DEPRECIATION
DEPRECIATION
The depreciation: is defined as “the decrease in market
value of an asset over time” through wear, deterioration
or obsolescence
A machine may depreciate (decline in value) because it
is wearing out and no longer performing its function
Another aspect of depreciation is that caused by
obsolescence
A machine is described as obsolete when the function it
performs can be done in some better manner
DEPRECIATION
As asset always has different values: initial value (P), book value
(BV), salvage value (F) and market value (MV)
The initial value: represents the purchase price of an asset
Salvage value: represents the expected price for selling the asset
at the end of its useful life
The book value: represents the current value in the accounting
systems. It equals the initial value of the asset minus all the
depreciation costs till given time. The book value is always
calculated at the end of each year
The market value: represents the value of the asset if it is sold in
the free market. It is not necessary that the book value equals the
market value
DEPRECIATION
There are three common methods for calculating
depreciation:
Straight-line,
Sum-of-years digits
Sinking fund method.
Each method involves the spreading of the amount
to be depreciated over the recovery life of an asset
in a systematic manner
DEPRECIATION
The straight-line method assumes linear
depreciation or the depreciation cost is allocated
equally over the asset useful life
The sum-of-years digits assumes high rate of
depreciation at the early age of an asset and
decreasing rate at its aged life
The sinking fund method assumes lower rate at the
early ages and faster rate at the late age
1.THE STRAIGHT LINE METHOD
In this method a constant depreciation charge is made
The total amount to be depreciated (initial value, P –
salvage value, F) is divided by the useful life, N years
(Annual depreciation charge) Dn = (P – F) / N
The book value at any time, n, could be calculated as
follows
BV(n) = P – nDn
1.THE STRAIGHT LINE METHOD
Example: If an asset has a initial value of LE50,000
with LE10,000 salvage value after five years.
Calculate the annual depreciation and calculate the
book value of the asset after each year
1.THE STRAIGHT LINE METHOD
Annual depreciation:
Dn = (P - F) / N = 50,000 - 10,000 / 5 = LE8,000 per year
Book value of the asset after each year:
BV(n) = P – nDn (n = 1, 2, 3, 4, 5)
BV(1) = 50,000 – (1) 8,000 = LE42,000
BV(2) = 50,000 – (2) 8,000 = LE34,000
BV(3) = 50,000 – (3) 8,000 = LE26,000
BV(4) = 50,000 – (4) 8,000 = LE18,000
BV(5) = 50,000 – (5) 8,000 = LE10,000 = F
2.SUM-OF-YEARS DIGITS METHOD
This method results in faster depreciation at the early
life of an asset and smaller charges as the asset nears
the end of its estimated life
Each year, the depreciation charge is computed as the
remaining useful life at the beginning of the year divided
by the sum of the years digits for the total useful life,
with this ratio multiplied by the total amount of
depreciation (P – F)
Thus means that the depreciation is calculated as the
percentage of the remaining life to the original life
2.SUM-OF-YEARS DIGITS METHOD
Dn = (Remaining useful life at beginning of a year /
Sum of years digits) × (P – F)
Sum of years digits = N (N + 1) / 2
Ν - n +1
Dn = × (P − F )
N ( N + 1)/2
2.SUM-OF-YEARS DIGITS METHOD
Example: If the purchase price of an equipment is
LE60,000 and its salvage value after 8 years is
LE6,000, calculate the annual depreciation and the
book value of the equipment each year.
P = 60,000; F = 6,000; N=8
Sum-of-years digits = 8 (8 + 1) / 2 = 36 years
2.SUM-OF-YEARS DIGITS METHOD
Remaining life / sum- Annual
Year Book value
of-years depreciation
0 0 0 60,000
1 8/36 12,000 48,000
2 7/36 10,500 37,500
3 6/36 9,000 28,500
4 5/36 7,500 21,000
5 4/36 6,000 15,000
6 3/36 4,500 10,500
7 2/36 3,000 7,500
8 1/36 1,500 6,000
Consideration of Inflation
❑ Inflation is the decrease in the
purchasing power of money caused by
an increase in general price levels of
goods & services without an
accompanying increase in its the value.
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Consideration of Inflation
❑ Prices of commodities increase over time without
accompanying increase in the value of these
commodities
❑ Created when more money is printed without an
accompanying increase in goods &/or services.
❑ Not uniform for all commodities
❑ Low inflation rates is a sign of a growing economy
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Consideration of Inflation
❑ Commonly-used indices to represent inflation
include the Consumer Price Index (CPI) &
Producer Price Index (PPI)
❑ Specialty indices used for various industries
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Consideration of Inflation
❑ Interest rate without considering inflation
is the real interest rate, denoted by ir .
❑ Inflation rate is denoted by iinf .
❑ Combined interest rate (considering
inflation) is denoted by ic .
(1+ic) = (1+ir)(1+iinf)
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