Depreciation1.ppt

Depreciation
• Introduction
• Definition
• Purpose of depreciation
• Types of depreciation
• Important Terms
• Methods for determining depreciation

Depreciation
• It is fact that value of physical asset
decrease with time .
• The factors for this :
– Physical deterioration
– Technology advances
– Economical changes etc.

Depreciation
• All these factors will cause a retirement of
the property. The reduction in value due to
any of these causes is called depreciation.
• The economic function of depreciation is a
means of disturbing original expenses for
a physical asset over the period for which
the asset in use.

Depreciation
• Depreciation is also defined as a reasonable
allowances for wear & tear of the property in
business including a reasonable allowances for
obsolescence
• The cost of the property is distributed over a
estimated period.
• To determine the depreciation it is necessary to
estimate life period of equipments and final
value at the end of life period.

Purpose of depreciation
• It permits realistic evolution of profit
earned by company
• It gives income tax benefit on profit earned
• A fund is set aside regularly to provide
recovery of the capital invested.

Types of depreciation
• Physical depreciation
– The decrease in value due to changes in physical
aspect of the property:
• Wear and tear
• Corrosion
• Accident
• Deterioration due to age
• Due to this type of depreciation, the
serviceability of the property is reduced because
of physical changes.

• Functional depreciation:
– The depreciation due to all other causes is called
functional depreciation:
• Obsolescence
• Change in demand
• Shifting of population
• Change in requirement of public authority
• In sufficient capacity for the service required
• Abandonment of the enterprise

• It is necessary to consider all possible
causes when depreciation is to be
determined.
• Physical losses are easier to evaluate
than the Functional losses.
• Both losses are accounted to make
fair allowances for depreciation.

Important Terms
• Depletion
• Capacity loss due to materials actually
consumed is measured as depletion.
– Depletion cost =
(The initial cost) X (Amount of material used)
(original amount of material purchased)
• This type of depreciation is particularly
applicable to natural resources, such as
- stands of timber
- mineral and oil
- Crude oil

SERVICE LIFE
• The period during which the use of a
property is economically feasible is known
as the service life of the property.
• Both physical and functional depreciation
are taken into consideration in determining
service life
• The term is also known as economic or
useful life.

SALVAGE VALUE
• Salvage value is the net amount of money
obtainable from the sale of used property over
and above any charges involved in removal and
sale.
– If a property is capable of further service, its salvage
value may be high.
• It depends on various factors:
-Location of the property,
-Existing price levels,
-Market supply and demand,
-Difficulty of dismantling,

Scrap, or Junk value.
• If the property cannot be disposed of as a
useful unit, it can often be dismantled and
sold as junk
• The profit obtainable from such disposal is
known as the Scrap, or Junk, value.
-This can be used again as a
manufacturing raw material.

Important terms
• Salvage value, Scrap value, and Service life are
usually estimated on the basis of conditions at
the time the property is put in use.
• These factors cannot be predicted with absolute
accuracy, but improved estimates can be made
as the property increases in age.
• It is advisable, therefore, to make new estimates
from time to time during the service life and
make any necessary adjustments in the
depreciation costs.

PRESENT VALUE
• The present value of an asset may be
defined as the value of the asset in its
condition at the time of valuation.
• There are several different types of
present values.
• Standard meanings of the various types
should be distinguished.

Book Value, or Unamortized Cost
• The difference between the original cost of
a property, and all the depreciation
charges made to date is defined as the
Book value
• Sometimes called Unamortized Cost
• It represents the worth of the property as
shown on the owner’s accounting records.

Market Value
• The price which could be obtained for an
asset if it were placed on sale in the open
market is designated as the Market value.
• The use of this term conveys the idea that
the asset is in good condition and that a
buyer is readily available.

Replacement Value
• The cost necessary to replace an existing
property at any given time with one at least
equally capable of rendering the same service is
known as the Replacement value.
• It is difficult to predict future market values or
replacement values with a high degree of
accuracy because of fluctuations in market
demand and price conditions.

Methods For Determining
Depreciation
• Depreciation costs can be determined by a
number of different methods
• Government sanctioned methods for
determining depreciation costs, both for
income-tax calculations and for reporting
the concern’s costs and profits.
• So the design engineer should understand
the bases for the various methods.

Methods For Determining
Depreciation
• In general, depreciation accounting methods
may be divided into two classes:
– (1) Arbitrary methods giving no consideration to
interest costs:
– Straight-line
– Declining-balance
– Double declining-balance
– Sum-of-the-years-digits
– (2) methods taking into account interest on the
investment.
– Sinking-fund
– The present-worth

Straight-Line Method
• In the straight-line method for determining depreciation,
it is assumed that the value of the property decreases
linearly with time.
• Equal amounts are charged for depreciation each year
throughout the entire service life of the property.
• The annual depreciation cost may be expressed in
equation form as follows:
d= V - Vs
n
Where d = annual depreciation,
V = original value of the property at start of service life
Vs = salvage value of property at end of service life
n = service life, years

Straight-Line Method
• The asset value (or book value) of the equipment at any time during the
service life may be determined from the following equation:
Va = V - a d
Va= asset or book value,
a = the number of years in actual use.
• Because of its simplicity, the straight-line method is widely used for
• Because it is impossible to estimate exact service lives and salvage values
when a property is first put into use, it is sometimes desirable to re-estimate
these factors from time to time during the life period of the property.
• If this is done, straight-line depreciation can be assumed during each of the
periods, and the overall method is known as Multiple Straight-Line
depreciation.

Declining-Balance (or Fixed
Percentage) Method
• In this method, annual depreciation cost is a fixed
percentage of the property value at the beginning of the
particular year.
• The fixed-percentage (or DB) factor remains constant
throughout the entire service life of the property,
• Annual cost for depreciation is different each year.
• The depreciation cost for the first year
= V * f,
where f = Fixed-percentage factor.

Declining-Balance Method
• At the end of the first year Asset value =
Va1, = V(1 - f)
• At the end of the second year
Va2 = V(1 - f)2
• At the end of 3 years
Va3 = V(1 - f)3
• At the end of n years (i.e., at the end of service life)
Van = V(1 - f)n = Vs
Therefore, Vs = (1 - f)n
V
f = 1- (Vs / V)1/n
This equation represents the method for determining the fixed percentage
factor, and the equation is sometimes designated as the Matheson
formula.

• This method permits the investment to be
paid off more rapidly during the early years
of life.
• The increased depreciation costs in the
early years are very attractive.
• This reduces the income-tax load and
recovery of depreciation is rapid in early
years.

• This method is seldom used in actual
practice, because it places too much
emphasis on the salvage value.
• If salvage value is zero this method can
not be used.
• To overcome this problem, the value of the
fixed-percentage factor[ f = 2/n] is often
chosen arbitrarily using a sound economic
basis.

• The value of the asset cannot be zero at
the end of the service life and may
possibly be greater than the salvage or
scrap value.
• To handle this difficulty, sometimes for
early portion of service life declining-
balance method is used and for remaining
service life, straight-line method is used
this is known as the combination method

• The main advantage of this method that they
permit greater depreciation allowances in the
early life of the property than in the later life.
• They are particularly applicable for units in which
the greater proportion of the production occurs in
the early part of the useful life or when operating
costs increase markedly with age

Double declining-balance method
• This is also known as 200 percent method.
• This method using a fixed-percentage factor giving a
depreciation rate equivalent to twice the minimum rate
with the straight-line method
• Straight-line method:
– V= 22,000/-, Vs=2000/- n = 10 years
– d = (V-Vs)/n = 2000/- per year
– depreciation rate f = (d/V) = 2000/22000 =
0.1818
• the double declining-balance method is often applied to
cases where the salvage value is considered to be zero.
• Under this condition, double declining-balance , this
fixed-percentage factor for this example would be
(0.2000.)

Sum-of-the-Years-Digits Method
• This method is an arbitrary process for
determining depreciation
• Results are similar to those obtained by
the declining-balance method.
• Larger costs for depreciation are allotted
during the early-life years than during the
later years.
• This method has the advantage of
permitting the asset value to decrease to
zero or a given salvage value at the end of
the service life.

• The annual depreciation is based on the
number of service-life years remaining and
the sum of the arithmetic series of
numbers from 1 to n service life.
• The yearly depreciation factor
F = The number of service-life years left
The sum of the arithmetic series.
Annual Depreciation = FX Depreciable value
d = F X (V-Vs)

• The Equations for determining annual
depreciation by this method are
• d = depreciation =
=

Sinking-Fund Method
• The use of compound interest is involved
in the sinking-find method.
• It is assumed that the basic purpose of
depreciation allowances is to accumulate
a sufficient fund to provide for the recovery
of the original capital invested in the
property.

Sinking-Fund Method
• An ordinary annuity plan is set up wherein
a constant amount of money should
theoretically be set aside each year.
• At the end of the service life, the sum of all
the deposits plus accrued interest must
equal the total amount of depreciation.

Sinking-Fund Method
• Derivation of the formulas for this method:
• Let,
• i =annual interest rate expressed as a fraction
• R = uniform annual payments made at end of
each year (this is the annual depreciation cost)
• V-Vs = total amount of the annuity accumulated
in an estimated service life of n years
• (original value of property minus salvage value
at end of service life),

Sinking-Fund Method
• For simple interest
• S = P + Z= P (1 + in)
– Where P =Principal amount I = Interest rate
Z = interest Amount n= no of years
Interest Z = P . i . N
Total Amount including Interest =
S = P +Z = P + P .i .n = P ( 1+i.n)

Sinking-Fund Method
• Compound Interest :
Year Principal
Amount
Interest
earned
Compound amount
S= P+Z
1 P P . i P + P. i = P(1+i)
2 P(1+i) P(1+i) . i P(1+i)+ P(1+i) . i
= P(1 + i )2
3 P(1 + i )2 P(1 + i )2. i P(1 + i )2 +P(1 + i )2. i
= P(1 + i )3

Sinking-Fund Method
• So after n years
• Sn = P (l + i )n
• (l + i )n= discrete single-payment
compound-interest factor.
• Let,
• R =Uniform periodic payment
• S = Total compound amount
• i = Rate of interest

Sinking-Fund Method
• The first payment of R is made at the end
of the first year and will bear interest for
(n – 1) periods giving an accumulated
amount of R(1 + i)n-1
• The second payment of R is made at the
end of the second period and will bear
interest for n - 2 periods = R(1 + i)n-2

Sinking-Fund Method
• Similarly, each periodic payment will give an
additional accumulated amount until the last
payment of R is made at the end of the (n-n)
annuity term.
• S =R(l + i)n-l +R(l + i)n-2+R(l + i)n-3+*..+R(l + i)+ R
• multiply each side by (1 + i) and subtract from
the result.
• This gives:
• Si = R(1 + i)n - R 0r
• S = {R[(1 + i)n – 1] /i }

Sinking-Fund Method
• S = Total depreciation = V – Vs
• [V-Vs] ={R[(1 + i)n – 1] /i }
• R = [V-Vs] {1/[(1 + i)n – 1]}
• After ‘a’ years depreciation collected up
to ‘a’ years = V-Va [ Va= asset value]
• [V-Va] ={R[(1 + i)a – 1] /i }
• Putting value of R
• [V-Va] =(V-Vs){[(1 + i)a – 1] / [(1 + i)n – 1]}
• Va=V-(V-Vs){[(1 + i)a – 1] / [(1 + i)n – 1]}

PRESENT WORTH
• It is often necessary to determine the
amount of money which must be available
at the present time in order to have a
certain amount accumulated at some
definite time in the future.
• Because the element of time is involved,
interest must be taken into consideration.
P = S/(l + i )n

Depreciation1.ppt

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Depreciation1.ppt