Depreciation

1. Depreciation
Depreciation is a measure of the decrease in the value of a property with time. It is a
reasonable allowance for the exhaustion, wear, and tear and obsolescence of property used
in the trade or business. For payment of tax, depreciation is deducted from the profit and the
tax is computed based on the remaining amount.
Example 1:
Suppose a plant cost Rs 50 crores and if its estimated life is 10 years and its estimated value
at the end of its life is Rs. 5 crores. Then depreciation is
50 − 5
𝑑= = 4.5 𝑐𝑟𝑜𝑟𝑒𝑠/𝑎𝑛𝑛𝑢𝑚
10
If the gross profit per year is Rs. 12 crores, and if the tax is 30%,
𝐶𝑡𝑎𝑥 = (12 − 5)0.3 = 2.1 𝑐𝑟𝑜𝑟𝑒𝑠/𝑎𝑛𝑛𝑢𝑚
𝐶𝑃𝑟𝑜𝑓𝑖𝑡 = 12 − 2.1 = 9.9 𝑐𝑟𝑜𝑟𝑒𝑠/𝑎𝑛𝑛𝑢𝑚

Depreciation is not taxed since it is treated as cost. The value of the capital invested in a
chemical plant is locked and cannot be liquidated. Moreover its value reduces with time.
Simultaneously, the consideration of depreciation as a cost provides a means whereby funds
are set aside regularly to provide recovery of the invested capital. When accountants deal
with depreciation, they must follow certain rules which are established by the government
for determination of income taxes. These rules deal with allowable life for the depreciable
equipment and acceptable mathematical procedures for allocating the depreciation cost over
the life of the asset.

Note that land is a non-depreciable asset since its value does not decrease with time.
However, if the land is on lease, the lease amount can be included in the fixed cost of
production.

2. Salvage Value

Salvage value is the net amount of money obtainable from the sale of used property in excess
charges involved in removal and sale. These charges are deducted from the sale value. There
are agencies which conduct purchase and sale of second hand equipment. If the property
cannot be disposed of as a useful unit, it can often be dismantled and sold as junk to be used

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again as a manufacturing raw material. The profit obtainable from this type of disposal is
known as the scrap, or junk value. Salvage value, scrap value, and service life are usually
estimated on the basis of conditions at the time the property is put in use. These factors
cannot be predicted with absolute accuracy, but improved estimates can be made as the
property increases in age. It is advisable, therefore, to make new estimates from time to time
during the service life and make any necessary adjustments in the depreciation costs. Because
of the difficulties involved in making reliable estimates of salvage and scrap values, engineers
often neglect the small error involved and designate these values as zero.

3. Present Value

The present value of an asset may be defined as the value of the asset in its condition at the
time of valuation. There are several different types of present values, and the standard
meanings of the various types should be distinguished. One of them is the book value. Book
value is the difference between the original cost of a property, and all the depreciation
charges made to date. It represents the worth of the property as shown on the owner’s
accounting records. The market value is the price which could be obtained for an asset if it
were placed on sale in the open market is designated as the market value. The use of this
term conveys the idea that the asset is in good condition and that a buyer is readily available.
The replacement value is the cost necessary to replace an existing property at any given time
with one that is equally capable of rendering the same service. It is difficult to predict future
market values or replacement values with a high degree of accuracy because of fluctuations
in market demand and price conditions. On the other hand, a future book value can be
predicted with absolute accuracy as long as a constant method for determining depreciation
costs is used. It is quite possible for the market value, replacement value, and book value of
a property to be widely different from one another because of unrealistic depreciation
allowances or changes in economic and technological factors.

4. Straight line depreciation

There are various ways in which the depreciation is computed. The
𝐶𝑉 − 𝐶𝑆 𝐶𝑅
𝑑=( )=
𝑛 𝑛

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𝐶𝑉 = original value of the asset, 𝐶𝑠 = salvage value of the asset, 𝑑 = yearly depreciation, 𝑛 =
service life in years. Note that 𝑑, the yearly depreciation remains constant throughout the
service life.
5. Depreciation based on the units of production
In some cases, natural resources are exploited for profit. Examples are excavation of a mineral
from a mine, or crude oil extraction from an oil well. In such cases, the asset, say mine, which
has a fixed amount of mineral. With time, the mineral content decreases and at the end, the
content of the remaining mineral is either low or dilute so that it is not profitable to recover
it. The mine is then abandoned. Depreciation is computed based on amount of minerals
produced. Depreciation in year 𝑗 is given by
𝑄𝑗−1 − 𝑄𝑗
𝑑𝑗 = ( ) 𝐶𝑉
𝑄𝑇

𝑑𝑗 = depreciation for year 𝑗, 𝐶𝑉 = value of the mine 𝑄𝑇 =total quantity of mineral in the
mine, 𝑄𝑗 = quantity of mineral remaining at the end of 𝑗 years

6. Declining balance method

When the declining-balance method is used, the annual depreciation cost is a fixed
percentage of the property value at the beginning of the particular year. The fixed-percentage
(or declining-balance) factor remains constant throughout the entire service life of the
property, while the annual cost for depreciation is different each year.

If𝐶𝑉 is the initial value of the asset, then depreciation for the first year is

𝑑1 = 𝐶𝑓
Value of the asset at the end of first year is
𝐶𝑉1 = 𝐶𝑉 (1 − 𝑓).
Hence depreciation for the second year is
𝑑2 = 𝐶𝑉 (1 − 𝑓)𝑓
Value of the asset at the end of second year is
𝐶𝑉2 = 𝐶𝑉 (1 − 𝑓)2 .
Thus the value of the asset at the end of year 𝑗 is
𝐶𝑉𝑗 = 𝐶𝑉 (1 − 𝑓)𝑗 .

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 And the corresponding depreciation is
𝑑𝑗 = 𝐶𝑉 𝑓(1 − 𝑓)𝑗
If 𝑛 is the service life and 𝐶𝑠 is the salvage value, then
𝐶𝑠 = 𝐶𝑉𝑛 = 𝐶𝑉 (1 − 𝑓)𝑛
𝐶𝑆
Hence = (1 − 𝑓)𝑛
𝐶𝑉

𝐶 1/𝑛
Or 𝑓 = 1 − (𝐶 𝑆 )
𝑉

This formula is known as Matheson formula.

Example 2:
Suppose a plant cost Rs 50 crores and if its estimated life is 10 years and its estimated value
at the end of its life is Rs. 5 crores. Then the fractional depreciation by Matheson formula is
1 1
𝐶𝑆 𝑛 5 10
𝑓 = 1 − ( ) = 1 − ( ) = 1 − 0.794 = 0.206
𝐶𝑉 50

Value of the asset decreses as

𝑑1 = 2.06 𝑐𝑟𝑜𝑟𝑠, 𝐶𝑉1 = 𝐶𝑉 (1 − 𝑓) = 10(1 − 0.206) = 7.94 𝑐𝑟𝑜𝑟𝑒𝑠

𝑑2 = 1.64 𝑐𝑟𝑜𝑟𝑠, 𝐶𝑉2 = 𝐶𝑉1 (1 − 𝑓) = 7.94(1 − 0.206) = 6.30, crores

𝑑3 = 1.30 𝑐𝑟𝑜𝑟𝑠, 𝐶𝑉3 = 𝐶𝑉2 (1 − 𝑓) = 6.30(1 − 0.206) = 5.00 crores

𝑑4 = 1.03 𝑐𝑟𝑜𝑟𝑠, 𝐶𝑉4 = 𝐶𝑉3 (1 − 𝑓) = 5.00(1 − 0.206) = 3.97 crores

𝑑5 = 0.82 𝑐𝑟𝑜𝑟𝑠, 𝐶𝑉5 = 𝐶𝑉4 (1 − 𝑓) = 3.97(1 − 0.206) = 3.15 crores

It is seen that the depreciation by declining balance method is higher than straight line
method during the first four years, but falls below the straight line from 5th year.

7. Double declining balance method

In many cases, it is difficult to estimate the salvage value of an asset. In some cases, the asset
may have negligible salvage value. Lower the salvage value, larger is the value of 𝑓, which is
be advantageous to the company and disadvantageous to the income tax authority.
Hence, the tax authority limits the maximum value of 𝑓. It is usually
𝑓𝑚𝑎𝑥 = 2/𝑛

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Thus for 10 years of service life 𝑓𝑚𝑎𝑥 = 0.2. The method which uses 𝑓 = 2/𝑛 is called double
declining balance method.

8. Combination method

Another problem of declining balance method is that depreciation becomes smaller and
smaller as the service life is approached. One way to overcome the problem is to use
combination method. It is desirable to switch from the declining-balance to the straight-line
method after a portion of the service life has expired. This is known as the combination
method. It permits the property to be fully depreciated during the service life, yet also gives
the advantage of faster early-life write-offs.

9. Modified accelerated cost recovery system (MACRS)

This method is most commonly used for income tax purpose and hence for most economic
evaluations. This is based on combination of double declining balance method and straight
line method. Thus changeover from the double declining balance method to straight line
balance method occurs when the straight line method gives larger value of depreciation.
However, the difference between this method and conventional combination method is that
the straight line depreciation is computed by adding half extra year to the life expectancy of
the asset to be depreciated ( half-year convention)
Example 3:

Calculate the yearly depreciation for an asset having the value of Rs. five crores and five year
expected life span of 5 years using MACRS method.

5
First year : Depreciation by double declining balance method = 𝑅𝑠 2 5 = 0.4 × 5 = 2 𝑐𝑟,
5
Depreciation by straight line method =𝑅𝑠 = 0.909 𝑐𝑟. Since double declining balance
5.5

method has a higher depreciation, it is accepted

Second year : Depreciation by double declining balance method = 𝑅𝑠 0.4(1 − 0.4)5 = 1.2 𝑐𝑟,
5−2 3
Depreciation by straight line method =𝑅𝑠 = 4.5 = 0.667 𝑐𝑟. Since double declining
4.5

balance method has a higher depreciation, it is accepted

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Third year : Depreciation by double declining balance method = 𝑅𝑠 0.4(1 − 0.4)2 5 =
3−1.2 1.8
0.72 𝑐𝑟, Depreciation by straight line method =𝑅𝑠 = 3.5 = 0.514 𝑐𝑟. Since double
3.5

declining balance method has a higher depreciation, it is accepted

Forth year : Depreciation by double declining balance method = 𝑅𝑠 0.4(1 − 0.4)3 5 =

1.8−0.72 1.08
0.432 𝑐𝑟, Depreciation by straight line method =𝑅𝑠 = = 0.432 𝑐𝑟. Since
2.5 2.5

Straight line method has a equal depreciation, it is accepted.

Fifth year : Depreciation by double declining balance method = 𝑅𝑠 0.4(1 − 0.4)4 5 =

1.08−0.432 0.648
0.2592 𝑐𝑟, Depreciation by straight line method =𝑅𝑠 = = 0.432 𝑐𝑟. Now
1.5 1.5

the straight line method produces higher value and hence accepted.

Sixth year: Depreciation . 𝑅𝑠 0.648 − 0.432 = 0.216 𝑐𝑟

10. The sum-of-the-years digits method

The gives results which gives results similar to the declining-balance method. But is more
stable. In the application of the sum-of-the-years-digits method, the annual depreciation is
based on the number of service-life years remaining and the sum of the arithmetic series of
numbers from 1 to n, where n represents the total service life. If 𝑛 the number of years of the
service life, then we form the sum of digits from 1 to n.

𝑛(𝑛 + 1)
𝑆 = 1 + 2 + ⋯𝑛 =
2

𝑛 2
𝑓1 = =
𝑆 𝑛+1

𝑛−1 1
𝑓2 = , ⋯ , 𝑓𝑛 =
𝑆 𝑠

Note that ∑ 𝑓𝑖 = 1. Hence, the asset is completely depreciated at the end of the service life.

Example 3:

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Suppose a plant cost Rs 50 crores and if its estimated life is 10 years and its estimated value
at the end of its life is Rs. 5 crores. Then the fractional depreciation by the sum-of-the-years
digits formula is

𝑛−𝑗+1 2(𝑛 − 𝑗 + 1)
𝑓𝑗 = =
𝑆 𝑛(𝑛 + 1)
𝑛 = 10,
2(11 − 𝑗 ) 11 − 𝑗
𝑓𝑗 = =
10 × 11 55
10 9 8
𝑓1 = , 𝑓2 = , 𝑓3 = , … ….
55 55 55
10 9 8
𝑑1 = 55 (45) = 8.18 𝑐𝑟𝑜𝑒𝑠, 𝑑2 = 55 (45) = 7.36 𝑐𝑟𝑜𝑟𝑠 , 𝑑3 = 55 (45) = 6.54 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑4 =
7 6 5
(45) = 5,73 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑5 = (45) = 4.91 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑6 = (45) = 4.09 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑7 =
55 55 55
4 3 2
(45) = 3.27 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑8 = (45) = 2.45 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑9 = (45) = 1.64 𝑐𝑟𝑜𝑟𝑒𝑠, 𝑑10 =
55 55 55
1
(45) = 0.82 𝑐𝑟𝑜𝑟𝑒𝑠
55

11. Sinking-Fund Method

This method is based on assumption that the basic purpose of depreciation is to accumulate
a sufficient fund to provide for the recovery of the original capital invested in the asset. An
ordinary annuity plan is set up wherein a constant instalment 𝑅 is set aside each year. At the
end of the service life, the sum of all the deposits plus accrued interest must equal the total
amount of depreciation.

𝐴 = 𝐶𝑉 − 𝐶𝑆

(1 + 𝑖)𝑛 − 1 (1 + 𝑖)𝑛 − 1
𝐴 = 𝑅(1 + 𝑖)𝑛−1 + 𝑅(1 + 𝑖)𝑛−2 + ⋯ + 𝑅(1 + 𝑖) + 𝑅 = 𝑅 =𝑅
(1 + 𝑖) − 1 𝑖

Or

𝑖
𝑑 = 𝑅 = (𝐶𝑉 − 𝐶𝑆 )
(1 + 𝑖)𝑛 − 1

If 𝐶𝑎 is the book value of the asset, after 𝑎 years, then

(1 + 𝑖)𝑎 − 1 (1 + 𝑖)𝑎 − 1
𝐶𝑉 − 𝐶𝑎 = 𝑅 = (𝐶𝑉 − 𝐶𝑆 )
𝑖 (1 + 𝑖)𝑛 − 1

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Since R represents the annual depreciation, it is constant for the sinking-fund method . The
book value estimated from this method is higher than that by straight line method.

The sinking-fund theory of cost accounting is not very popular in chemical industries since
service life is not accurately predictable. Hence, company likes to depreciate asset as fast as
possible. This method is useful in the public-utilities field. Theoretically, the method would be
applicable for depreciating any property that did not undergo heavy service demands during its early
life and stood little chance of becoming obsolete or losing service value due to other functional causes.

12. Single unit and group depreciation

In depreciation accounting procedures, assets may be depreciated on the basis of

individual units or on the basis of various types of property groups or classifications. The
single-unit method requires keeping records on each individual asset. Although the
application of this method is simple, the large number of detailed records required makes the
accounting expenses very high. To simplify the accounting procedures, many concerns
combine their various assets into groups for depreciation purposes. There are several types
of group accounts employed, and the most common among these are composite accounts,
classified accounts, and vintage-group accounts. A composite account includes all
depreciable assets in one single group, and an overall depreciation rate is applied to the entire
account. With this method, the composite depreciation rate must be redetermined when
important changes occur in the relative distribution of the service lives of the individual
assets. Instead of including all assets in a single depreciation account, it is possible to classify
properties into general types, such as machinery and equipment, office furniture and fixtures,
buildings, and transportation equipment. The records for these groups are known as
classified accounts. A classified account is similar to a composite account because many items
are included in the same group, regardless of life characteristics. Another approach to group
depreciation is to include in each account all similar assets having approximately the same
service lives. These accounts are known as vintage-group accounts. A separate record is kept
for each group and the same depreciation rate is applied to all the items included in each
account. With this method, the advantages of single-unit depreciation are obtained since life
characteristics serve as the basis. If a large number of items are contained in a vintage-group

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account, the overall depreciation results can be quite accurate because the law of averages
will apply to the true service lives as compared with the estimated service lives.

13. Adjustment of depreciation accounts

The estimated service life and salvage value of a property are seldom exactly equal to the
actual service life and salvage value. It is, therefore, advisable to adjust depreciation accounts
by making periodic re-estimations of the important variables. When a property is retired
under conditions which do not permit exact agreement between estimated and actual values,
the difference between the book depreciation and the actual depreciation may be handled in
one of the following ways: (1) The gain or loss may be credited or charged on the financial
record for the current period; (2) the difference may be credited or charged to a special
depreciation reserve; or (3) the difference may be carried on the books for amortization
during a reasonable future period.

According to the Federal income-tax laws, any gain on the retirement of a property is taxed
as a capital gain. However, losses cannot be subtracted from the taxable income unless the
maximum expected life was used. Because of the losses involved when a property must be
retired before the end of its estimated service life, some concerns prefer to use a combination
of methods 2 and 3 indicated in the preceding paragraph. A special depreciation reserve is
built up by continuing the book depreciation of properties whose actual service lives exceed
the estimated service lives. This fund is then used to handle losses due to early retirement of
assets. The final choice of method for adjusting depreciation accounts depends on the
accounting policies of the individual concern and on income-tax regulations.

14. Evaluation of depreciation methods

Comparison of the various depreciation methods shows that the declining-balance and the
sum-of-the-years-digits methods give similar results. In both cases, the depreciation costs are
greater in the early-life years of the property than in the later years. Annual depreciation costs
are constant when the straight-line, sinking-fund, or present-worth method is used. Because
interest effects are included in the sinking-fund and present-worth methods, the annual
decrease in asset value with these two methods is lower in the early-life years than in the
later years. The straight-line method is widely used for depreciation cost accounting because

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it is very simple to apply, both to groups and single units, and it is acceptable for cost-
accounting purposes and for some income-tax determinations. From the viewpoint of
financial protection, it is desirable to make a greater charge for property depreciation during
early life than during later life. This can be accomplished by use of the declining-balance or
sum-of-the-yearsdigits method. The difficulties of accurate application to group accounts and
income-tax restrictions have served to suppress the widespread usage of these methods.
However, in recent years, a large number of industrial concerns have started using declining-
balance and sum-of-the-years-digits depreciation, with many companies finding it desirable
to use the combination method approved by Federal income-tax regulations of declining
balance plus straight-line with statutory percentages for each year based on property life
class. The liberalized tax laws passed in 1954 first permitted use of double declining-balance
depreciation as well as sum-of-the-years-digits depreciation for income-tax calculations. In
general, these laws gave approval to any depreciation method which did not give faster write-
offs during the first two-thirds of an asset’s useful life than the double declining-balance
method. These regulations were not applicable to assets with service lives of less than 3 years.
The final choice of the best depreciation method depends on a number of different factors.
The type and function of the property involved is, of course, one important factor. Also, it is
desirable to use a simple formula giving results as accurate as the estimated values involved.

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