Chapter

DEPRECIATION

Definition:
Depreciation may be defined as the permanent and continuing diminution in the quality or
value of an asset, resulting from wear and tear, obsolescence, effluxion of time. Depreciation
denotes a permanent decrease in value; not a fluctuation in value since it indicates merely a
temporary decrease or increase in value not in quality; on the other hand, wear and tear
signifies shrinkage of value arising from use of effluxion of time.

The main agents or causes of depreciation are:-

(a) Wear and tear due to actual use;

(b) Physical factors like evaporation of liquids, loss of potency of acids, erosion, dampness,
etc;

(c) Obsolescence due to a new invention or change in tastes and fashions or a permanent
change in demand may render an asset useless;

(d) Permanent fall in market prices including foreign exchange rates;

(e) Effluxion of time – a mere passage of time will cause a fall in the value of an asset even
if it is not used, since new machines come constantly with technological developments
and old machines have to give way to new ones.

Causes of Depreciation
All assets, except land, wear out as they are used. Greg’s delivery truck can only go so many
miles before it is worn out. As the truck is driven, this use is part of what causes depreciation.
Additionally, physical factors, like age and weather, can cause depreciation of assets. Some

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assets, such as computers and software, may become obsolete before they wear out. An asset
is obsolete when a newer asset can perform the job more efficiently. As a result, an asset’s
useful life may be shorter than its physical life. In all cases, the asset’s cost is depreciated
over its useful life. Now that we have discussed causes of depreciation, let’s itemize what
depreciation is not.

1. Depreciation is not a process of valuation. Businesses do not record depreciation based on

changes in the asset’s market (sales) value. Depreciation is recapturing the cost invested in
the asset.
2. Depreciation does not mean that the business sets aside cash to replace an asset when it is
used up. Depreciation has nothing to do with cash.

Measuring Depreciation
Depreciation of a plant asset is based on three main factors:

1. Capitalized cost
2. Estimated useful life
3. Estimated residual value

 Capitalized cost is a known cost and, as mentioned earlier in this chapter, includes all
items spent for the asset to perform its intended function. The other two factors are
estimates.

 Estimated useful life is the length of the service period expected from the asset. The
estimated useful life is how long the company expects it can use the asset. Useful life
may be expressed in years, units, output, or miles. For each asset, the goal is to define
the estimated useful life with the measure (years, units, etc.) that best mimics the
asset’s decline or use. For example, a building’s life is stated in years, a truck’s in the
number of miles it can drive, and a copier’s in the number of copies it can make.

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  Estimated residual value—also called salvage value—is the asset’s expected cash value
at the end of its useful life. A delivery truck’s useful life may be 100,000 miles. When
the truck has been driven that distance, the company will sell or scrap it. The expected
cash receipt at the end of the truck’s life is the truck’s estimated residual value.
Estimated residual value is not depreciated because you expect to receive this amount
at the end. Cost minus estimated residual value is called depreciable cost.

Or Factors in Computing Depreciation

Three factors affect the computation of depreciation, as shown below:

Cost:
Earlier, we explained the issues affecting the cost of a depreciable asset. Recall that companies
record plant assets at cost, in accordance with the cost principle.

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, its expected repair and maintenance, and its vulnerability to
obsolescence. Past experience with similar assets is often helpful in deciding on expected useful life.
We might reasonably expect Rent-A-Wreck and Avis to use different estimated useful lives for their
vehicles.

Salvage value:
Salvage value is an estimate of the asset’s value at the end of its useful life. This value may be based
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

Depreciation is generally computed using one of the following methods:

(1) Straight-line method.

(2) Units-of-Activity method.
(3) Declining-balance method.
(4) Sum-of-the-years'-digits method

Rules: Sum of the years' digits for n years

= 1 + 2 + 3 + ...... + (n-1) + n = (n+1) x (n / 2)

Sum of the years' digits for 500 years

= 1 + 2 + 3 + ...... + 499 + 500
= (500 + 1) x (500 / 2) = (501 x 500) / 2 = 125,250

Problems and Solution

Problem: 01
DuPage Company purchases a factory machine at a cost of $18,000 on January 1, 2012.
DuPage expects the machine to have a salvage value of $2,000 at the end of its 4-year useful
life.

During its useful life, the machine is expected to be used 160,000 hours. Actual annual hourly
use was: 2012, 40,000; 2013, 60,000; 2014, 35,000; and 2015, 25,000.

Instructions
Prepare depreciation schedules for the following methods: (a) Straight-line, (b) Units-of-
activity, and (c) Declining-balance using double the straight-line rate.

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Solution:

a) Straight-Line Method:
Year Depreciation Depreciation = Annual Accumulated Book value
Cost Rate Depreciation Depreciation at the end of
Expense year
2012 16000 25% = 4000 4000 14000
2013 16000 25% = 4000 8000 10000
2014 16000 25% = 4000 12000 6000
2015 16000 25% = 4000 16000 2000
Tk 18000-2000=16000
Tk 18000-4000=14000

b) Units-of-Activity Method:
Year Units of Depreciation = Annual Accumulated Book
activity Cost (per Depreciation Depreciation value at
unit) Expense the end of
year
2012 40000 0.10 = 4000 4000 14000
2013 60000 0.10 = 6000 10000 8000
2014 35000 0.10 = 3500 13500 4500
2015 25000 0.10 = 2500 16000 2000

(c) Declining-Balance Method:

Year Book value Depreciation = Annual Accumulated Book value

at the Rate Depreciation Depreciation at the end of
beginning Expense year
of year
2012 18000 50% = 9000 9000 9000
2013 9000 50% = 4500 13500 4500
2014 4500 50% = 2250 15750 2250
2015 2250 50% = 250 16000 2000
* ¼ x 2.
** Adjusted to $250 because ending book value should not be less than expected salvage value.

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d) Sum-of-the-years-digits Method:

Example
Company A purchased an asset on January 1, 2011. What is the amount of depreciation
expense for the year ended December 31, 2011? Acquisition cost of the asset is $100,000.
Useful life of the asset is 5 years. Residual value (or salvage value) at the end of useful life is
$10,000.

Required: Depreciation method: sum-of-the-years'-digits method.

Solution:

Calculation of depreciation expense

Sum of the years' digits = 1+2+3+4+5 = 15
Depreciation for 2011 = ($100,000 - $10,000) x 5/15 = $30,000
Depreciation for 2012 = ($100,000 - $10,000) x 4/15 = $24,000
Depreciation for 2013 = ($100,000 - $10,000) x 3/15 = $18,000
Depreciation for 2014 = ($100,000 - $10,000) x 2/15 = $12,000
Depreciation for 2015 = ($100,000 - $10,000) x 1/15 = $6,000

Problem: 2

On January 1, 2012, Skyline Limousine Co. purchased a limo at an acquisition cost of

$28,000. The vehicle has been depreciated by the straight-line method using a 4-year service
life and a $4,000 salvage value. The company’s fiscal year ends on December 31.

Instructions:

Prepare the journal entry or entries to record the disposal of the limousine assuming that it
was:
(a) Retired and scrapped with no salvage value on January 1, 2016.
(b) Sold for $5,000 on July 1, 2015.

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Solution:

(a)
1/1/16 Accumulated Depreciation— Limousine 24,000
Loss on Disposal of Limousine 4,000
Limousine 28,000
(To record retirement of limousine)

(b)
7/1/15 Depreciation Expense 3,000
Accumulated Depreciation— Limousine 3,000
(To record depreciation to date of disposal)

Cash 5,000
Accumulated Depreciation— Limousine 21,000
Loss on Disposal of Limousine 2,000
Limousine 28,000
(To record sale of limousine)