Module 11: Depreciation

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Introduction
 Asset will eventually loss its value due to age,
wear (physical depreciation) and
obsolescence (functional depreciation) over
its useful life.
 The loss of value through the time must be
considered in economic evaluation of (asset)
investment .
 Thus, the loss in capital investment
(equipment, building, machinery, vehicle)
must be recovered through tax-allowed
expense deduction, called deprecation.
 The act of recovery loss of value of asset is
known as (cost) capital recovery.
 EXAMPLE:
 It is common to consider loss of value of an
investment as partSI-4251
of expenses that would bePh.D.
2 recovered from revenue (volume x unit price)
Ekonomi TeknikMuhamad Abduh,
Introduction
Depreciation ( in relation to business and tax purposes )


 Is an artificial (non cash) accounting entry intended

to capture the consumption of a capital asset over
its economic life.
 Depreciation increases after-tax profit
What can be depreciated?
Property that meets the following criteria:

 Used in business and/or held for the production of income

 Must expected to last for more than one year (must be
substantially beyond the year it was placed in service)
 It losses on values caused by natural causes.
What cannot be depreciated?


 Property put in placed into service and disposed in

the same year
 Land (can never be depreciated)
 Inventory (property held for resale during the normal
course of business)
 Leased property (in accounting this was placed under
3 expenses) SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Terminology
 Depreciation (D) aka Capital Recovery
 Book Value (BV)

 Market Value aka Realized Value

 Basis Cost aka First Cost (B)



 Recovery Period aka Depreciable Life (n)

 Depreciation Rate aka Recovery Rate (d)
 Salvage Value (SV)

4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Depreciation

BV B

BV 1
D
Book Value

BV 2

BV 3

SV

0 1 2 3 4 Time n
5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Straight Line Depreciation
B − SV
BV B Dt =
n
1
dt = d =
n
SV BVt = BVt −1 − Dt
 B − SV 
BVt = B − t  
0 1 2 3 4 n  n 
Where:
t = year (t = 1, 2, 3, …n)
n = estimated service life
Dt = annual depreciation
dt = depreciation rate (the same for each year)
B = first cost / basis cost
BVt = book value at end of year t
SV = salvage value = BVn

6 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Declining Balance Depreciation
 In this method, an asset is depreciated faster
early than in the latter portion of its service
life
 The depreciation is calculated based on a
fixed percentage of the book value at the
D = α .BV t −1
beginning of anyt year of the service life
 BVt = BVt −1 − Dt
 since

BVt = BVt −1 − αBVt −1 = (1 − α ) BVt −1
 then
Dt = α (1 − α ) B
 t −1

 therefore,
BVt = (1 − α ) B
t

7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Double Declining Balance Depreciation
 Under the US tax law, an asset can only be
depreciated at the maximum rate of
twice the rate 0f straight line
depreciation method.
 Double declining balance method:
2

α=
n

8 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Sum-of-Year-Digits Depreciation
 Under this method, an asset is depreciated
faster on the first one-third of the
recovery period.
 The depreciation value at any end of the
year: D =  n − t + 1( B − SV )
t
  S 
 n ( n + 1)
S= = dt
 where 2

 t ( n − t / 2+ 0.5) 
 thus BVt = B −   ( B − SV )
 S 

9 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Graphical Representation of Depreciation
Methods

B
Book Value

SLD

SYD

DDB

SV

0 1 2 3 4 5 6 n
10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Exercise
 A man just bought a Mercedes for Rp 675.000.000,-. He
expects to use that car for 6 years after which he hopes to
sell it for Rp 450.000.000,-
 Calculate the book value of that piece of car each year for
the next six years using SLD, DB @ 175%, and SYD
EOY
methods SLD DB@175% SYD
 Dt BVt Dt BVt Dt BVt
0
1
2
3
4
5
6
11 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Other Reduction in Values of Asset
UNITS - OF - PRODUCTION DEPRECIATION


 Sometimes calculating recovery of capital cost in accordance

to theoretical value-time approach is undesirable.
 Alternatively, it can be assumed that depreciation occurs
based on unit of production
 example:
 A tractor was bought 3 years ago for $ 2,400,000. The owners has
estimated the equipment to be used for another 4 years, and to be
sold for $ 950,000. During 7 years of ownership the tractor is
expected to help moving 6 million cm of dirt. If in its 3 years
of operation that tractor has excavated 2.5 millions cm of dirt,
what is the current book value?
 answer:
dv = (B-SV)/Volume = ($2,400,000 - $ 950,000)/6.000.000 = $
0.24/cm
D = dv x Vol = $ 0.24 x 2,500,000 = $ 0.6
25m
.
millions
BV = B – dv x Vol = $ 2,400,000 - $ 0.24 x 2.5 m
25m
.
12= $ 1.8 millions SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Other Reduction in Values of Asset
 DEPLETION
 This term refers to activity that tends to exhaust a supply (of resources)


COST METHOD :


 This method is similar to the units-of-product depreciation method, where the depletion
charge is based on the amount of resources consumed and the initial investment.
 example:
 A coal mining site worth $ 3.5 billions is estimated to produce 20 million tons of
coal. Last year the mine produce 2,2 million ton of coal.
 The unit depletion rate = $ 3.5 billions/20 million tons = $ 175 / ton
 Depletion charge = 2.2 million to x $ 175/ton = $ 33 millions


PERCENTAGE METHOD :


 This method is based on the application of a fixed percentage of depletion rate for
individual type of natural resource, e.g., oil, gas. copper, etc. (max charge is 50%)
 example:
 The fixed percentage of depletion for coal is 10%. The coal can be sold for $ 195
/ton.
 The gross depletion income = 2.2 million tons x $ 195 /ton = $ 429 millions.
 Depletion rate = 10% x $ 429 millions = $ 42.9 millions


13 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Other Reduction in Values of Asset
 REDUCED BALANCE METHOD
 This method assumes assets are used more in early years, thus
larger depreciation charges made in early years
 Depreciation is calculated by applying a fixed rate to the
“net book value” (reduced balance) of the asset.
 Where:
R
 r = 1− n r
n
= depreciation rate
= estimated service life
 C R = residual value (BVt)
 example: C = historic cost (B)
 The installed cost of an asphalt mixing plant is $ 1,150,000
and is estimated to serve for 12 years. After 5 years in
service this piece of plant has recorded book value of $
725,000. Calculate the book value at the end of 7th , 10th ,
and 12th year


14 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Exercise/Homework
1. A scraper was bought for $ 1,375,000. Service life was estimated
at 12 years, and would then be resold for 485,000. Compute the
annual depreciation charge for 4th , 7th , and 10th year using a)
straight line and b) double declining balance method. Compare
the book value of both method.
2. A gold mine that is estimated to produce 300,000 ounces of gold is
purchased for $45 million. The gold can sold for $620 per
ounce. If 28,500 ounce was produced this year, what will be the
depletion for a) cost depletion, and b) percentage depletion
where the fixed percentage for gold is 22,5%? For what price
should the gold be sold so that percentage depletion will be
advantageous than cost depletion?
3. A truck bought for Rp 675,000,000 was to be used for 6 years on
an average of 2,000 hours per year. So far the truck has
accumulated 5,400 operating hours. What was the depreciation
charge?
4. An investor is considering to choose applying depreciation method
15 between DDB and SYD for an asset
SI-4251 he bought
Ekonomi 2 years Abduh,
TeknikMuhamad ago for Rp
Ph.D.
1,175 million. At that time he estimated the service life of 9