BASIC CONCEPTS OF
DEPRECIATION
Depreciation Concepts and
Terminology
Depreciation is the decrease in value of physical
properties with the passage of time and use.
depreciation is an accounting concept that establishes
an annual deduction against before-tax income such
that the effect of time and use on an asset’s value can
be reflected in a firm’s financial statements.
Depreciation is a noncash cost that is intended to
“match” the yearly fraction of value used by an asset in
the production of income over the asset’s life.
Depreciable property is property for which depreciation
is allowed under federal, state, or municipal income tax
laws and regulations.
Property is depreciable if it meet the ff requirements:
It must be used in business or held to produce income.
It must have a determinable useful life and the life must be
longer than one year.
It must be something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.
It is not inventory, stock in trade, or investment property.
Types
Depreciable property can be:
Tangible – can be seen or touched
Personal property – machinery, vehicles, equipment,
furniture, and similar items.
Real property – land and generally anything that is
erected on, growing on, or attached to land.
Intangible – cannot be seen or touched
(copyright, patent, or franchise)
Additional Definitions
Adjusted (cost) basis – the original cost basis of
the asset, adjusted by allowable increases or
decreases, is used to compute depreciation
deductions. For example, the cost of any
improvement to a capital asset with a useful life
greater than one year increases the original cost
basis, and a casualty or theft loss decreases it. If
the basis is altered, the depreciation deduction
may need to be adjusted.
Basis or cost basis – the initial cost of
acquiring an asset (purchase price plus any
sales taxes), including transportation
expenses and other normal costs of making
the asset serviceable for its intended use;
this amount is also called the unadjusted
cost basis.
Book value (BV) The worth of a depreciable
property as shown on the accounting records of
a company. It is the original cost basis of the
property, including any adjustments, less all
allowable depreciation deductions. It thus
represents the amount of capital that remains
invested in the property and must be recovered
in the future through the accounting process.
Market value (MV) The amount that will be
paid by a willing buyer to a willing seller for
a property, where each has equal advantage
and is under no compulsion to buy or sell.
The MV approximates the present value of
what will be received through ownership of
the property, including the time value of
money (or profit).
Recovery period The number of years over which the
basis of a property is recovered through the
accounting process.
Salvage value (SV) The estimated value of a property
at the end of its useful life.
Useful life The expected (estimated) period that a
property will be used in a trade or business to produce
income. It is not how long the property will last but
how long the owner expects to productively use it.
Depreciation Methods
Straight-line Method – simplest depreciation
method
Example
Sinking Fund Method
In this method, an imaginary fund called a
sinking fund is invested yearly at a rate of
to amount to at the end of the property.
Example
An equipment costing P 250,000 has an
estimated life of 15 years with a book value
of P30,000 at the end of the period.
Compute the depreciation charge and its
book value after 10 years using sinking fund
method assuming .
Sum of the Years Digit Method (SOYD)
The depreciation charge in this method is
assumed to vary directly to the number of
years and inversely to the sum of the year’s
digit.
Sum of the year’s digit,
An equipment costing P 250,000 has an
estimated life of 15 years with a book value
of P30,000 at the end of the period.
Compute the depreciation charge and its
book value after 10 years using SOYD
method.
Declining Balance Method
Declining Balance Method (constant-
percentage method or Matheson formula) is
based on the compound interest formula
where is the first cost is the book value at
any time, and is the depreciation rate and is
equal to
Declining Balance Method
Constant percentage
Example
A machine costing P 720,000 is estimated to
have a book value of P 40,545.73 when
retired at the end of 10 years. Depreciation
cost is computed using a constant
percentage of declining book value . What is
the annual rate of depreciation? What is the
book value at the end of 5 years?
Double Declining Balance Method
Depreciation charge to date is at the
beginning of the year
Example
An equipment costing P 250,000 has an
estimated life of 15 years with a book value
of P30,000 at the end of the period.
Compute the depreciation charge and its
book value after 10 years using Double
Declining Balance Method.
