Chapter 16

Depreciation
Methods
Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

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 LEARNING OUTCOMES
1. Understand basic terms of asset depreciation
2. Apply straight line method of depreciation
3. Apply DB and DDB methods of depreciation;
switch between DDB and SL methods
4. Apply MACRS method of depreciation
5. Select asset recovery period for MACRS
6. Explain depletion and apply cost depletion &
percentage depletion methods

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 Depreciation Terminology

Definition: Book (noncash) method to represent decrease in value of

a tangible asset over time
Two types: book depreciation and tax depreciation

Book depreciation: used for internal accounting to track value of assets

Tax depreciation: used to determine taxes due based on tax laws

In USA only, tax depreciation must be calculated using MACRS;

book depreciation can be calculated using any method

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 Common Depreciation Terms
First cost P or unadjusted basis B: Total installed cost of asset
Book value BVt: Remaining undepreciated capital investment in year t
Recovery period n: Depreciable life of asset in years
Market value MV: Amount realizable if asset were sold on open market
Salvage value S: Estimated trade-in or MV at end of asset’s useful life
Depreciation rate Dt: Fraction of first cost or basis removed each year t

Personal property: Possessions of company used to conduct business

Real property: Real estate and all improvements (land is not depreciable)
Half-year convention: Assumes assets are placed in service in midyear
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 Straight Line Depreciation
Book value decreases linearly with time

B
Dt = n- S Where: Dt = annual depreciation charge
t = year
B = first cost or unadjusted basis
S = salvage value
n = recovery period

BVt = B - tDt Where: BVt = book value after t years

SL depreciation rate is constant for each year: d = dt = 1/n

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 Example: SL Depreciation

An argon gas processor has a first cost of $20,000 with a

$5,000 salvage value after 5 years. Find (a) D3 and (b) BV3
for year three. (c) Plot book value vs. time.

Solution: (a ) D3 = (B – S)/n
= (20,000 – 5,000)/5 (c) Plot BV vs. time
= $3,000 BVt
20,000

(b) BV3 = B – tDt 11,000

= 20,000 – 3(3,000) 5,000
= $11,000
0 3 5 Year, t

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 Declining Balance (DB) and
Double Declining Balance (DDB) Depreciation
Determined by multiplying BV at beginning of year by fixed percentage d

Max rate for d is twice straight line rate, i.e., d ≤ 2/n

Cannot depreciate below salvage value

Depreciation for year t is obtained by either relation:

Dt = dB(1 – d)t-1 = dBVt-1
Where: Dt = depreciation for year t
d = uniform depreciation rate (2/n for DDB)
B = first cost or unadjusted basis
BVt -1 = book value at end of previous year
Book value for year t is given by:
BVt = B(1 – d)t
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 Example: Double Declining Balance

A depreciable construction truck has a first cost of $20,000 with a

$4,000 salvage value after 5 years. Find the (a) depreciation, and
(b) book value after 3 years using DDB depreciation.

Solution: (a) d = 2/n = 2/5 = 0.4

D3 = dB(1 – d)t-1
= 0.4(20,000)(1 – 0.40)3-1
= $2880

(b) BV3 = B(1 – d)t

= 20,000(1 – 0.4)3
= $4320

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 Spreadsheet Functions for Depreciation

Straight line function: SLN(B,S,n)

Declining balance function: DB(B,S,n,t)

Double declining balance function: DDB(B,S,n,t,d)

Note: It is better to use the DDB function for DB and DDB

depreciation. DDB function checks for BV < S and is more
accurate than the DB function.
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 Switching Between Depreciation Methods
Switch between methods to maximize PW of depreciation
t=n
PWD = ∑ Dt (P/F,i%,t)
t=1

A switch from DDB to SL in latter part of life is usually better

Can switch only one time during recovery period
Procedure to switch from DDB to SL:
1) Each year t compute DDB and SL depreciation using the relations
DDDB = d(BVt-1) and DSL = BVt-1 / (n-t+1)
2) Select larger depreciation amount, i.e., Dt = max[DDDB, DSL]
3) If required, calculate PWD

Alternatively, use spreadsheet function VDB(B,S,n,start_t,end_t) to determine Dt

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 Example-
DB Switching to SL
Asset: Invoice Price $9,000
Freight 500
Installation 500
Depreciation Base $10,000
Salvage Value 0
Depreciation 200% DB
Depreciable life 5 years

• SL Dep. Rate = 1/5

• (DDB rate) = (200%) (SL rate)
= 0.40

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 Case 1: S = 0
(a) Without switching (b) With switching to SL
Book Book
n Depreciation Value n Depreciation Value
1 10,000(0.4) = $6,000 1 4,000
2 4,000 3,600 2 $6,000
3 6,000(0.4) = 2,160 3 6,000/4 = 1,500 < 2,400
4 2,400 1,296 4 3,600
5 3,600(0.4) = 778 5 3,600/3 = 1,200 < 1,440
1,440 2,160
2,160(0.4) = 2,160/2 = 1,080 > 864
864 1,080
1,296(0.4) = 1,080/1 = 1,080 > 518
518 0

Note: Without switching, we have not depreciated the entire

12
cost of the asset and thus have not taken full advantage of
depreciation’s tax deferring benefits
Case 2: S = $2,000
End of Depreciation Book Value
Year
1 0.4($10,000) = $4,000 $10,000 - $4,000 =
$6,000
2 0.4(6,000) = 2,400 6,000 – 2,400 = 3,600

3 0.4(3,600) = 1,440 3,600 –1,440 = 2,160

4 0.4(2,160) = 864 > 2,160 – 160 = 2,000

160
5 0 2,000 – 0 = 2,000

Note: Tax law does not permit us to depreciate assets below

their salvage values.
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 MACRS Depreciation
Required method to use for tax depreciation in USA only

Originally developed to offer accelerated depreciation for economic growth

Where: Dt = depreciation charge for year t

Dt = dtB B = first cost or unadjusted basis
dt = depreciation rate for year t (decimal)

Get value for dt from IRS table for MACRS rates

j=t
BVt = B - ∑Dj Where: Dj = depreciation in year j
j=1 ∑ Dj = all depreciation through year t

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 MACRS Depreciation
Always depreciates to zero; no salvage value considered

Incorporates switching from DDB to SL depreciation

Standardized recovery periods (n) are tabulated

MACRS recovery time is always n+1 years;

half-year convention assumes purchase in midyear

No special spreadsheet function; can arrange VDB

function to display MACRS depreciation each year

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 Example: MACRS Depreciation
A finishing machine has a first cost of $20,000 with a $5,000
salvage value after 5 years. Using MACRS, find (a) D and (b) BV
for year 3.

Solution: (a) From table, d3 = 19.20

D3 = 20,000(0.1920)
= $3,840

(b) BV3 = 20,000 - 20,000(0.20 + 0.32 + 0.1920)

= $5,760

Note: Salvage value S = $5,000 is not used by MACRS and BV6 = 0

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 MACRS Recovery Period
Recovery period (n) is function of property class
Two systems for determining recovery period:
general depreciation system (GDS) – fastest write-off allowed

alternative depreciation system (ADS) – longer recovery; uses SL

IRS publication 946 gives n values for an asset. For example:

MACRS n value
Asset description GDS ADS range
Special manufacturing devices, racehorses, tractors 3 3-5
Computers, oil drilling equipment, autos, trucks, buses 5 6 - 9.5
Office furniture, railroad car, property not in another class 7 10 – 15

Nonresidential real property (not land itself) 39 40

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 Unit-of-Production (UOP) Depreciation
 Depreciation based on usage of equipment, not time
 Depreciation for year t obtained by relation

actual usage for year t

Dt = (B – S)
expected total lifetime usage

Example: A new mixer is expected to process 4 million yd3 of concrete over

10-year life time. Determine depreciation for year 1 when 400,000 yd3 is
processed. Cost of mixer was $175,000 with no salvage expected.

400,000
4,000,000

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 Sum-of-Years-Digits (SYD)

 The SYD method is a historical accelerated depreciation technique

that removes much of the basis in the first one-third of the recovery
period; however, write-off is not as rapid as for DDB or MACRS.

 The mechanics of the method involve the sum of the year’s digits
from 1 through the recovery period n.

 The depreciation charge for any given year is obtained by

multiplying the basis of the asset, less any salvage value, by the
ratio of the number of years remaining in the recovery period to the
sum of the year’s digits SUM.
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Sum-of-Years-Digits (SYD)

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Sum-of-Years-Digits (SYD)

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 Sum-of-the-Year’s Digits
(SOYD or SYD)

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 Sum-of-the-Year’s Digits (an example)

Asset cost = $50,000

Asset life = 5 years
Salvage value = $10,000
Annual Depreciation:
Year 1 = (40,000) X (5/15) = $13,333.32
Year 2 = (40,000) X (4/15) = $10,666.68
Year 3 = (40,000) X (3/15) = $ 8,000.00
Year 4 = (40,000) X (2/15) = $ 5,333.33
Year 5 = (40,000) X (1/15) = $ 2,666.67
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 Switching between Depreciation
Methods

Switching between depreciation methods may assist

in accelerated reduction of the book value.

It also maximizes the present value of accumulated

and total depreciation over the recovery period.

Therefore, switching usually increases the tax

advantage in years where the depreciation is larger.
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 Switching between Depreciation
Methods
1. Switching is recommended when the depreciation for year t by the
currently used method is less than that for a new method. The
selected depreciation Dt is the larger amount.
2. Only one switch can take place during the recovery period.
3. Regardless of the (classical) depreciation methods, the book value
cannot go below the estimated salvage value.
When switching from a DB method, the estimated salvage value, not the DB-
implied salvage value, is used to compute the depreciation for the new method; we
assume S= 0 in all cases.
4. The undepreciated amount, that is, BV/, is used as the new adjusted
basis to select the larger Dt for the next switching decision.
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Switching between Depreciation
Methods

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 Procedure for switching from DB to
SL method

The procedure to switch from DDB to SL

depreciation is as follows:

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Example

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 Depletion Methods
Depletion: book (noncash) method to represent decreasing
value of natural resources
Two methods: cost depletion (CD) and percentage depletion (PD)

Cost depletion: Based on level of activity to remove a natural resource

 Calculation: Multiply factor CDt by amount of resource removed
Where: CDt = first cost / resource capacity
 Total depletion can not exceed first cost of the resource

Percentage depletion: Based on gross income (GI) from resource

 Calculation: Multiply GI by standardized rate (%) from table
 Annual depletion can not exceed 50% of company’s taxable income (TI)

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 Depletion
Percentage Depletion

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Example 16.5
A company has negotiated the rights to cut timber on privately held
forest area for $700,000
An estimated 350 million board feet of lumber are harvestable
① Determine the depletion amount for the first 2 years if 15 million
and 22 million board feet are removed
② After 2 years the total recoverable board feet was re-estimated
to be 450 million from the time the rights were purchased.
Compute the new cost depletion factor for years 3 and later

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 $700,000
Pt   $2,000 per million board feet
350
Multiply Pt by the annual harvest to obtain depletion of $30,000 in year 1 and
$44,000 in year 2

Continue using Pt until we reach $700,000

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After 2 years, a total of $74,000 has been depleted

A new pt value must be calculated based on the remaining $700,000 –

74.000 = $626,000 investment

Additionally, with the new estimate of 450 million board feet, a total of 450 – 15
– 22 = 413 million board feet remain

For years t = 3, 4, …., the cost depletion factor is

$626,000
Pt   $1,516 per million board feet
413

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 Example: Cost and Percentage Depletion
A mine purchased for $3.5 million has a total expected yield of one
million ounces of silver. Determine the depletion charge in year 4 when
300,000 ounces are mined and sold for $30 per ounce using (a) cost
depletion, and (b) percentage depletion. (c) Which is larger for year 4?

Solution: Let depletion amounts equal CDA4 and PDA4

(a) Factor, CD4 = 3,500,000/ 1,000,000 = $3.50 per ounce
CDA4 = 3.50(300,000) = $1,050,000

(b) Percentage depletion rate for silver mines is 0.15

PDA4 = (0.15)(300,000)(30) = $1,350,000

(c) Claim percentage depletion amount, provided it is ≤ 50% of TI

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A gold mine was purchased for 10 million. It has an
anticipated gross income of $5 million per year for
years 1 to 5 and $3 million per year after year 5

Compute:
① Annual depletion amounts for the mine
② How long will it take to recover the initial investment
at i = 0%?

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A 15% depletion applies to gold. Depletion amounts are:
Years 1 to 5: 0.15×5 million = $750,000
Years thereafter: 0.15×3 million = $450,000
A total of $3.75 million is written off in 5 years

The remaining $6.25 million is written off at $450,000 per year. The
total number of years is:

$6.25 million
5  513.9  18.9
$450,000
In 19 years, the initial investment could be fully depleted
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 Summary of Important Points
Two types for depreciation: tax and book

Classical methods are straight line and declining balance

In USA only, MACRS method is required for tax depreciation
Determine MACRS recovery period using either GDS or ADS

Switching between methods is allowed; MACRS switches

automatically from DDB to SL to maximize write-off
Depletion (instead of depreciation) used for natural resources
Two methods of depletion: cost (amount resource removed
× CDt factor) and percentage (gross income × tabulated %)
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