PART-II

5. Depreciation

Daniel Ab.

Bahir Dar Institute of Technology (BiT)

Faculty of Mechanical and Industrial Engineering
 Introduction and Definitions

• As time elapses, every asset undergoes a progressive loss

of value resulting from:
✓ Physical factors: wear and tear, exposure to elements
✓ Functional factors: technological change (obsolescence)

• Therefore, a point is eventually reached at which it

becomes economical to replace the existing asset with a
new one.
• The decline in the value of the asset is known as
Depreciation.

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 ….cont’d
• Asset: property that is acquired and exploited for monetary
gain such as machines, vehicles, office building, planes,
ships, boats, computers, etc.
• First Cost of an Asset: total expenditure required to place
an asset in operating condition.
• E.g. If an asset is purchased, it includes the purchase
price related and all incidental expenses such as
transportation, tax, telephone, assembly, expert advice,
etc.
• Salvage Value or Residual Value: the price at which a fixed
asset is expected to be sold at the end of its useful life.
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 ….cont’d

• Book Value: the value of an asset displayed on the

documents of the firm.
E.g. if the first cost of an asset is $20,000 and the
depreciation charges to date total $14,000 the current book
value is $6,000
• Depreciation is used to allocate an asset’s loss of value
over time.
• Depreciation is deducted from revenue and reduces the
taxable income of a business over time which produces a
cash flow on an after tax-basis.
• Since depreciation is a recognized business expense, it
reduces the taxes the firm is required to pay.
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• In contrast to other business expenses, depreciations does
not manifest itself in the form of cash transactions during
the life of the asset, and consequently it is necessary to
make an entry in the books of the firm at the close of
each accounting period, for two reasons:
1) to record the depreciation that occurred during that
period, and there by permit a true determination of
the earnings for that period.
2) to display the current value of the asset.
• This entry is known as a depreciation charge, and the
process of entering depreciation charges is known as
writing-off the asset.

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 Depreciation computation methods
The methods of accounting depreciation fund are:
• Straight line method of depreciation
• Declining balance method of depreciation
• Sum of the years—digits method of depreciation
• Sinking-fund method of depreciation
• Service output method of depreciation

The notational system for depreciation is as follows:

Bo = first cost of asset
Br = book value of asset at the end of rth year
L = estimated salvage value
Dr = depreciation charge for rth year
n = estimated life span of asset, years
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1. Straight- Line Method
▪ It is the simplest method of depreciation i.e. a fixed
sum is charged as the depreciation amount
throughout the lifetime of an asset.
▪ It is almost rough estimate.
▪ It assumes as the total depreciation cost to be
assigned uniformly over the life of the asset.

B0 - L
Then, Dr =
n

Bn = Bo - nDr , book value at the end of each year

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Example: A machine costing Birr 15,000 has an estimated
life span of 8 years and an estimated salvage value of Birr
3000. Compute the annual depreciation charge and the
book value of the machine at the end of each year under
the straight line depreciation method.

Solution:
Given:
Bo = Birr 15,000
L = Birr 3000
n = 8 years

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 B -L
Then, Dr = 0

Dr= (15000-3000)/8 = 1500, annual depreciation charge.

The Book Values for each year:

Bn = Bo - nDr , book value at the end of each year
▪ B1 = Bo - D = 15,000 – 1,500 = 13,500
▪ B2 = B1 –D = 13,500 – 1,500 = Bo –2D=12000
▪ B3 = 15,000 – 3 x 1,500 = $10,500
▪ B4 = 15,000 – 4 x 1,500 = $9,000
▪ B5 = 15,000 – 5 x 1,500 = $7,500
▪ B6 = 15,000 – 6 x 1,500 = $6,000
▪ B7 = 15,000 – 7 x 1,500 = $4,500
▪ B8 = 15,000 – 8 x 1,500 = $3,000
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2. Sum-of-Years’ Digits Method
• In this method of depreciation, it is assumed that the book
value of the asset decreases at a decreasing rate.
• By this method, the depreciation charges form a descending
arithmetic progression in which the first term is n times the
last term.
• If the asset has a life of eight years, first the sum of the
years is computed as Sum of the years = 1 + 2 + 3 + 4 + 5 + 6
+ 7 + 8 = 36 = n(n+ 1)/2
• The rate of depreciation charge for the first year is assumed
as the highest and then it decreases. The rates of
depreciation for the years 1–8, respectively are as follows:
8/36, 7/36, 6/36, 5/36, 4/36, 3/36, 2/36, and 1/36.
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 ….cont’d
• The depreciation charge for the final year is the total
depreciation divided by the sum of the integers from 1 to n,
inclusive. Since this sum is n(n+1)/2, we have
2(Bo − L)
Dn =
n(n + 1)
• For any year, the depreciation is calculated by:

Dr = (n - r + 1)Dn

• The Book value of the asset at the end of the rth year is:

2nr − r (r − 1)(B0 − L )
B r = B0 −
n(n + 1)

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Example: A machine costing $10,000 is estimated to have a service life of 8
years at the end of which time it will have a salvage value of $1000.
Calculate the depreciation charges, applying the sum-of-digits method?
Solution: using this formula, the depreciation at the end of 8th year is
2(B − L) 2(10,000 − 1000)
Dn = o
= = 250
n(n + 1) 8(8 + 1)

D1 = (8 -1+ 1)Dn = 8 * 250 = 2000 D2 = 7 * 250 = 1750

similarly D4 = 5 * 250 = 1250
D3 = 6 * 250 = 1500 D6 = 3 * 250 = 750
D5 = 4 * 250 = 1000 D7 = 2 * 250 = 500
Summing up these deprecation charges D8 = 1* 250 = 250
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 D = 9000
r =1

Therefore , the machine will have a salvage value of :

1000 at the end of 8th year
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 3. Declining-Balance Method
• This method postulates that the depreciation of an asset for a
given year is directly proportional to its book value at the
beginning of that year. i.e.
Dr α Br-1
• 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 a more realistic approach, since the depreciation
charge decreases with the life of the asset which matches with
the earning potential of the asset.
• The book value at the end of the life of the asset may not be
exactly equal to the salvage value of the asset. This is a major
limitation of this approach.

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 ….cont’d

• Let h denote the constant of proportionality (percentage),

then
Dr = h Br-1
h is expressed as k/n, where k is assigned the value 1.25,
1.5, and 2, depending on the nature of the asset.

Then,

• Since book value diminishes as the asset ages, the

depreciation charges form a decreasing series, and the
declining-balance also yields an accelerated write-off.
• When k is 2, the corresponding approach is called the
double declining balance method of depreciation.
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Example: Applying the double-declining-balance method,
calculate the depreciation charges for an asset having a first
cost of $20,000, a life span of 8 years and an estimated
salvage value of
a) $4000 b) $500
Solution a) given Bo =$20,000
L= $4,000
k = 2, n = 8
Required: Depreciation charges
a. We shall first establish the depreciation charges & final
book value that result if the declining-balance method is
applied throughout the life of the asset
h = k/n = 2/8 = 0.25
Dr = h Br-1

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D1 =hBo B1 = Bo – D1 B1 = Bo – hBo = Bo (1-h)
= 0.25 (20,000) = 20,000-5,000
= $5,000 = $15,000

D2 =hB1 B2 = B1 – D2 B2 = Bo (1-h) – hBo (1-h)

= 0.25 (15,000) = 15,000-3750 = Bo (1-h) (1-h)
= $3750 = $11,250 = Bo (1-h)2

D3 =hB2 B3 = B2 – D3 B3 = Bo(1-h)2 – hBo (1-h)2

= 0.25 (11,250) = 11,250-2813 = Bo (1-h)2 (1-h)
= $2813 = $8,437 = Bo (1-h)3

Bn = Bo (1-h)n
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Consistently using the above equations, the depreciation charge and
final book values can be summarized as below:

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• Since the book value can never fall below the salvage
value, the declining-balance method must be abandoned
at the end of the 5th year.
• Depreciation is charged for the sixth year but not for the
7th & 8th years.

Then
D1 = $ 5000 D3= $ 2813 D5= $ 1582
D2= $ 3750 D4= $ 2109 D6= 4746 – 4000 = $ 746
D7= D8= 0

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b) The declining-balance method yields a final book value of
$2002, but the salvage value is only $500. One possibility is to
apply the declining balance method for the first 7 years and
then set the depreciation for the 8th year equal to 2669-500 =
$2169.

Assume that the transfer from declining-balance to straight-line

method occurs at the beginning of the rth year. The remaining
depreciation must be allocated uniformly among the remaining
years of the life of the asset. Therefore, the depreciation
charge for the rth year (and all subsequent years) is

B r -l − L
Dr =
n - r +1
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• Referring to the table above, which is constructed by applying
the values obtained in the first table. The depreciation charge
for the rth year as given by equation above is recorded in
column 2, and the depreciation charge as obtained by a
continuation of the declining-balance method is recorded in
column 3.
• A comparison of the values in the two columns discloses that a
reversal occurs at the beginning of the 6th year & therefore
the transfer from declining balance method to straight-line
method should be made at that date. Then
D1 = $5000 D3= $2813 D5= $1582
D2= $3750 D4= $2109 D6= D7= D8= $1415
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 4. Sinking Fund Method
• In this method of depreciation, the book value decreases at
increasing rates with respect to the life of the asset.

Let
Bo= first cost of the asset,
F=Future value
L= Salvage value of the asset,
n= life of the asset,
i = rate of return compounded annually,
A= the annual equivalent amount,
Br= the book value of the asset at the end of the period r,
Dr = the depreciation amount at the end of the period r.
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 ….cont’d
• The loss in value of the asset (P– F) is made available and the
form of cumulative depreciation amount at the end of the life
of the asset by setting up an equal depreciation amount (A) at
the end of each period during the life time of the asset.
A= (Bo– L) [A/F, i, n]

• The fixed sum depreciated at the end of every time period

earns an interest at the rate of i% compounded annually, and
hence the actual depreciation amount will be in the increasing
manner with respect to the time period. A generalized formula
for Dr is

Dr = (Bo– L) (A/F, i, n) (F/Bo, i, r– 1)

• The formula to calculate the book value at the end of period t
is
Br = Bo– (Bo– L) (A/F, i, n) (F/A, i, r)
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Example: A company has purchased an equipment whose first cost
is Birr. 100,000.00 with an estimated life of eight years. The
estimated salvage value of the equipment at the end of its
lifetime is Birr. 20,000. Determine the depreciation charge and
book value at the end of various years using the sinking fund
method of depreciation with an interest rate of 12%, compounded
annually.

Bo= Birr. 100,000 L= Birr. 20,000 n= 8 years i = 12%

A= (Bo – L) [A/F, 12%, 8] = (100,000 – 20,000) X 0.0813

= Birr. 6,504
• In this method of depreciation, a fixed amount of Birr 6,504
will be depreciated at the end of every year from the earning
of the asset. The depreciated amount will earn interest for the
remaining period of life of the asset at an interest rate of 12%,
compounded annually. For example, the calculations of net
depreciation for some periods are as follows:
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Depreciation at the end of year 1 (D1) = Birr. 6,504.
Depreciation at the end of year 2 (D2) = 6,504 + 6,504 X 0.12 =
Birr. 7,284.48
Depreciation at the end of the year 3 (D3) = 6,504 + (6,504 +
7,284.48) X 0.12 = Birr. 8,158.62
Depreciation at the end of year 4 (D4) = 6,504 + (6,504 +
7,284.48 + 8,158.62) X 0.12 = Birr. 9,137.65

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 5. Units of Production Method

• If deterioration of an asset is primarily of exploitation rather

than obsolescence, we have to use production/service volume
as the base of depreciation charge.
• Moreover, if the asset is a machine that is used to produce a
standard commodity, the magnitude of its use can be measured
by the number of units it produces.
The depreciation charge/unit of production
= Bo–L/Units produced by the asset
• Depreciation charges for consecutive years are allocated by
multiplying the volume of production by this unit charge.

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Example: A machine costing $42000 will have a life of 5 years and salvage
value of $3000. It is estimated that 10,000 units will be produced with
this machine, distributed in this manner: first year, 2000; second year,
2400; third year, 2100; fourth year, 1800; fifth year, 1700. If
depreciation is allocated on the basis of production, calculate the
depreciation charges:
Solution:
The depreciation charge per unit of production is:
42,000 − 3000
D= = 3.90
10,000

Multiplying the volume of production by this unit charge, we obtain

the following results:

D1 = 2000* 3.90 = 7800

D2 = 9360 D3 = 8190 D4 = 7020 D5 = 6630

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