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CHAPTER 5
DEPRECIATION
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5.1 Depreciation
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Depreciation is an accounting procedure for allocating the cost of capital assets, such as buildings, machinery tools and vehicles over their useful life.
Can also be viewed as decline in value of assets because of age, wear and tear or decreasing efficiency.
Many properties such as buildings, machinery, vehicles, and equipment depreciate in value as they get older.
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Several terms are commonly used in calculation relating to depreciation:
1. Original cost
The original cost of an asset is the amount of money paid for an asset plus many sales taxes, delivery charges, installation charges and other costs incurred.
2. Salvage value
The salvage value (scrap value or trade-in value) is the value of an asset at the end of its useful life.
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3. Useful life
The useful life is the expectancy of the asset or the number of years the asset is expected to last.
4. Total depreciation
The total depreciation or the wearing value of an asset is the difference between cost and scrap value.
5. Annual depreciation
The annual depreciation is the amount of depreciation in a year. It may or may not be equal from year to year.
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6. Accumulated depreciation
The accumulated depreciation is the total depreciation to date.
7. Book value
The book value or carrying value of an asset is the value of the asset as shown in the accounting record. It is the difference between the original cost and the accumulated depreciation charged to that date.
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Three methods of depreciation are commonly used.
These methods are:
Straight line method
Declining balance method
Sum of years digits method
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5.2 Straight Line Method
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The simplest of the three methods and probably the most common method used.
The total amount of depreciation is spread evenly to each accounting period through the useful life of the asset.
Formula:
Annual depreciation = Cost – Salvage Value Useful life
= Total depreciation Useful life
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Annual rate of depreciation
= Annual depreciation x 100% OR
Total depreciation
= x 100%
Useful life
Book value = Cost – Accumulated depreciation
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Example 1:
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ABC company bought a lorry for RM The
lorry is expected to last 4 years and its salvage
value at the end of 4 years is RM using the
straight line method, calculate:
a) The annual depreciation.
b) The annual rate of depreciation.
c) Calculate the book value of the lorry at the end of the second year.
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Solution:
a) Annual depreciation = Cost – Salvage Value Useful life
= – 10000 4
= RM 13000
b) Annual rate of depreciation
= Annual depreciation x 100%
Total depreciation
= x 100%
52000
= 25%
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c) Book value = Cost – Accumulated depreciation
= – (2 x 13000)
= RM 36000
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Example 2:
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A firm bought a machine for RM The
machine is expected to be obsolete in four years
with a salvage value of RM Find,
a) The book value of the machine after three years, and
b) Prepare a depreciation schedule,
Using the straight line method.
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Solution:
a) Annual depreciation = Cost – Salvage Value Useful life
= 5000 – 1000
= RM 1000
Book value = Cost – Accumulated depreciation
= 5000 – (3 x 1000)
= RM 2000
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14. b) The depreciation schedule
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End of year
Annual depreciation (RM)
Accumulated depreciation (RM)
Book value at end of year (RM) -
5000 1
1000
4000 2
2000
3000 3 4
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15. 5.3 Declining Balance Method
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Declining balance method is an accelerated in which higher depreciation charges are deducted in the early life of the asset.
Formula: BV = C (1 – r)n
Where:
BV = Book value
C = Cost of asset
r = Rate of depreciation
n = Number of years
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Annual rate of depreciation =
Where :
S = the Book value at the end of the Useful life (salvage value)
C = Cost of the product
r = Annual rate of depreciation
n = Useful life in years
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Example 1:
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A new equipment costing RM is purchased.
Using a declining balance rate of 12%, find,
a) The book value at the end of five years, and
b) Construct the depreciation schedule for the five years of use.
Solution:
a) BV = C (1 – r)n
BV = (1 – 0.12)5
BV = RM
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18. b) The depreciation schedule
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Year
Annual depreciation (RM)
Accumulated depreciation (RM)
Book value at the end of year (RM) -
10000 1
1200
8800 2
1056
2256
7744 3
929.28 4
817.77 5
719.63
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Example 2:
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A machine costing RM has a life expectancy
of four years and a salvage value of RM
Calculate the accumulated depreciation and book
value at the end of three years using the declining
balance method.
Solution:
= 24%
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BV = C (1 – r)n
BV = (1 – 0.24)3
BV = RM
Accumulated depreciation after 3 years
= Cost – Book value
= –
= RM
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21. 5.4 Sum of Years Digits Method
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Based on the sum of the digits representing the number of years of useful life of the asset.
If an asset has a useful life of 3 years, the sum of digits is S = = 6
It can be calculated with the formula:
S = n(n + 1) 2
Where:
S = Sum of years digits
n = Useful life
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The amount of depreciation in the first year is n/S of the depreciable value of the asset, the second is (n-1)/S, the third is (n-2)/S and so on.
Example 1:
A machine purchased for RM Its life is 4
years with a zero trade-in value. Calculate the
annual depreciation.
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Solution:
Sum of years’ digit, S = = 10 OR
S = 4(4 + 1) 2
= 10
Year
Annual Depreciation 1
4/10 x = RM 20000 2
3/10 x = RM 15000 3
2/10 x = RM 10000 4
1/10 x = RM 5000
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Example 2:
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A machine costing RM has a life
expectancy of five years and a salvage value of
RM Using the sum-of-year digits method,
a) Calculate the book value at the end of 2 years.
b) Prepare a depreciation schedule.
Solution:
a) Depreciable value = cost – salvage value
= – 10000
= RM 40000
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S = n(n + 1) 2
= 5(5 + 1)
= 15
Accumulated depreciation at the end of 2 years
= (5/15 + 4/15) x 40000
= RM 24000
BV = Cost – Accumulated depreciation
= – 24000
= RM 26000
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26. b) The depreciation schedule
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Year
Annual depreciation (RM)
Accumulated depreciation (RM)
Book value at the end of year (RM) -
50000 1 2
24000 3
8000
32000
18000 4 5
40000
10000
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