Depreciation. Depreciation is the decrease in value of physical properties with the passage of time....

Depreciation

Depreciation is the decrease in value of physical properties with the passage of

time.

• It is an accounting concept, a non-cash cost, that establishes an annual deduction against before-tax income.

• It is intended to approximate the yearly fraction of an asset’s value used in the production of income.

• Applied only to Fixed Asset

FIXED ASSET

• What are fixed asset:

Used in business to produce income for more than 12 months

Fixed Asset Vs Inventory

Car dealers (Vimal) Vs Celcom car

INVENTORY FIXED ASSET

Property is depreciable if• it is used in business or held to produce

income.• it has a determinable useful life, longer than

one year.• it is 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.

• One exception to depreciation is land

Definition2011 2012 2013 2014

Revenue (mill) 1 1 1 1

Cost of good sold

Variable (thousand)

-100 -100 -100 -100

Factory Retooling (Fixed Cost) (thousand)

-500 -500

Gross Profit 400 900 400 900

SG & A (Selling General & Administration

-500 -500 -500 -500

Operating Profit -100 400 -100 400

• Not a good way of accounting• Lumpiness of the statement• Create impression of vulnerable business on

very stabile business• Spreading throughout the years - depreciation

Definition2011 2012 2013 2014

Revenue (mill) 1 1 1 1

Cost of good sold

Variable (thousand)

-100 -100 -100 -100

Factory Retooling (Fixed Cost) (thousand)

-250 -250 -250 -250

Gross Profit 650 650 650 650

SG & A (Selling General & Administration

-500 -500 -500 -500

Operating Profit 150 150 150 150

Definition2011 2012 2013 2014

Revenue (mill) 1 1 1 1Cost of good soldVariable (thousand)

-100 -100 -100 -100

Factory Retooling (Fixed Cost) (thousand)

-250 -250 -250 -250

Gross Profit 650 650 650 650SG & A (Selling General & Administration

-500 -500 -500 -500

Operating Profit 150 150 150 150

Depreciation

DEPRECIATION METHODS

• Straight line depreciation methods• Declining balance depreciation methods• Double declining method• Sum-of-the-year depreciation method• Unit-of-production depreciation method

DEPRECIATION METHODS

• Straight line depreciation methods• Declining balance depreciation methods• Double declining method (DDB)• Sum-of-the-year depreciation method• Unit-of-production depreciation method

IMPORTANT TERMS

• Book Value – It is the original cost of property, including any adjustments with depreciation deductions. Represent the amount of capital that remains invested in the property

• Market Value - The amount that will be paid by a willing buyer to a willing seller for a property.

DEPRECIATION METHODS

Example that we will be used throughout the class:Purchase cost : $304,000Service life : 8 yearsEst. Salvage Value : $16,000

Straight Line MethodsPurchase cost : $304,000Service life : 8 yearsEst. Salvage Value : $16,000

Formula : (Cost-Selvage value)/est. service life =Depreciation charge

: (304,000 – 16,000)/8 = 36,000/yr

Straight Line MethodsDepreciation schedule

Yr Depreciation Charge

Cumulative depreciation

BV end year

304,000

1 36,000 36,000 268,000

2 36,000 72,000 232,000

3 36,000 108,000 196,000

4 36,000 144,000 160,000

5 36,000 180,000 124,000

6 36,000 216,000 88,000

7 36,000 252,000 52,000

8 36,000 288,000 16,000

Declining Balance Methods (DB)Depreciation schedule

Yr BV Beg. Years

Rate, DB Deprec. Charge

Cum. Deprec.

BV end year

1 304,000 25% 76,000 76,000 228,000

2 228,000 25% 57,000 133,000 171,000

3 171,000 25% 42,750 175,750 128,250

4 128,250 25% 32,063 207,813 96,188

5 96,188 25% 24,047 231,859 72,141

6 72,141 25% 18,035 249,895 54,105

7 54,105 25% 13,526 263,412 40,579

8 40,579 25% 10,145 273,566 30,434

Declining Balance Methods (DB)How to determine the rate?DB methods also known as double declining rate;declining rate (%) is the rate from straight line method, and in our example is 1/81/8 = 12.5Double declining rate is 2 times of declining rate:= 2 x 12.5% = 25%

Double Declining Methods (DDB)Formula:

Depreciation charge for yr 1 = BV at the start of year 1 X double declining rate (DD)BV at the start of yr 1 = Original cost – AD at the start of year 1Double declining rate = 100%/useful life x2Depr charge for yr 1 = BV year 1 x DDDepr charge for yr 2 = BV year 2 x DD