 $5,750
6 $1,250 $4,500
7 $1,250 $3,250
8 $1,250 $2,000 15
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16.2 Straight Line (SL) Depreciation

Example
Simpson and Jones Pharmaceuticals purchased a prescription drug
tablet-forming machine in 2004 for $750,000. They had planned to use
the machine for 10 years, but due to rapid obsolescence it should be
retired after 4 years. Calculate the following.
(a) What is the amount of capital investment remaining when the asset
is retired due to obsolescence?
(b) If the asset is sold at the end of 4 years for $75,000, what is the
amount of capital investment lost based on straight line
depreciation?
(c) If the new technology machine has an estimated cost of $300,000,
how many more years should the company retain and depreciate the
currently owned machine to make its book value and the first cost
of the new machine equal?

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16.2 Straight Line (SL) Depreciation

Example (cont.):
(a) dt = 1/n = 1/10 = 0.1
Dt = 0.1* 750,000 = $75,000
BV4 = B – t(Dt) = 750,000 – 4(75,000) = $450,000

(b) Loss = BV4 - selling price = 450,000 – 75,000 =

$375,000
(c) Two more years when book value is $300,000

Sum-of-Years’ Digits (SOYD) Method

• Principle
Depreciation concept similar to DB but with decreasing depreciation rate.

Charges a larger fraction of the cost as an expense of the early years than
of the later years.
• Formula
•Annual Depreciation
D n  ( B  S )( N  n  1) / SOYD
•Book Value

BVn  I  nj1 D j where SOYD=N(N+1)/2

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Example:
Time-Based Method: Sum-of-the-Years’
Digits
Years of service remaining at beginning of year Years
Remaining
1 5
2 4
3 3
4 2
5 1
Sum-of-the-Years’-Digits = 15 15

(n + 1) n = 30 = 15
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Time-Based Method: Sum-of-the-Years’

Digits
B = $120,000
N = 5 years
SV = $20,000
SOYD = 15
Depreciation Book Value at
Year Base Fraction Depreciation Year-End
2006 $100,000 5/15 $ 33,333 $86,667
2007 100,000 4/15 26,667 60,000
2008 100,000 3/15 20,000 40,000
2009 100,000 2/15 13,333 26,667
2010 100,000 1/15 6,667 20,000
$100,000
Residual
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Example – Sum-of-years’ digits method

Annual Depreciation
$10,000
Book Value

Total depreciation at end of life

D1 B = $10,000
$8,000
N = 5 years
SV = $2,000
$6,000 SOYD = 15
D2

B1 D3
$4,000
n Dn Bn
B2 D4 1 (5/15)(8,000)=$2,667 $7,333
2 (4/15)(8,000)=$2,133 5,200
D5 3 (3/15)(8,000)=$1,600 3,600
$2,000
B3 4 (2/15)(8,000)=$1,067 2,533
5 (1/15)(8,000)=$533 2,000
0 B4 B5
0 1 2 3 4 5 n

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