Depreciation Methods and Concepts

Overview

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

Importance of Book Depreciation Methods

• Tax depreciation methods are based on book depreciation methods.
• Used in external reporting by companies.
• Some older equipment and specific jurisdictions use these methods for tax depreciation.

Key Terms

• Depreciation Rate (d or α): Percentage or fraction of the first cost removed by depreciation each year.
  • Straight Line: Constant amount every year.
  • Other Methods: Rate changes.
• Depreciation Charge (D): Actual dollar amount subtracted from gross income.
• Book Value: Cost basis minus all depreciation charges to date.
  • Reflects undepreciated value of an asset.
  • May differ from Market Value (actual sale value).

Straight Line Depreciation

• Book value declines in a constant manner to the salvage value over the depreciable life.
• Depreciation Rate:
  • d = 1 / N
• Depreciation Amount:
  • (Initial Investment - Salvage Value) / Number of Years
• Book Value Formula: Initial investment minus cumulative depreciation.

Example

• Argon Gas Processor:

  • Initial cost: $20,000
  • Salvage value: $5,000
  • Useful life: 5 years

• Depreciation Rate: d = 1 / 5 = 0.20

• Annual Depreciation Charge: $3,000

• Book Value at Year 3:

  • Initial Investment - (Years x Depreciation Charge) = $20,000 - 3 x $3,000 = $11,000

Declining Balance Depreciation

• Accelerated depreciation method.
• Takes larger charges earlier in an asset's life.
• Benefits: Lowers taxable income, minimizing taxes, higher net present value.
• Rates:
  • Straight Line Rate: 1 / N
  • Double Declining Rate: 2 / N
  • 150% Declining Balance Rate: 1.5 / N

Example

• Equipment: $180,000 initial cost, $30,000 salvage, 12-year life
• 150% Declining Balance Rate: 0.125
  • Book Value at Year 5: $92,324
• Double Declining Balance Rate: 0.167
  • Book Value at Year 5: $72,193

Units of Production Depreciation

• Based on actual use or output of the asset.
• Particularly useful for equipment where wear and tear correlates with use instead of time.

Summary of Depreciation Charges and Formulas

• Straight Line Depreciation: Constant yearly deduction.
• Declining Balance Methods: Larger deductions early on.
• When deciding on a method, consider the impact on taxable income and the financial goals of the company or project.

Case Studies

1. Corn Husking Machine:

• Cost: $10,000
• Salvage value: $778
• Useful life: 5 years
• Depreciation Rate: 0.40
• Yearly calculations of book value and depreciation charges confirm concepts discussed.

2. Equipment in Dubai: Illustrating differences between 150% and double declining balance methods.