DEPRECIATION

ADVENCED ENGINEERING ECONOMY

PERPARED BY
MOHAMED ELMAHDI MANSOUR

SUPERVISED BY
DR.MEDHAT LASHIN

SPRING 2015
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Contents
INTRODUCTION .....................................................................................................................2

FACTORS IN COMPUTING DEPRECIATION .....................................................................4

DEPRECIATION METHODS ..................................................................................................5

STRAIGHT-LINE .....................................................................................................................6

DECLINING-BALANCE ..........................................................................................................8

UNITS-OF-ACTIVITY .......................................................................................................... 12

COMPARISON OF METHODS ............................................................................................. 14

OTHER METHODS ................................................................................................................ 15

UNITS OF TIME DEPRECIATION ....................................................................................... 16

GROUP DEPRECIATION METHOD ................................................................................... 16

COMPOSITE DEPRECIATION METHOD .......................................................................... 17

REFERENCE ........................................................................................................................... 18

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Introduction
Depreciation is the process of allocating to expense the cost of a plant
asset over its useful (service) life in a rational and systematic manner. Such
cost allocation is designed to properly match expenses with revenues.

Depreciation affects the balance sheet through accumulated

depreciation, which companies report as a deduction from plant assets. It
affects the income statement through depreciation expense.
It is important to understand that depreciation is a cost allocation process,
not an asset valuation process. No attempt is made to measure the change
in an asset's market value during ownership. Thus, the book value—cost
less accumulated depreciation—of a plant asset may differ significantly
from its market value. In fact, if an asset is fully depreciated, it can have
zero book value but still have a significant market value.
A method of allocating the cost of a tangible asset over its useful life.
Businesses depreciate long-term assets for both tax and accounting
purposes. The former affects the balance sheet of a business or entity, and
the latter affects the net income that they report. Generally the cost is
allocated, as depreciation expense, among the periods in which the asset is
expected to be used. This expense is recognized by businesses for financial
reporting and tax purposes. Methods of computing depreciation, and the
periods over which assets are depreciated, may vary between asset types
within the same business and may vary for tax purposes. These may be
specified by law or accounting standards, which may vary by country.

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There are several standard methods of computing depreciation expense,

including fixed percentage, straight line, and declining balance methods.
Depreciation expense generally begins when the asset is placed in service.
For example, a depreciation expense of 100 per year for 5 years may be
recognized for an asset costing 500.
Depreciation applies to three classes of plant assets: land improvements,
buildings, and equipment. Each of these classes is considered a depreciable
asset because the usefulness to the company and the revenue-producing
ability of each class decline over the asset's useful life. Depreciation does
not apply to land because its usefulness and revenue-producing ability
generally remain intact as long as the land is owned.
In fact, in many cases, the usefulness of land increases over time because
of the scarcity of good sites. Thus, land is not a depreciable asset.

During a depreciable asset's useful life its revenue-producing ability

declines because of wear and tear. A delivery truck that has been driven
100,000 miles will be less useful to a company than one driven only 800
miles.
A decline in revenue-producing ability may also occur because of
obsolescence. Obsolescence is the process by which an asset becomes out
of date before it physically wears out. The rerouting of major airlines from
Chicago's Midway Airport to Chicago-O'Hare International Airport
because Midway's runways were too short for giant jets is an example.
Similarly, many companies replace their computers long before they
originally planned to do so because improvements in new computers make
their old computers obsolete.
Recognizing depreciation for an asset does not result in the accumulation
of cash for replacement of the asset. The balance in Accumulated

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Depreciation represents the total amount of the asset's cost that the
company has charged to expense to date; it is not a cash fund.

Factors in Computing Depreciation

Three factors affect the computation of depreciation are:
1. Cost. Companies record plant assets at cost, in accordance with the
cost principle.

2. Useful life. Useful life is an estimate of the expected productive life,

also called service life, of the asset for its owner. Useful life may be
expressed in terms of time, units of activity (such as machine hours),
or units of output. Useful life is an estimate. In making the estimate,
management considers such factors as the intended use of the asset,
repair and maintenance policies, and vulnerability of the asset to
obsolescence. The company's past experience with similar assets is
often helpful in deciding on expected useful life.

3. Salvage value. Salvage value is an estimate of the asset's value at the

end of its useful life for its owner. Companies may base the value on
the asset's worth as scrap or on its expected trade-in value. Like
useful life, salvage value is an estimate. In making the estimate,
management considers how it plans to dispose of the asset and its
experience with similar assets.

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Depreciation Methods
Although a number of methods exist, depreciation is generally computed
using one of three methods:

1. Straight-line

2. Declining-balance

3. Units-of-activity

Each of these depreciation methods is acceptable under generally

accepted accounting principles. Management selects the method it believes
best measures an asset's contribution to revenue over its useful life. Once
a company chooses a method, it should apply that method consistently over
the useful life of the asset. Consistency enhances the comparability of
financial statements.

The following illustration of depreciation methods, both here and in the

appendix, is based on the following data relating to a small delivery truck
purchased by Bill's Pizzas on January 1, 2007.

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Cost $13,000
Expected salvage value $1,000
Estimated useful life (in years) 5
Estimated useful life (in miles) 100,000

Straight-Line
Under the straight-line method, companies expense an equal amount of
depreciation each year of the asset's useful life. Management must choose
the useful life of an asset based on its own expectations and experience.

To compute the annual depreciation expense, we divide depreciable cost

by the estimated useful life. Depreciable cost represents the total amount
subject to depreciation; it is calculated as the cost of the asset less its
salvage value. Next figure shows the computation of depreciation expense
in the first year for Bill's Pizzas' delivery truck.

Alternatively, we can compute an annual rate at which the company

depreciates the delivery truck. In this case, the rate is 20% (100% ÷ 5
years). When an annual rate is used under the straight-line method, the
company applies the percentage rate to the depreciable cost of the asset, as
shown in the depreciation schedule in next figure.

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Note that the depreciation expense of $2,400 is the same each year. The
book value at the end of the useful life is equal to the estimated $1,000
salvage value.
What happens when an asset is purchased during the year, rather than on
January 1 as in our example? In that case, it is necessary to prorate the
annual depreciation for the portion of a year used. If Bill's Pizzas had
purchased the delivery truck on April 1, 2007, the company would use the
truck for 9 months in 2007. The depreciation for 2007 would be $1,800
($12,000 x 20% x 9/12 of a year).

As indicated earlier, the straight-line method predominates in practice. For

example, such large companies as Campbell Soup, Marriott, and General
Mills use the straight-line method. It is simple to apply, and it matches
expenses with revenues appropriately when the use of the asset is
reasonably uniform throughout the service life. The types of assets that

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give equal benefits over useful life generally are those for which daily use
does not affect productivity. Examples are office furniture and fixtures,
buildings, warehouses, and garages for motor vehicles.

Declining-Balance

The declining-balance method computes periodic depreciation using a

declining book value. This method is called an accelerated-depreciation
method because it results in more depreciation in the early years of an
asset's life than does the straight-line approach. However, because the total
amount of depreciation (the depreciable cost) taken over an asset's life is
the same no matter what approach is used, the declining-balance method
produces a decreasing annual depreciation expense over the asset's useful
life. In early years declining-balance depreciation expense will exceed
straight-line, but in later years it will be less than straight-line. Managers
might choose an accelerated approach if they think that an asset's utility
will decline quickly.

Companies can apply the declining-balance approach at different rates,

which result in varying speeds of depreciation. A common declining-
balance rate is double the straight-line rate. Using that rate, the method is
referred to as the double-declining-balance method.

If we apply the double-declining-balance method to Bill's Pizzas'

delivery truck, assuming a five-year life, we get the pattern of depreciation
shown in next figure. The appendix which follows presents the
computations behind these numbers. Again, note that total depreciation
over the life of the truck is $12,000, the depreciable cost.

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The declining-balance method produces a decreasing annual depreciation

expense over the useful life of the asset. The method is so named because
the computation of periodic depreciation is based on a declining book value
(cost less accumulated depreciation) of the asset. Annual depreciation
expense is computed by multiplying the book value at the beginning of the
year by the declining-balance depreciation rate. The depreciation rate
remains constant from year to year, but the book value to which the rate is
applied declines each year.

Book value for the first year is the cost of the asset because the balance in
accumulated depreciation at the beginning of the asset's useful life is zero.
In subsequent years, book value is the difference between cost and
accumulated depreciation at the beginning of the year. Unlike other
depreciation methods, the declining-balance method ignores salvage value
in determining the amount to which the declining-balance rate is applied.
Salvage value, however, does limit the total depreciation that can be taken.

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Depreciation stops when the asset's book value equals its expected salvage
value.
As noted earlier, a common declining-balance rate is double the straight-
line rate—the double-declining-balance method. If Bill's Pizzas uses the
double-declining-balance method, the depreciation rate is 40% (2 × the
straight-line rate of 20%). Illustration A-1 presents the formula and
computation of depreciation for the first year on the delivery truck.

The delivery equipment is 69% depreciated ($8,320 ÷ $12,000) at the end

of the second year. Under the straight-line method it would be depreciated
40% ($4,800 ÷ $12,000) at that time. Because the declining-balance
method produces higher depreciation expense in the early years than in the
later years, it is considered an accelerated-depreciation method.

The declining-balance method is compatible with the matching principle.

It matches the higher depreciation expense in early years with the higher
benefits received in these years. Conversely, it recognizes lower
depreciation expense in later years when the asset's contribution to revenue
is less. Also, some assets lose their usefulness rapidly because of

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obsolescence. In these cases, the declining-balance method provides a

more appropriate depreciation amount.

When an asset is purchased during the year, it is necessary to prorate the

declining-balance depreciation in the first year on a time basis. For
example, if Bill's Pizzas had purchased the delivery equipment on April 1,

2007, depreciation for 2007 would be $3,900 . The book value for
computing depreciation in 2008 then becomes $9,100 ($13,000 − $3,900),
and the 2008 depreciation is $3,640 ($9,100 × 40%).

Under the units-of-activity method, useful life is expressed in terms of the

total units of production or use expected from the asset. The units-of-
activity method is ideally suited to equipment whose activity can be
measured in units of output, miles driven, or hours in use. The units-of-
activity method is generally not suitable for assets for which depreciation
is a function more of time than of use.

To use this method, a company estimates the total units of activity for the
entire useful life and divides that amount into the depreciable cost to
determine the depreciation cost per unit. It then multiplies the depreciation
cost per unit by the units of activity during the year to find the annual
depreciation for that year.

To illustrate, assume that Bill's Pizzas estimates it will drive its new
delivery truck 15,000 miles in the first year. Illustration A-3 presents the
formula and computation of depreciation expense in the first year.

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The units-of-activity method is not nearly as popular as the straight-line

method, primarily because it is often difficult to make a reasonable
estimate of total activity. However, this method is used by some very large
companies, such as Standard Oil Company of California and Boise
Cascade Corporation. When the productivity of the asset varies
significantly from one period to another, the units-of-activity method
results in the best matching of expenses with revenues.
This method is easy to apply when assets are purchased during the year. In
such a case, companies use the productivity of the asset for the partial year
in computing the depreciation.

Units-of-Activity
As indicated earlier, useful life can be expressed in ways other than a time
period. Under the units-of-activity method, useful life is expressed in terms

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of the total units of production or the use expected from the asset. The
units-of-activity method is ideally suited to factory machinery: Companies
can measure production in terms of units of output or in terms of machine
hours used in operating the machinery. It is also possible to use the method
for such items as delivery equipment (miles driven) and airplanes (hours in
use). The units-of-activity method is generally not suitable for such assets
as buildings or furniture because activity levels are difficult to measure for
these assets.

Applying the units-of-activity method to the delivery truck owned by Bill's

Pizzas, we first must know some basic information. Bill's expects to be able
to drive the truck a total of 100,000 miles. Illustration 4 shows depreciation
over the five-year life based on an assumed mileage pattern.

As the name implies, under units-of-activity depreciation, the amount of

depreciation is proportional to the activity that took place during that
period. For example, the delivery truck was driven twice as many miles in

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2008 as in 2007, and depreciation was exactly twice as much in 2008 as it

was in 2007.

Comparison of Methods
Next figure compares annual and total depreciation expense for Bill's
Pizzas under the three methods.

Periodic depreciation varies considerably among the methods, but total

depreciation is the same for the five-year period. Each method is acceptable
in accounting because each recognizes the decline in service potential of
the asset in a rational and systematic manner. Illustration 6 graphs the
depreciation expense pattern under each method.

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Other methods
Sum-of-years-digits is a depreciation method that results in a more
accelerated write-off than the straight line method, and typically also more
accelerated than the declining balance method. Under this method the
annual depreciation is determined by multiplying the depreciable cost by a
schedule of fractions.

Sum of the years' digits method of depreciation is one of the accelerated

depreciation techniques which are based on the assumption that assets are
generally more productive when they are new and their productivity
decreases as they become old. The formula to calculate depreciation under
SYD method is:

SYD Depreciation = Depreciable Base x (Remaining Useful Life/Sum of

the Years' Digits)

Depreciable Base = Cost - Salvage Value

Example: If an asset has original cost of $1000, a useful life of 5 years and
a salvage value of $100, compute its depreciation schedule.

First, determine years' digits. Since the asset has useful life of 5 years, the
years' digits are: 5, 4, 3, 2, and 1. Next, calculate the sum of the digits:
5+4+3+2+1=15

The sum of the digits can also be determined by using the formula (n2+n)/2
where n is equal to the useful life of the asset in years. The example would
be shown as (52+5)/2=15 Depreciation rates are as follows:

5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for
the 4th year, and 1/15 for the 5th year.

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Base Depreciation Depreciation Accumulated Book value at

rate expense depreciation end of year

$1,000 (original cost)

900 5/15 300 =(900 x 5/15) 300 700

900 4/15 240 =(900 x 4/15) 540 460

900 3/15 180 =(900 x 3/15) 720 280

900 2/15 120 =(900 x 2/15) 840 160

900 1/15 60 =(900 x 1/15) 900 100 (scrap value)

Units of time depreciation

Units of time depreciation is similar to units of production, and is used

for depreciation equipment used in mining or natural resource exploration,
or cases where the amount the asset is used is not linear year to year.

A simple example can be given for construction companies, where some

equipment is used only for some specific purpose. Depending on the
number of projects, the equipment will be used and depreciation charged
accordingly.

Group depreciation method

Group depreciation method is used for depreciating multiple-asset

accounts using straight-line-depreciation method. Assets must be similar
in nature and have approximately the same useful lives.

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Composite depreciation method

The composite method is applied to a collection of assets that are not

similar, and have different service lives. For example, computers and
printers are not similar, but both are part of the office equipment.
Depreciation on all assets is determined by using the straight-line-
depreciation method.

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Reference
 Kimmel, Paul. D., Weygandt, Jerry. J. & Kieso, Donald. E. (2006).
Financial Accounting: Tools for Business Decision Making (4th
ed.). Hoboken, NJ: John Wiley & Sons. Used with permission from
the publisher.
 http://economictimes.indiatimes.com
 https://en.wiktionary.org/wiki/depreciation

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