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Depreciation

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Lilian Gauiran
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16 views22 pages

Depreciation

Uploaded by

Lilian Gauiran
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Depreciatio

n
Learning Objectives
The student should be able to:
• Describe depreciation, deterioration, and
obsolescence.
• Distinguish various types of depreciable
property and differentiate between depreciation
expenses and other business expenses.
• Use historical depreciation methods to calculate
the annual depreciation charge and book value
over the asset’s life.
• Explain the differences between the historical
depreciation methods and the modified
accelerated cost recovery system (MACRS).
Learning Objectives
• Use MACRS to calculate allowable annual
depreciation charge and book value over
the asset’s life for various cost bases,
property classes, and recovery periods.
• Fully account for capital gains/losses,
ordinary losses, and depreciation recapture
due to the disposal of a depreciated
business asset.
• Use the units of production and depletion
depreciation methods as needed in
engineering economic analysis problems.
• Use spreadsheets to calculate depreciation.
Basic Aspects of Depreciation
The word depreciation is defined as a “decrease in
value.”
In economic analysis, value may refer to either market
value or value to the owner.

For example, an assembly line is far more valuable to


the manufacturing firm that it was designed for, than it
is to a used equipment market.

Thus, we now have two definitions of depreciation: a


decrease in value to the market or a decrease
to the owner.
Deterioration and Obsolescence
A machine may depreciate because it is deteriorating,
or wearing out and no longer
performing its function as well as when it was new.

Many kinds of machinery require increased


maintenance as they age, reflecting a slow but
continuing failure of individual parts.

In other types of equipment, the quality of output may


decline due to wear on components and resulting
poorer mating of parts.
Deterioration and Obsolescence
Depreciation is also caused by obsolescence.

A machine that is in excellent working condition, and


serving a needed purpose, may still be obsolete.

In the 1970s, mechanical business calculators with


hundreds of gears and levers became obsolete.

The advance of integrated circuits resulted in a


completely different and far superior approach to
calculator design.
Deterioration and Obsolescence
The accounting profession defines depreciation in yet
another way, as allocating an asset’s cost over its useful
or depreciable life. Thus, we now have three distinct
definitions of depreciation:
1. Decline in market value of an asset.
2. Decline in value of an asset to its owner.
3. Systematic allocation of an asset’s cost over its
depreciable life.
Depreciation and Expenses
It is the third (accountant’s) definition that is used to
compute depreciation for business assets.

Business costs are generally either expensed or


depreciated.

Expensed items, such as labor, utilities, materials, and


insurance, are part of regular business operations and
are “consumed” over short periods of time (sometimes
recurring).

These costs do not lose value gradually over time.

For tax purposes they are subtracted from business


revenues when they occur.

Expensed costs reduce income taxes because


businesses are able to write off their full amount when
they occur.
Depreciation and Expenses
In contrast, business costs due to capital assets
(buildings, forklifts, chemical plants, etc.) are not fully
written off when they occur.

Capital assets lose value gradually and must be written


off or depreciated over an extended period.

For instance, consider an injection-molding machine


used to produce the plastic beverage cups found at
sporting events.

Depreciable life is determined by the depreciation


method used to spread out the cost—depreciated
assets of many types operate well beyond their
depreciable life.
Depreciation and Expenses
Depreciation is a noncash cost that requires no
exchange of dollars.
Companies do not write a check to someone to pay
their depreciation expenses.

Rather, these are business expenses that are allowed


by the government to offset the loss in value of
business assets.

In general, business assets can be depreciated only if


they meet the following basic requirements:
1. The property must be used for business purposes to
produce income.
2. The property must have a useful life that can be
determined, and this life must be longer than one year.
3. The property must be an asset that decays, gets
used up, wears out, becomes obsolete, or loses value
to the owner from natural causes.
Sample Problem:
Consider the costs that are incurred by a local pizza
business. Identify each cost as either expensed or
depreciated and describe why that term applies.
• Cost for pizza dough and toppings
• Cost to pay wages for janitor
• Cost of a new baking oven
• Cost of new delivery van
• Cost of furnishings in dining room
• Utility costs for soda refrigerator
Types of Property
The rules for depreciation are linked to the
classification of business property as either tangible or
intangible.
Tangible property is further classified as either real or
personal.
Tangible property can be seen, touched, and felt.

Real property includes land, buildings, and all things


growing on, built upon, constructed on, or attached to
the land.

Personal property includes equipment, furnishings,


vehicles, office machinery, and anything that is tangible
excluding assets defined as real property.

Intangible property is all property that has value to


the owner but cannot be directly seen or touched.
Examples include patents, copyrights, trademarks,
trade names, and franchises.
Depreciation Calculation Fundamental
To understand the complexities of depreciation, the first
step is to examine the fundamentals of depreciation
calculations.

Figure 11-1 illustrates the general depreciation problem


of allocating the total depreciation charges over the
asset’s depreciable life.

The vertical axis is labeled book value.

At time zero the curve of book value starts at the cost


basis
(= the first cost plus installation cost).

Over time, the book value declines to the salvage


value. Thus, at any point in time:

Book value = Asset cost−Depreciation charges


made to date
Straight Line Depreciation
The simplest and best known depreciation method is
straight-line depreciation.
To calculate the constant annual depreciation charge,
the total amount to be depreciated, B − S, is divided by
the depreciable life, in years, N
Sample Problem:
Consider the following (in $1000):
Cost of the asset, B: $900
Depreciable life, in years, N: 5
Salvage value, S: $70
Compute the straight-line depreciation schedule.
Sum-of-the-Years’-Digits Depreciation
Another method for allocating an asset’s cost minus
salvage value over its depreciable life is called sum-of-
years’-digits (SOYD) depreciation.

This method results in larger than- straight-line


depreciation charges during an asset’s early years and
smaller charges as the asset nears the end of its
depreciable life. Each year, the depreciation charge
equals a fraction of the total amount to be depreciated
(B−S).

The denominator of the fraction is the sum of the years’


digits
Sum-of-the-Years’-Digits Depreciation

where = depreciation charge in any year t


N = number of years in depreciable life
SOYD = sum of years’ digits, calculated as N(N + 1)/2
B = cost of the asset made ready for use
S = estimated salvage value after depreciable life
Sample Problem:
Compute the SOYD depreciation schedule (in $1000):
Cost of the asset, B: $900
Depreciable life, in years, N: 5
Salvage value, S: $70
Declining Balance Depreciation
Declining balance depreciation applies a constant
depreciation rate to the property’s declining book value.

Two rates were commonly used before the 1981 and


1986 tax revisions, and they are used to compute
MACRS depreciation percentages.

These are 150 and 200% of the straight-line rate.

Since 200% is twice the straight-line rate, it is called


double declining balance, or DDB; the general equation
is

Since book value equals cost minus depreciation


charges to date,
Sample Problem:
Compute the DDB depreciation schedule (in $1000):
Cost of the asset, B: $900
Depreciable life, in years, N: 5
Salvage value, S: $70
Sample Problem:
It
Sample Problem:
It

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