Lecture on Depreciation Methods

Overview

• Depreciation Methods Covered:
  • Straight Line Method
  • Declining Balance Method
  • Double Declining Balance Method
  • Units of Production Method

Importance of Book Depreciation Methods

• Foundation for Tax Depreciation Methods:
  • Tax depreciation based on book depreciation principles
  • Relevant for understanding external company reports
• Regulatory Variations:
  • Different methods used in other countries and states
  • Equipment placed in service in the US before 1981 uses these methods (not MACRS)

Key Terms

• Depreciation Rate (d / alpha): Percentage or fraction of the first cost removed by depreciation each year
  • Straight Line: Constant amount every year
  • Other Methods: Rate changes annually
• Depreciation Charge (D): Actual amount in dollars subtracted from gross income
• Book Value: Cost basis minus all depreciation charges taken to date
  • Updated at the end of the company's accounting year
  • Reflects undepreciated value, may differ from market value
• Market Value: Amount obtained by selling an asset to a willing buyer
• Salvage Value: Estimated value at the end of the useful life

Straight Line Depreciation

• Method: Book value declines uniformly to salvage value over depreciation life
• Depreciation Rate: 1 / N
• Depreciation Amount: (Initial Investment - Salvage Value) / N
• Book Value Calculation:
  • Year 1: Initial Investment - Depreciation
  • Year 2: Previous Book Value - Depreciation
  • General Formula: Initial Investment - (Years * Depreciation Charge)*

Example

• Asset: Argon gas processor
  • Initial Cost: $20,000
  • Salvage Value: $5,000
  • Useful Life: 5 years
• Depreciation Rate Calculation: 1/5 = 0.2
  • Annual Depreciation Charge: 0.2 * ($20,000 - $5,000) = $3,000
• Book Value Calculation:
  • Year 3: 20,000 - 3 * 3,000 = 11,000

Declining Balance Depreciation

• Method: Accelerated depreciation, higher charges early in asset's life
  • Higher early depreciation = lower taxable income = lower taxes
  • Results in higher Net Present Value (NPV) over project life
• Rates
  • Straight Line Rate: 1/N
  • 150% Declining Balance: 1.5/N
  • 200% (Double Declining) Rate: 2/N
• Book Value Declines Rapidly: Major depreciation charges early on
• Formula:
  • Depreciation Charge in Year 1: Rate * Investment
  • Depreciation Charge in Year 2: Book Value * Rate
  • General Formulas:
    • Total Depreciation: I * (1 - alpha)^n
    • Book Value: I * (1 - alpha)^n

Example

• Asset: Equipment in Dubai
  • Initial Cost: $180,000
  • Salvage Value: $30,000
  • Useful Life: 12 years
• Book Value After 5 Years:
  • 150% Method: Alpha = 1.5 / 12 = 0.125
    • Book Value: 180,000 * (1 - 0.125)^5 = $92,324
  • Double Declining Method: Alpha = 2 / 12 = 0.167
    • Book Value: 180,000 * (1 - 0.167)^5 = $72,193

Example: Special Case

• Asset: Corn Husking Machine
  • Initial Cost: $10,000
  • Salvage Value: $778
  • Useful Life: 5 years
• Depreciation Rate: 0.40 annually
• Annual Depreciation Charge:
  • Year 1: 4,000
  • Year 2: 2,400
  • Year 3: 1,440
  • Year 4: 864
  • Year 5: 518
• Book Values:
  • Year 1: 6,000
  • Year 2: 3,600
  • Year 3: 2,160
  • Year 4: 1,296
  • Year 5: 778
• Observation: Book value equals salvage value at the end of the useful life.