DEPRECIATION

Depreciation

• is defined as the decrease in the value of a

property, such as machinery, equipment, building
or other structure, due to the passage of time.
• Must always be included in the cost of production of any
product or the rendering of any service where equipment is
used for the following reason :

1. To provide for the replacement of the equipment either at the

end of its physical or economic life or at the time when its
operation no longer results in a satisfactory profits.
2. To provide the maintenance of capital to replace the decrease
in the value of equipment cost by physical or functional causes.
 TYPES OF DEPRECIATION

• Physical depreciation
• Functional
• Changes in the price levels of similar property
 DEPRECIATION COST
 The depreciation cost depends upon the physical or economic life of
the equipment and its first cost.
 The physical life of an equipment is the length of time during which it
is capable of performing the function for which it was designed and
manufactured.
 The economic life of an equipment is the length of time during which
it will operate as a satisfactory profit. Thus, even though the equipment
can still perform its function, but if it can only operate at a loss, then it
is considered economically dead. Replacement is in order.
 DETERMINATION OF DEPRECIATION
COST
1. STRAIGHT-LINE FORMULA
2. SINKING FUND FORMULA
3. MATHESON FORMULA
4. SUM OF THE YEAR DEGREE METHOD ( SYD METHOD )
5. SERVICE-OUTPUT or PRODUCTION-UNITS METHOD
6. STRAIGHT-LINE PLUS AVERAGE INTEREST FORMULA
7. DOUBLE-RATE DECLINING-BALANCE METHOD
8. OPERATING DAY METHOD
9. RETAIRMENT METHOD
10. ANNUAL INVENTORY METHOD
REQUIREMENT FOR A DEPRECIATION
METHOD
1. Payment to the depreciation fund should be equal to the loss in
value due to depreciation.
2. The method should be simple
3. Prior to its adoption, approval of the method should be
secured from the BIR
4. To be satisfactory, the actual value of the equipment should, at
all times, be equal to the book value.
 PROPERTIES OF THE DEFFERENT
DEPRECIATION METHOD
• Straight-Line formula
1. It is simple and more widely used than any other method
2. It does not need annuity table nor computing machines for using it.
3. It gives a uniform annual charge.
4. It is acceptable to the Bureau of Internal Revenue.
5. It does not take into account the interest of profit earn on the accumulated
depreciation fund. Likewise, operation and maintenance costs are
disregarded.
• The Sinking Fund Formula
1. It is also relatively simple, though it will require the use of annuity tables in the
absence of the electronic calculator.
2. It also gives a uniform annual charge.
3. A sinking fund is created in which funds accumulate for replacement purposes.
4. All amounts in the sinking fund earn interest.
5. Usually the company uses the amount accumulated in its operation, and therefore
the amount in the fund is assumed to earned a certain profit or interest.
6. It is generally the method use for economy study purposes.
• The Matheson formula
1. The basic assumption for this method is that the annual cost of
depreciation is a constant percentage of the salvage value at the
beginning of the year.
2. The annual depreciation charges, different each year, decrease
from year to year, greatest during the first year and less in the last
year of life of the property.
3. With this formula, however, a property can never depreciate to
zero value.
• The Sum of the Year-Digits (SYD) Method
1. It provides very rapid depreciation during the early years of life
of the property, and therefore enables faster recovery of capita.
2. It is easier than the Matheson formula.
3. Properties can depreciated to zero value.
4. The basic assumption for the method is that the value of the
property decreases at a decreasing rate.
 The Service-Output Method
1. Depreciation during any year is charged on the basis of actual service
rendered or actual units produced by the property during the year.
2. The depreciation cost per unit is constant and gives low depreciation expense
during periods of little production. Theoretically, if the property is idle during
any year no depreciation is charged.
3. It is difficult to apply because one has to estimate not only the economy life
span, but also the total amount of service or units the property will render or
produced during its life.
4. It is used in certain cases for computing the depreciation of public utility
equipment like taxis, buses, commercial planes, etc.
 The Straight-Line Plus Average Interest
Formula
1. It is an approximate method, because it adds and subtracts amounts
which do not occur at the same point in time.
2. The method closely approximate the true equivalent annual cost in
certain cases but a poor approximation in others.
3. The recovery of capital is on a straight-line basis, that is, an equal
amount is recover each year.
4. Depreciation cost computed by this method is low. The error is
considerable when the rate of interest is high and the life period long.
 The Double-Rate Declining-Balance
Method
1. The depreciation cost in any year is a constant ratio of the book value
at the beginning of the year.
2. The book value of this method can never become zero.
3. The salvage value, if any does not enter into the computations.
 The Operating Day Method
This is confined to assets where the major factor in
depreciation is wear and tear a rising from news. The
depreciation cost to be charged daily depends upon the number
of units produced during the day – the greater the production,
the higher the depreciation cost will be. This method may be
considered an extension of the service-output method, which
applied on an annual basis.
 The Retirement Method
A change is made in the investment account when the property
is retired or replaced. At this time the full initial book value of the
asset is taken out of the capital account. This sum diminished by the
salvage value is charged to current expenses. Any expenses for
repairs or replacement of worn-out parts made during the life of
the equipment are charged directly to current expenses and are
never included in the capital account.
 The Annual Inventory Method
This method involves the right-off of annual depreciation
determined by officers of the company who posses the required
experience and technical knowledge. In this respect the year end
book value of the asset may be more responsive to the actual
conditions obtaining during the year.
 The Straight-Line Formula
In this method the loss in value is considered to be directly
proportional the age of the property. No interest is assumed to
be paid on the amounts set aside in the depreciation fund.
• We shall adopt the following symbols:
n = useful life of the property in years
m= age of the property at any time less than or equal to n (m<=n)
d = annual cost od depreciation
Dm = accrued or total depreciation up to m years
Co = original or first cost of the property
Cm = book value of the property at the end of m years
Cn = book value at the end of life, n years, (salvage or scrap value, as the case
may be).
 The Sinking Fund Formula
• In this method it is assumed that a sinking fund is established in
which finds will accumulate for replacement purposes and will
bear interest. The total depreciation which has occurred up to any
given time is assumed to equal the amount in the sinking fund at
that time.
Using the same symbols as those for the Straight-Line Formula, the formulas for this
method are:
 Matheson Formula
• assumes that the annual cost of depreciation is fixed percentage of the book
value at the beginning of the year.

• k = ratio of the depreciation in any one year to the book value at the
beginning of the year. This is constant throughout the life of the property.
Example:
• A contractor imported a bulldozer fir his job, paying Php 250,000 to the
manufacturer. Freight and insurance charges amounted to Php 18,000;
customs, broker’s fees and arrester services, Php 8,500; taxes, permits, and
other expenses, Php 25,000. if the contractor estimates the life of the
bulldozer to be 10 years with a salvage value of Php 20,000, determine the
book value at the end of 6 years, using the Matheson formula.
 l

Sum of the Years-Digits (SYD) Method

• determine the sum of the years (summation years) of the life of

the property.
• determine the lose in value due to depreciation, Co-Cn
Example:
• A certain company makes it the policy that for any new piece of equipment
the annual depreciation cost should not exceed 10% of the original cost at
any time with no salvage or scrap value. Determine the length of service life
necessary if the depreciation method used is the SYD method.
DEPLETION
Depletion
 Two Methods of Theoretical Depletion

1. The Unit or Factor Method

2. The Percentage or Depletion Allowance Method
1. The Unit or Factor Method

• the depletion charge depends upon initial cost of the property

and number of units in the property.

• Depletion cost during any year

= Initial cost of property/Total units in property
(Units sold
Example:
• To develop an oil well containing 2,000,000 barrels of oil required an initial
investment of Php 30,000,000. In a certain year, 400,000 barrels of oil were
produced from this well. Determine the depletion charge during the year.
 2. The Percentage or Depletion
Allowance Method

• allows a fixed percentage of gross income received during a year

to be depletion charge.
• Some of the fixed percentages allowed for certain natural
resources are:

Natural Resources
• Gravel, sand, clay (5%)
• Coal, sodium chloride (10%)
• Gold, silver, copper, iron ore (15%)
• Oil and gas wells (22%)
• Sulfur, cobalt, lead, nickel, zinc, etc. (22%)
Example:
• The total gross income of the oil company is Php 34,000,000 for the
particular year, and the taxable income after taking all deductions, except for
depletion, is Php 14,100,000. Determine the allowance for the year.