Depreciation

Depreciation Concepts
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 an asset’s value can be reflected
in a firm’s financial statements.
Depreciation is a noncash cost that is intended to “match” the yearly fraction of value used by an
asset in the production of income over the asset’s life. The actual amount of depreciation can
never be established until the asset is retired from service. Because depreciation is a noncash cost
that affects income taxes, we must consider it properly when making after-tax engineering
economy studies.
To determine whether depreciation deductions can be taken, the classification of various types of
property must be understood. In general, property is depreciable if it meets the following basic
requirements:
1. It must be used in business or held to produce income.
2. It must have a determinable useful life and the life must be longer than one year.
3. It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from
natural causes.
4. It is not inventory, stock in trade, or investment property
Value of an Asset
Models of depreciation can be used to estimate the loss in value of an asset over time, and also to
determine the remaining value of the asset at any point in time. This remaining value has several
names, depending on the circumstances.
Market value is usually taken as the actual value an asset can be sold for in an open market. Of
course, the only way to determine the actual market value for an asset is to sell it. Consequently,
the term market value usually means an estimate of the market value.
Book value is the depreciated value of an asset for accounting purposes, as calculated with a
depreciation model. The book value may be more or less than market value.
Scrap value can be either the actual value of an asset at the end of its physical life (when it is
broken up for the material value of its parts) or an estimate of the scrap value calculated using a
depreciation model.
Salvage value can be either the actual value of an asset at the end of its useful life (when it is
sold) or an estimate of the salvage value calculated using a depreciation model.
The Classical Depreciation Methods
Straight-Line (SL) Method
SL depreciation is the simplest depreciation method. It assumes that a constant amount is

depreciated each year over the depreciable (useful) life of the asset. If we define
N = depreciable life (recovery period) of the asset in years;
B = cost basis, including allowable adjustments;
dk = annual depreciation deduction in year k(1 ≤ k ≤ N);
BVk = book value at end of year k;
SVN = estimated salvage value at end of year N; and
d∗k = cumulative depreciation through year k,
then dk = (B - SVN)/N, (1)

d∗k = k · dk for 1 ≤ k ≤ N, (2)
BVk = B - d∗k (3)
Note that, for this method, you must have an estimate of the final SV, which
will also be the final BV at the end of year N. In some cases, the estimated SVN may
not equal an asset’s actual terminal Market Value (MV).
Example 1 SL Depreciation
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.
Solution
The depreciation amount, cumulative depreciation, and BV for each year are obtained by
applying Equations (1), (2), and (3). Sample calculations for year three are as follows:
d3 = = $36,000
d*3 = 3( ) = $ 108,000
BV3 = $200,000 - $108,000 = $92,000

The depreciation and BV amounts for each year are shown in the following table.
EOY,k dk BVk
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
Note that the BV at the end of the depreciable life is equal to the SV used to calculate the yearly
depreciation amount.
Declining-Balance (DB) Method
In the DB method, sometimes called the constant-percentage method or the Matheson formula, it
is assumed that the annual cost of depreciation is a fixed percentage of 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 is designated by R (0 ≤ R ≤ 1). In this method, R =
2/N when a 200% DB is being used (i.e., twice the SL rate of 1/N), and N equals the depreciable
(useful) life of an asset. If the 150% DB method is specified, then R = 1.5/N. The following
relationships hold true for the DB method:
d1 = B(R), (4)
dk = B(1-R)k-1(R) (5)
d*k = B[1- (1-R)k] (6)
BVk = B(1-R)k (7)
Example 2 DB Depreciation
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 SV 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.
Solution
Annual depreciation, cumulative depreciation, and BV are determined by using Equations (5),
(6), and (7), respectively. Sample calculations for year six are as follows:
(a)
R = 2/10 = 0.2,
d6 = $4,000(1 - 0.2)5(0.2) = $262.14,
d∗6 = $4,000[1 - (1 - 0.2)6] = $2,951.42,
BV6 = $4,000(1 - 0.2)6 = $1,048.58.
(b)
R = 1.5/10 = 0.15,
d6 = $4,000(1 - 0.15)5(0.15) = $266.22,
d∗6 = $4,000[1 - (1 - 0.15)6] = $2,491.40,
BV6 = $4,000(1 - 0.15)6 = $1,508.60.
The depreciation and BV amounts for each year, when R = 2/N = 0.2, are shown in the following
table:
200% DB Method Only

EOY, k dk BVk
0 — $4000
1 $800 3200
2 640 2560
3 512 2048
4 409.60 1638.40
5 327.68 1310.72
6 262.14 1048.58
7 209.72 838.86
8 167.77 671.09
9 134.22 536.87
10 107.37 429.50

Depreciation

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Depreciation Concepts

1. It must be used in business or held to produce income.

4. It is not inventory, stock in trade, or investment property

Straight-Line (SL) Method

SL depreciation is the simplest depreciation method. It assumes that a constant amount is

N = depreciable life (recovery period) of the asset in years;

B = cost basis, including allowable adjustments;

dk = annual depreciation deduction in year k(1 ≤ k ≤ N);

BVk = book value at end of year k;

SVN = estimated salvage value at end of year N; and

d∗k = cumulative depreciation through year k,

then dk = (B - SVN)/N, (1)

BV3 = $200,000 - $108,000 = $92,000

Declining-Balance (DB) Method

200% DB Method Only

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