Chapter -05 Depreciation

 CONTENTS :

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 DEPRECIATION CONCEPT AND TERMINOLOGY
 METHODS OF DEPRECIATION
 STRAIGHT LINE METHOD,
 DECLINING BALANCE METHOD ,
 SINKING FUND METHOD ,
 SUM OF THE YEAR DIGIT METHOD
 MODIFIED ACCELERATED COST RECOVERY SYSTEM ( MACRS) )

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Concept and Terminology of Depreciation :
 Gradual decrease in the capital value of assets .
 It is the decrease in the value of assets with the passage of time .
 Most assets lose their value with the passage of time and must be replaced at the
end of the useful life .

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 The amount of the annual depreciation depends upon following factors :
• Investment in the property
• Date placed in service .
• Estimated useful life .
• Estimated salvage value .
• Method of Depreciation used .
• Estimated expenditure for repair .
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Common Terms used in Depreciation :

 Initial Cost : It is the total cost of acquiring the asset .

 Salvage Value : It represents estimated market value of the asset at the end of
its useful life . It is the expected cash inflow that the owner of the asset will

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receive by disposing it at the end of the useful life .
 Book Value : It is the value of asset recorded on the accounting books of the firm
at a given time period . It is generally calculated at the end of each year . Book
Value at the end of a given year equals the initial cost less the total depreciation
amount till that year .
Book Value = Original Cost –Amount of Depreciation at last year
 Useful Life : It represents the expected number of years the asset is useful in
terms of generating revenue . Useful life is also known as depreciable life . The
asset is depreciated over its useful life .
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 Basic Methods of Depreciation :

 The Commonly used Depreciation Methods are :

1) Straight Line Depreciation Method ( SL- Method )
2) Declining Balance Method ( DB Method )

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3) Sum of Years – digits Method (SYD/SOYD Method )
4) Sinking Fund Method
5) Modified Accelerated Cost Recovery System ( MACRS)
6) Double Declining Balance Method ( DDB Method )
7)Unit Rate Method
8) Declining and Double declining balance method switchover to Straight Line

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1) Straight Line Method ( SL- Method )
 In this methods of depreciation , fixed sum is charged as depreciation
amount through the lifetime of an asset such that the accumulated sum at the
end of the life of the asset is exactly equal to the purchase value of asset .

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Here , we make an important assumptions that inflation is absent .
=
= -
Where , - Depreciation Amount of Year .
I – Investment
SV – Salvage Value
N – Useful life of asset
- Book Value in Year .
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 Q. 1 A Machine costs Rs. 2,00,000 now . Its Salvage Value is Rs.30,000 after 6 Years .
Calculate Depreciation amount and corresponding Book Value in each Year .
Solution : SL- Depreciation Rate ( = = = 28,333.333

End of Year SL- Book Value

Depreciation

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0 _ 2,00,000
1 28,333.33 1,71666.66
2 28,333.33 1,43333.33

3 28,333.33 1,15,000.00

4 28,333.33 86,666.67

5 28,333.33 58333.33

6 28,333.33 30,000 = Salvage Value

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2) Declining Balance Method ( DB – Method )
• In this method a constant percentage of the book value of the previous period of the asset
will be charged as the depreciation amount for the current period .
• This approach is more realistic approach since the depreciation charge decrease with the life of the
asset which matches with the earning potential of the asset .
• The main limitation of this approach is that, the book value at the end of the life of the asset may

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not be exactly equal to the salvage value .

• DB- Depreciation rate , r = 100% / N

 Case –I : If Salvage value is not given

Q. A machine costs Rs.1,00,000 now . Calculate depreciation and corresponding book value in each
year for 5 year.
Solution : DB –Depreciation rate , r = 100% /N = 100% / 5 = 20%
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End of DB- depreciation (@20% ) Book Value
Year

0 _ 1,00,000

1 1,00,000*20% =20,000 80,000

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2 80,000*20%= 16,000 64,000

3 64,000 *20% = 12,800 51,200

4 51,200*20%= 10,240 40,960

5 40960*20%= 8192 32,768 = Salvage Value

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 • Mathematically Calculations :
= I ( 1- r ) ,
where r= Depreciation rate , I= Investment

= ( 1- r ) , =

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=
Salvage Value ) =
Case II : If Salvage value is given

Q. A machine costs Rs.1,00,000 now. Calculate depreciation and corresponding book value in
each year for 5 year if salvage value is Rs.20,000 .

solution : Salvage Value ) =

20,000= r = 27.52 %

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End of Year DB- depreciation (@27.52% ) Book Value

0 _ 1,00,000

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1 1,00,000*27.52% =27,520 72,480

2 72,480*27.52%= 19,946.496 52,533.504

3 52,533.504*27.52%= 14,457.2203 38,076.2837

4 38,076.2837*25.52%=10,478.59327 27,597.69043

5 27,597.69043*27.52%=7,594.884 20,002.80¬¬20,000= Salvage

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3 ) Sum of Year- digits Method (SYD – SOYD Method ) :
 It is also known as accelerated depreciation method .
 This method ensures that the full capital invested in a project is recovered at the end
of project’s life .
In this method the annual depreciation rate for any year is calculated by dividing the
number of years left in the useful life of the asset by sum of years over the useful

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life .

SOYD = * ( I-S)
Sum of First N natural numbers =
= ( I- ) * (SOY multification Factor )
 Under this method , depreciation per annum is calculate on the basis of proportion of total
number of estimated life year of an asset .

Q. Given data , I= Rs1,00,000 , = 20,000 , N = 5 Years

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End of Year in SOYD SOYD Depreciation Book Value
Year reverse Depreciation
Order Factor
0 __ __ __ 1,00,000

1 5 5/15 (1,00,000-20,000) * 73,333.333

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5/15=26,666.67
2 4 4/15 80,000*4/15=21,333.333 52,000

3 3 3/15 80,000*3/15=16,000 36,000

4 2 2/15 80,000*2/15=10,666.67 25,333.333

5 1 1/15 80,000*1/15= 5,333.333 20,000 = (Salvage

Value )
SOYD =15
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4) Modified Accelerated Cost Recovery System ( MACRS) :
• MACRS is the only depreciation method approved for use in the U.S. For income tax purposes .
• It was created in 1986 and prescribed by the Internal Revenue Service (IRS) .
• MACRS is the most commonly used depreciation method for computing income tax liability .
• MACRS is now the principal method for computing depreciation .

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• It calculates depreciation for tax purposes .
• MACRS assigns a class ( tax life ) to various kinds of property .
• MACRS gives percentage depreciation for each year.
• The depreciation amount is the percentage times the initial cost .
• Depreciation in the first year (for personal property ) is based on the assumption that the asset was
purchased halfway through the year .

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 Half Year Convention

 Current system in U.S.

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 Assumed all assets are place in service at mid –year and they have zero salvage value .

 Property class 3,5,7,10,15,20,27.5,39 Years

 Double rate for 3,5,7and 10 years classes.

 1.5 rates for 15 and 20 Years classes .

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Q. Given data , I= 1,00,000, 5 Year property class , Salvage value = 0
DDB depreciation rate , R = 200% / N 200%/ 5 = 40%
EOY Year DDB Depreciation (@40%) SL-Depreciation Actual Book Value
factor Deprec
iation
0 ___ ___ ___ ____ 1,00,000

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1 0.5 1,00,000*40%*0.5 =20,000 1,00,000*0.5/5=10,000 20,000 80,000

2 1 80,000*40%*1= 32,000 80,000*1/4.5=17,777.78 32,000 48,000

3 1 48,000*40%*1=19200 48,000*1/3.5=13,714.28 19,200 28,800

4 1 28,800*40%*1=11,520 28,800*1/2.5=11,520 11,520 17,280

(Switch)

5 1 17,280*40%*1=6912 17,280*1/1.5=11,520 11,520 5,760

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6 0.5 5,760*40%*0.5=1152 5,760*0.5/0.5=5,760 5,760 0= Salvage
Value
5) Sinking Fund Method :
• Under the Sinking fund method , the business sets aside an amount of money to
invest annually so that the Principal Plus the interest earned in the fund will be
enough to replace the asset .
• This is the only method that include interest rate to calculate depreciation .
• Annual Equivalent Amount / Fixed depreciation =

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Q. Given data , I = 1,00,000
= 20,000
Life = 5 Years
Interest Rate i% = 12 %

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Annual Equivalent Amount / Fixed depreciation =
Annual Equivalent Amount / Fixed depreciation =
Annual Equivalent Amount / Fixed depreciation = 9,600/0.76234
Annual Equivalent Amount / Fixed depreciation = 12,592.806

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EOY Fixed Depreciation Net Depreciation Book Value

0 ____ ____ 1,00,000

1 12,592.77 12,592.77 87,407.23

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2 12,592.77 12,592.77* = 73,330.333
14,103.90

3 12,592.77 12,592.77* = 57,506.959

15,796.3706

4 12,592.77 12,592.77* 39,815.0244

=17,691.935

5 12,592.77 12,592.77* 20,000 = 20

=19,814.967
 NUMERICAL

Q. A Tax payer wants to place in service a Rs10,000 asset that is assigned to the

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5 Years class . Compute the MACRS percentage and depreciation amount for
the asset .
Solution : Straight Line Rate = 100% /N = 100%/5 = 20%
DDB = 200%/N = 200/ 5 = 40%
Under MACRS , Salvage Value = 0

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 Year Calculation Calculation Actual Decision
Yea Factor DDB Dep. % SL Dip.% MACRS
r %
1 0.5 ½* Year DDB= ½*40%=20% ___ 20% Don’t
Switch

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2 1 0.4(100%-20%)*1 =32% 1*80%/4.5=17.7% 32% Don’t
Switch

3 1 0.4(100%-20%-32%)*1 1*48%/3.5=13.7% 19.2% Don’t

=19.2% Switch

4 1 0.4(100%-20%-32%- 1*28.8%/2.5=11.52% 11.52% Switch to

19.2%)*1 =11.52% SLD

5 1 0.4(100%-20%-32%-19.2%- 1*17.28%/1.5=11.52% 11.52% Don’t

11.52%)*1 =6.912% Switch

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6 0.5 0.4(100%-20%-32%-19.2%- 0.5*5.76%/0.5=5.76% 5.76% Don’t
11.52%-11.52%)*0.5 Switch
=1.152%
Year MACRS ( %) Depreciation Basis Depreciation Amount

1 20% 10,000 10,000*20%=2,000

2 32% 10,000 10,000*32%=3,200

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3 19.2% 10,000 10,000*19.2%=1,920

4 11.52% 10,000 10,000*11.52%=1,152

5 11.52% 10,000 10,000*11.52%=1,152

6 5.76% 10,000 10,000*5.76%=5,76 23

THANK YOU

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