IT2007

DEPRECIATION

Fundamentals

• Depreciation is one of the costs considered in every balance sheet and income statement.
The depreciation can be applied to land, machine, equipment, or tools that decrease in
value through time.

• Depreciation is the decrease in the value of physical properties through time. More
specifically, depreciation is an accounting concept that establishes an annual deduction
against a 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.

• The purpose of the annual depreciation deductions is to match the yearly fraction of value
used by an asset in the production of income over the asset’s actual economic life. The
actual amount of depreciation can never be established until the asset is retired from
service.

• Depreciable property is the property that is eligible for depreciation deductions such as
vehicles, real estate, machinery, and heavy equipment. Simply put, they are the assets
that have a tendency to lose value over time. As such, every asset that loses its value over
time because of usage or obsolescence can be considered a depreciable property.
Depreciable property items tend to be long-term assets because they have a life span of
more than a year. Depreciation for the depreciable property is considered by the tax laws
as one form of expense to a business entity that could potentially decrease the income of
the business or organization.

• To determine if depreciation can be applied at a certain property, it must follow some basic
requirements. First, it must be used in business or held to produce income. Second, it must
have a determinable useful life, which must be longer than one year. Third, it must be
something that wears out, decays, gets used up, becomes obsolete, or loses value from
natural causes. Lastly, it is not inventory, stock in trade, or investment property.

• Depreciable property is classified as either tangible or intangible. Tangible property can

be seen or touched. It has two main types, namely personal property and real property.
Personal properties include assets such as vehicles, equipment, furniture, machinery, and
similar items. Real property, on the other hand, refers to land and generally anything that
is erected on, growing on, or attached to land. However, the land itself is not depreciable
because it does not have a determinable life.

• Intangible property is personal property such as copyright, patent, and franchise.

• A property begins to depreciate when it is placed in service when it is ready and available
for a specific use, even if it is not actually used yet. Depreciation stops when the cost of
placing an asset in service has been stopped.

• Depreciation can be classified in three ways according to how property changes through
time. The first type is normal depreciation, which includes both the physical and functional
depreciation of a property. Physical depreciation is applied because of the lessening of
a property’s physical ability to produce results. Its common causes are wear and
deterioration. Functional depreciation or obsolescence is applied because of the
lessening in demand for the function that the property was designed to render. Its common
causes are inadequacy, changes in styles, population centers shift, saturation in markets
or more efficient machines are produced.

• Another type of depreciation is the depreciation due to changes in price levels. However,
this is almost impossible to predict and, therefore, is not considered in economic studies.

• Lastly, a property can deplete the value of the resource base when natural resources are
being consumed in producing products or services. For example, a certain farm produces

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1 thousand acres every end of May. When the harvest season is done, and crops have
already been gathered, the price of that farm will decrease or deplete. The farm is only as
good as the crops it could produce. If through time it could no longer produce the same
amount of crops, the farm is said to be depleting through time.

• The depreciation formula involves many symbols. The original installed cost of the
depreciable property (P) is the initial cost of acquiring an asset. The depreciable or
useful life of the asset (N) is the expected period that a property will be used in a trade or
business to contribute to income and not how long the property will last. The salvage value
(F) is the estimated value of a property at the end of its depreciable life. The annual
depreciation is represented by dn to denote a depreciation charge for year n. To avoid
confusion, the notation n is different from the notation N in that the symbol “n” denotes a
specific period in time like year 3 or year 4, whereas “N“ pertains to the total number of
periods equal to the useful life of the asset like after a span of 3 years or after a span of 4
years. The symbol Dn, on the other hand, is the accumulated depreciation charges from
the time of acquisition up to the end of the year n. This symbol is the summation of all
annual depreciation (dn). Lastly, the symbol BVn represents the book value of the asset
at the end of year n. It is the worth of a depreciable property at a current period.

Depreciation Methods

• The Straight Line Method is the simplest and most widely used depreciation method. This
method assumes that a constant amount is depreciated each year over the depreciable life
of the asset. SLM can be applied using the formula:

P−F
dn =
N
D n = nd n
BVn = P − D n

P−F
• The equation d n = pertains to the depreciation charge for a certain year n, which is
N
equal to the difference between the original cost of the asset and its salvage value at the
end of its useful life divided by the total number of periods the asset can still be used.

• The equation D n = nd n pertains to the accumulated depreciation at the end of a certain

year n, which is equal to the number of periods that had passed since year n multiplied by
the depreciation per period.

• The equation BVn = P − D n pertains to the book value of the asset at the end of a certain
year n, which is equal to the difference between the original cost of the asset and the
accumulated depreciation as of year n.

Illustrative Example:

An electronic lumber cutter was initially bought at a price of ₱200,000 and has a 10-year
depreciable life. At the end of 10 years, the cutter will have no more useful value. Using the
SLM method:

Solution:

a. Determine the annual depreciation in the 4th year of its useful life.

P − F 200,000 − 0
d4 = = = 20,000
N 10

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b. Compute for the book value of the cutter in the 4th year of its useful life.

D4 = n  d 4 = 4  20,000 = 80,000
BV4 = P − D4 = 200,000 − 80,000 = 120,000

c. Find the accumulated depreciation at the end of its useful life.

P − F 200,000 − 0
d10 = = = 20,000
N 10
D10 = n  d10 = 10  20,000 = 200,000

• The Sum-of-the-Years-Digit (SYD) Method considers the digits corresponding to the

number of each permissible year of life. These digits are first listed in reversed order to
determine the sum of these digits. The depreciation factor for any year is the number from
the reverse-oriented listing for that year divided by the sum of the digits. For example, for
a property having a depreciable (useful) life of 5 years, SYD depreciation factors are as
follows.

No. of the Year in SYD Depreciation

Year
Reverse Order Factor
1 5 5/15
2 4 4/15
3 3 3/15
4 2 2/15
5 1 1/15
Sum of the
15
Digits

• The depreciation for any year is the product of the SYD depreciation factor that year and
the difference between the initial cost of acquiring an asset and the estimated final salvage
value. The formula for the annual cost of depreciation for any year n, the accumulated
depreciation and book value, when N is equal to the useful life of an asset is as follows:

 2( N − n + 1) 
d n = (P − F)  
 N( N + 1) 
 (2 N − n + 1)n 
D n = (P − F)  
 N( N + 1) 
BVn = P − D n

• The notations in the formula are similar to the one used in the straight-line method. To avoid
confusion, take note that the symbol “N” pertains to the total useful life of an asset, whereas
the symbol “n” is the current period in the span of the useful life when the depreciation will be
computed.

Illustrative Example:

An electronic lumber cutter was initially bought at a price of ₱200,000 and has a 10-year
depreciable life. At the end of 10 years, the cutter will have no more useful value. Using the
SYD method:

Solution:

a. Determine the annual depreciation in the 4th year of its useful life.

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 2( N − n + 1) 
d 4 = (P − F)  
 N( N + 1) 
 2(10 − 4 + 1) 
d 4 = (200,000 − 0)  
 10(10 + 1) 
d 4 = 25,454.55

b. Find the accumulated depreciation at the end of year 4.

 (2 N − n + 1)n 
D 4 = (P − F)  
 N( N + 1) 
 (2(10) − 4 + 1)4 
D 4 = (200,000 − 0)  
 10(10 + 1) 
D 4 = 123,636.36

c. Compute for the book value of the cutter in the 4th year of its useful life.

BV4 = P − D4 = 200,000 − 123,636.36

BV4 = 76,363.64

• The Sinking Fund Method is another depreciation method which assumes that a sinking
fund is established in which funds will accumulate for replacement purposes and will bear
interest. It is a method of depreciation under which the depreciation expense is an amount
of an annuity so that the amount of the annuity at the end of the useful life would equal the
acquisition cost of the asset. Theoretically, the depreciation charge should include an
interest in accumulated depreciation at the beginning of the period. This method is rarely
used in practice. The sinking fund formula is applied using the following formula:

 i 
d n = (P − F)  
 (1 + i) − 1 
N

 (1 + i) n − 1
Dn = d n  
 i 
BVn = P − D n

The notations in the formula are similar to that of the straight line method. The value of
each notation will just have to be plugged in the formula to arrive at the depreciation charge
per period, the accumulated depreciation at the end of a certain period n, and the book
value at the end of period n.

Illustrative Example:

An asset for drilling was purchased and placed in service by a petroleum production
company. Its cost basis is ₱60,000, and it has an estimated salvage value of ₱12,000 at
the end of 14 years. The interest in the sinking fund is 10%. What is the annual
depreciation and using the sinking fund formula? Lastly, what are the book value and
accumulated depreciation at the end of 5 years?

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Solution:
𝑖
𝑑𝑛 = (𝑃 − 𝐹) [ ]
(1 + 𝑖)𝑁 − 1
0.10
𝑑𝑛 = (60,000 − 12,000) [ ] = 1,715.82
(1 + 0.10)14 − 1
(1 + 0.10)5 − 1
𝐷5 = 1,715.82 [ ] = 10,475.25
0.10
𝐵𝑉5 = 60,000 − 10,475.25 = 49,524.75

• The Declining Balance (DB) Method, which is also called the Matheson formula, assumes
that the annual cost of depreciation is a fixed percentage of the book value 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 to 1).

DB% / 100%
R=
N
BVn = P(1 − R ) n
d n = RBVn −1 = RP (1 − R ) n −1
D n = P − BVn = P [1 − (1 − R ) n ]

• The notations for this formula are the same as that of the straight line method, only that
there is an additional notation of R. In the formula, R=2/N when 200% declining balance is
used and R=1.5/N when 150% declining balance is used.

Illustrative Example:

An electronic lumber cutter has a cost basis of ₱200,000 and 10-year depreciable life. At
the end of 10 years, the cutter will have no more useful value. When a 150% declining
balance is being used, determine the following:

Solution:

a. Depreciation at the end of year 4 of the cutter’s depreciable life.

DB % / 100% 150% / 100% 1.5

R= = = = 0.15
N 10 10
d 4 = RP (1 − R) n−1 = (0.15)(200,000)(1 − 0.15) 3
d 4 = 18,423.75

b. Book value at the end of year 4 of the cutter’s depreciable life.

BV4 = P(1 − R) n = 200,000(1 − 0.15) 4

BV4 = 104,401.25

c. Accumulated depreciation at the end of year 4.

D4 = P − BV4 = 200,000 − 104,401.25

D4 = 95,598.75

• All the depreciation methods discussed are based on elapsed time (years) on the theory
that the decrease in value of the property is mainly a function of time. When the decrease
in value depends more on the function of use, depreciation may be based on a method not
expressed in terms of years rather on the units of production. Such a method results in the
acquisition cost of the asset minus the salvage value being allocated equally over the

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estimated number of units produced during the asset’s useful life. The formula to get the
depreciation per unit of production is:

Illustrative Example:

A photocopier for business use has a cost basis of ₱250,000 and will have a salvage value
of ₱50,000 if it will be replaced after 33,000 hours of use.

Solution:

a. To get the depreciation rate, use the formula:

Depreciati on per P−F

=
unit of production Estimated lifetime production in units
Depreciati on per 250,000 − 50,000
= = 6.06 / hr
unit of production 33,000

b. To get the book value after 12,000 hours of use, subtract the depreciation cost for
12,000 hours to the initial acquisition cost of the equipment. So after 12,000 hours,

 6.06 
BV = 250,000 − 12,000hrs  
 hr 
BV = 177,280

REFERENCES:
Blank, L. & Tarquin A. (2018). Engineering economy (8th ed.). McGraw-Hill.

Khan, Z., Siddiquee, A., Kumar, B., & Abidi, M. (2018). Principles of engineering economics with applications
(2nd ed.). Cambridge University Press.

Sharma, K.R. (2015). An introduction to engineering economics. Momentum Press Engineering.

Sullivan et al. (2006). Understanding engineering economy (13th Edition). New Jersey: Pearson Education Inc.

Yates, J.K. (2017). Engineering economics. CRC Press.

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