Chapter 3

Depreciation
Prepared by:
Definition
• Depreciation is the decrease in the value of
physical property with the passage of time.
• Value, in a commercial sense, is the present worth
of all future profits that are to be received through
ownership of a particular property.
• The market value of a property is 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.
• The utility or use value of a property is what the
property is worth to the owner as an operating unit.
Fair Value, Book Value, Salvage and
Scrap Value
• Fair value is the value which is usually determined
by a disinterest third party in order to establish a
price that is fair to both seller and buyer.
• Book value, sometimes called depreciated book
value, is the worth of a property as shown on the
accounting records of an enterprise.
• Salvage, or resale, value is the price that can be
obtained from the sale of the property after it has
been used.
• Scrap value is the amount the property would sell
for if disposed off as junk?
Purpose of Depreciation
1. To provide for the recovery of capital which
has been invested in physical property.

2. To enable the cost of depreciation to be

charged to the cost of producing products or
services that results from the use of the
property.
Types of Depreciation
• Normal Depreciation
▫ Physical
▫ Functional
• Depreciation due to changes in price levels
• Depletion
Physical and Functional 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

in the demand for the function which the property
was designed to render. Its common causes are
inadequacy, changes in styles, population centers
shift, saturation of markets or more efficient
machines are produced.
Price Depreciation and Depletion
• Depreciation due to the changes in price
levels is almost 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.
Physical and Economic Life
• 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.
Requirements of a Depreciation
Method
1. It should be simple.
2. It should 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
• We shall 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
The Straight Line Method
• This method assumes that the loss in value is
directly proportional to the age of the property.

d = Co – CL (3-1)
L

Dn = n(Co - CL) (3-2)

L

Cn = Co – Dn (3-3)
Problem 3-1
• An electronic balance costs 90,000 Birr and has
an estimated salvage value of 8,000 at the end of
its 10 years life time.

• What would be the book value after three years,

using the straight line method in solving for the
depreciation?
Solution
1. Write the given
Co = 90,000 Birr CL = 8,000 Birr L = 10 n = 3

2. Substitute the given using the formula of d

d = Co - CL = 90,000 – 8,000 = 8,200 Birr

L 10
3. Solve for D
D3 = (n)(d) = (3) (8,200 Birr) = 24,600

4. Compute for C
Co = Co – D3 = 90,000 Birr – 24,600 Birr
= 65,400 Birr (Ans.)
The Sinking Fund Formula
• This method assumes that a sinking fund is
established in which funds will accumulate for
replacement.

• 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.
Formula

d = Co – CL (3-4)
F/A, i%, L

Dn = d(F/A, i%, n) (3-5)

Cn = Co - Dn (3-6)
Problem 3-2
• A broadcasting corporation purchased an equipment
for 53,000 Birr and paid 1,500 Birr for freight and
delivery charges to the job site. The equipment has
a normal life of 10 years with a trade-in value of
5,000 Birr 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 6-1/2%
compounded annually.
Solution
1. Determine Co and CL

Co = 53,000 Birr + 1,500 Birr = 54,500 Birr

2. Compute for d
(a) d = Co - CL = 54,000 Birr – 5,000 Birr
L 10
= 4,950 Birr (Ans.)

(b) d = Co - CL = 54,000 Birr – 5,000 Birr

F/A, i%, L F/A, 6.5%, 10
= 49,500 Birr = 3,668 Birr (Ans.)
13.3846
PROBLEM 3-3
• A firm brought an equipment for 56,000 Birr.
Other expenses including installation amounted
to 4,000 Birr. 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.
SOLUTION
1. Determine Co, CL, and write the given

Co = 56,000 Birr + 4,000 Birr = 60,000 Birr

CL = 60,000 Birr (0.10) = 6,000 Birr

L = 16, n =12, I = 12%

(a) Straight Line Method
d = Co - CL = 60,000 Birr – 6,000 Birr
L 16
= 3,375 Birr

D12 = (d) (n) = 3,375 Birr (12) = 40,500 Birr

C12 = Co - D12 = 60,000 Birr – 40,500 Birr

= 19,500 Birr (Ans.)
(b) Sinking Fund Method
d = Co - CL = 60,000 – 6,000
F/A, 12%, 16 42.7533
= 1,263 Birr

D12 = (d) (F/A, 12%, 12) = 1,263 Birr (24.1331)

= 30,480 Birr

C12 = Co - D12 = 60,000 Birr – 30,480 Birr

= 29,520 Birr (Ans.)
Declining Balance Method
• In this 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 salvage value at the
beginning of the year. The ratio of the
depreciation in any year to the book value at the
beginning of the year is constant throughout the
life of the property and is designated by k, the
rate of depreciation.
Cash Flow Diagram
Derivation of Formula
Year Book Value at Depreciation Book value at the
beginning of during the end of year
year year

1 Co d1 = kCo C1 = C0 – d1 = C0(1 – k)
2 Co(1-k) d2 = kC1 C2 = C1 – d2 = C0(1 – k)2
3 Co(1-k)2 d3 = kC2 C3 = C2 – d3 = C0(1 – k)3
- - - -
n Co(1-k)n-1 dn = kCn-1 Cn = Cn-1 – dn = C0(1 – k)n
- - - -
L Co(1-k)L-1 dL = kCL-1 CL = CL-1 – dL = C0(1 – k)L
Formula for Declining Balance
dn = Co(1 – k)n-1k (3-7)

Cn = Co(1 – k)n = C o CL n/L (3-8)

Co

CL = Co(1 – k)L (3-9)

k =1- = 1- (3-10)

This method does not apply, if the salvage value is zero,

because k will be equal to one and d1 will be equal to Co.
Problem 3-4
• A certain type of machine loses 10% of its value
each year. The machine costs 2,000 Birr
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.
Solution
Year Book Value Depreciation Total Depreciation Book Value
at beginning during the at the end of at the end
of year year 10% year of year (Ans.)

1 2,000.00 Birr 200.00 Birr 200.00 Birr 1,800.00 Birr

2 1,800.00 180.00 380.00 1,620.00
3 1,620.00 162.00 542.00 1,458.00
4 1,458.00 145.80 687.80 1,312.20
5 1,312.20 131.22 819.12 1,180.98
Double Declining Balance (DDB)
Method
• This method is very similar to the declining balance
method except that the rate of depreciation k is
replaced by 2/L. When the DDB method is used, the
salvage value should not be subtracted from the first
cost when calculating the depreciation charge.

dn = Co(1 – )n-1 (3-11)

Cn = Co(1 – )n (3-12)

CL = Co(1 – )L (3-13)
Problem 3-5
• 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 15,000 Birr new and has an estimated
scrap value of 2,000 Birr at the end of 10 years
by (a) the declining balance method and (b) the
double declining balance method.
Solution
• Write the given

Co = 15,000 Birr CL = 2,000 Birr

L = 10 n=8

• Solve using (a) Declining balance method

k=1- =1- = 0.1825 or 18.25%

C8 = Co (1 – k)8 = 15,000 (1 – 0.1528)8

= 2,992 Birr (Ans.)

D8 = Co – C8 = 15,000 – 2,992 = 12,008 Birr

Solve using (b) Double declining
balance method
Rate of depreciation = = = 0.20 or 20%

C8 = Co(1 – )8 = 15,000 (1 – )8 = 2,517 Birr

D8 = Co – C8 = 15,000 – 2,517 = 12,483 Birr

(Ans.)
Problem 2-6
• A plant brought a calciner for 220,000 Birr and
used it for 10 years, the life span of the
equipment. What is the book value of the
calciner after 5 years of use? Assume a scarp
value of 20,000 Birr for straight line method;
22,000 Birr for textbook declining balance
method and 20,000 for the declining balance
method.
Solution
• Write the given

Co = 220,000 Birr L = 10
n=5

• Solve using (a) Straight Line Method using CL =

20,000 Birr

D5 = = = 100,000

C5 = Co - D5 = 220,000 – 100,000
= 120,000 Birr (Ans.)
Solve using (b) Declining Balance
Method using Cl = 22,000 Birr

• C5 = Co = 220,000

= 69,570 Birr (Ans.)

Solve using (d) Double Declining
Balance Method using CL = 20,000 Birr

• C5 = Co(1 – )5 = 220,000 (1 – )5

= 72,090 Birr (Ans.)

The Sum-of-the-Years’-Digits (SYD)
Method
• Let dn = depreciation charge during the nth year

dn = (depreciation factor)(total depreciation)

dn = reverse digit (Co – CL) (3-14)

sum of digits
For example, for a property whose life
is 5 years
Year Year in Depreciation Depreciation
Reverse Order Factor during the
year
1 5 5/15 (5/15)(Co – CL)
2 4 4/15 (4/15)(Co – CL)
3 3 3/15 (3/15)(Co – CL)
4 2 2/15 (2/15)(Co – CL)
_5 1 1/15 (1/15)(Co – CL)
Summation of digits = 15
Problem 3-7
• A structure costs 12,000 Birr new. It is
estimated to have a life of 5 years with a salvage
value at the end of life of 1,000 Birr. Determine
the book value at the end of year of life.
Solution
• Solve for Co - CL
Co – CL = 12,000 Birr – 1,000 Birr = 11,000 Birr
• Tabulate the data
Year Year in Depreciation Depreciation
Reverse Order Factor during the year
1 5 5/15(11,000) 8,333
2 4 4/15(11,000) 5,400
3 3 3/15(11,000) 3,200
4 2 2/15(11,000) 1,733
_5 1 1/15(11,000) 1,000
Summation of digits = 15
Problem 3-8
• A consortium of international telecommunication
companies contracted for the purchase and
installation of a fiber optic cable linking two major
cities at a total cost of 960 Million Birr. This
amount includes freight and installation charges
estimated at 10% of the above contract price. If the
cable shall be depreciated over a period of 15 years
with zero salvage value:
• Given the sinking fund deposit factor of 0.0430 at
6% interest where n = 15, what is the annual
depreciation charge?
• What is the depreciation charge during the 8th year
using the sum-of-the-years-digits method?
Solution
• Write the given

Co = 960,000,000 Birr CL = 0 L = 15

• Solve for the annual depreciation charge using (a)

sinking fund method.

d = Co - CL = (Co - CL)(A/F, 6%, 15)

F/A, 6%, 15
= 960,000,000(0.0430)

= 41,280,000 Birr (Ans.)

Solve for the depreciation charge
during the 8th year using (b) the-sum-
of-the-years-digits method.

• Sum of digits = = = 120

• Reverse digit corresponding to the 8th year of life

=8

• d8 = (960,000,000) = 64,000,000 (Ans.)

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.
• Let T = total units of output up to the end of life

Qn = total number of units of output during the

nth year

• Depreciation per unit of output =

• dn = Qn (3-15)
Problem 3-9
• A Television Company purchased machinery for 100,000
on July 1, 1979. It is estimated that it will have a useful
life of 10 years; scrap value of 4,000 Birr, 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 each method
given below:
a) Straight Line
b) Working Hours
c) Output Method
Solution
• Write the given

Co = 100,000 Birr CL = 4,000

L = 10 years T = 400,000 units
H = 120,000 hours

• Solve using (a) Straight Line Method

• d80 = =

= 9,600 Birr (Ans.)

• Solve using (b) Working Hours

d80 = H80 = (18,000)

= 14,400 Birr (Ans.)

• Solve using (c) Output Method

d80 = Q80 = (44,000)

= 10,560 Birr (Ans.)

What Depreciation Method Should Be
Used?
• It is worth mentioning what the National Internal
Revenue Code says about depreciation specifically
Section 29 (f).
1. General Rule. “There shall be allowed as a
depreciation deduction a reasonable allowance for the
exhaustion, wear and tear (including reasonable
allowance for obsolescence) of property used in the
trade or business.
2. Use of certain methods and rates. The term
“reasonable allowance” as used in the preceding
paragraph shall include (but not limited to) an
allowance computed in accordance with regulations
prescribed by the Secretary of Finance, under any of
the following methods:
 a) The Straight Line Method
b) Declining Balance Method, using a rate not
exceeding twice the rate which would have been
used had the annual allowance been computed
under the method described in paragraph (f) (1).
c) The Sum-of-the-Year-digits method, and
d) Any other method which may be prescribed by
the Secretary of Finance upon recommendation
of the Commissioner of Internal Revenue.

• Notes: Taxpayer may enter into an “agreement in

writing specifically dealing with the useful life and
rate of depreciation of any property, the rate so
agreed shall be biding.”
Problem 3-10
• A machine costs 7,000 Birr last 8 years and has
salvage value at the end of life of 350 Birr.
Determine the description charge during the 4th
year and the book value at the end of 4 years by
the (a) straight line method, (b) declining
balance method, (c) SYD method, and (d)
sinking fund method with interest at 12%.
Solution
• Write the given

Co = 7,000 Birr CL = 350

L=8 n=4

• Solve using (a) Straight Line Method

d80 = = = 831 Birr

C4 = Co - D4 = 7,000 – 831(4)
= 3,676 Birr (Ans.)
Solve using (b) Declining Balance
Method

k=1- =1- = 0.3123

d4 = Co (1 – k)4-1 k = 7,000 (1 – 0.3123)3 (0.3123)

= 711 Birr

C4 = Co (1 – k)4 = 7,000 (1 – 0.3123)4 = 1,566

Birr (Ans.)
Solve using (c) SYD Method
1 8 Sum of digits = = 36
2 7
3 6 d4 = (5/36)(7,000 – 350) = 924 Birr
4 5_
5 26 D4 = (26/36)(7,000 – 350)
6 = 4,803 Birr
7
8_ C4 = Co – D4 = 7,000 – 4,803
36 = 2,197 Birr (Ans.)
Solve using (d) Sinking Fund Method
d = Co - CL = 7,000 Birr – 350 Birr
F/A, 12%, 8 12.2997
= 541 Birr

D4 = (d) (F/A, 12%, 4) = 541 Birr (4.7793)

= 2,586 Birr

C4 = Co - D4 = 7,000 Birr – 2,586 Birr

= 4,414 Birr (Ans.)
Problem 3-11
• A machine costs 20,000 Birr and has a salvage
value of 2,000 Birr after a useful life of 8 years.
Money is worth 12%. If average inflation is 8%
per year during this period, what is the annual
cost of depreciation to replace the machine after
8 years? What is the annual cost of depreciation
if inflation is not considered?
Solution
• With inflation:
Future cost = PC (1 + F)n = 20,000 (1 + 0.08)8 =
37,018 Birr

• A= = = 3,009.67
Without inflation:

• A= =

= 1.463 Birr (Ans.)

Valuation
• Valuation or appraisal is the process of determining the
value of certain property for specific reasons. The
person engaged in the task of valuation is called an
appraiser.

• Intangible Values
• In the determination of the value of industrial property
or equipment, four intangible items are often
encountered.
• Goodwill is that element of value which a business has
earned through the favorable consideration and
patronage of its customers arising from its well-known
and well-conducted policies and operation.
• Franchise is an intangible item of value arising
from the exclusive right of a company to provide
a specific product in a stated region of the
country.
• Going value is an intangible value which an
actually operating concern has due to its
operation.
• Organization cost is the amount of money spent
in organizing a business and arranging for its
financing and building.
End of Chapter 3