Chapter 6: Depreciation CHAPTER 6 DEPRECIATION Chapter Objectives At the end of this chapter you should be able to * explain the meaning of depreciation explain the various depreciation methods compute annual depreciation, accumulated depreciation and book value construct a depreciation schedule 6.0 Introduction to Depreciation ‘Depreciation is an accounting procedure for allocating the cost of capital assets over their useful life. It can also be viewed as decline in value of assets because of age, wear and tear or decreasing efficiency. Depreciation is important to business as depreciation charges can be deducted from revenue when computing income tax and hence reduces tax liabilities. 6.1 Terms Related to Depreciation The original cost of an asset is the amount paid for the asset charges such as delivery cost and installation cost. For example, you order a machine costing RM 20.000 from West Malaysia. Let's say the delivery cost and the installation cost of the machine are RM 500 and RM 200 respectively therefore, the total cost for the machine = Amount of the machine + delivery cost + installation cost = 20,000 + 500 +200 =RM 20,700 Also called as salvage value or: * Scrap value is the value of an asset at the(end of its useful life * For instance, if an asset is bought for RM 3,000 and sold for RM 300 at the end of its useful life, the its salvage value is RM 300 Page | 101‘Chapter 6: Depreciation * Ifthe asset is condemned at the end of its useful life, then its salvage value is zero fulLife~ ~~ [ ‘The useful life of an asset is the life expectancy of the asset + The total depreciation of an asset is the otal Joss in value of the asset over 1) its useful life depreciation for the first 2 years is the Sum of the depreciation of the 1” and 2" year ‘* The book value isan asset is the value of the asset to date. So, we have the book value of an asset at the end of the 1° year, The book value at the end of the 2” year and so on * The book value of an asset keeps on decreasing from one accounting period to another period due to depreciation 6.2 Methods of Depreciation There are two methods of depreciation that are commonly used. They are: a. Straight Line Method b, Declining Balance Method c. Sum of year Digits Method 62.1 Straight Line Method It is the simplest and hence the most common method. Under this method, the annual depreciation is of the same value Formulas: Total Depreciation (TD) = Cost (C) — Scrap Value (S.V) (6.1) Annual Depreciation = Cost — Scrap Value * Useful Life = iat Useful Life (n) (6.2) Page | 102Chapter 6: Depreciation Note that, “tthe amount of annual depreciation under straight line method is the same throughout the accounting period. Annual Rate of Depreciation, r= x 100% = 1 x 100% 63 Useful life n sa OR r= Annual Depreciation x 100% Total Depreciation (en Book Value (to date), (BV1) = Cost (C)— Accumulated Depreciation (io Gals) (AccDD] (6.5) preciation (AD) x t (6.6) ‘n= useful life (in years) t=at the end of certain years Example Ts e ‘The cost of an air conditioner is RM 4000, The depreciation for each of the year is RM 500 throughout and its useful life is 3 years. Find the Book valuSor the air conditioner for end of the each year. Solution: The book value of the asset atthe end of the first year, BVi= C — [Link] = 4000-500 = 3500 The book value of the asset at the end of the second year, BV2= C— Ace,D2 1000 — (500 x 2) = 3000 The book value of the asset at the end of the third year, BV3=C — [Link] = 4000 — (500 x 3) = 2500 jqictefore, we can see thatthe book value of the asset keeps on decreasing atthe end of each of the accounting period. Page | 103‘Chapter 6: Depreciation Exercise 1: The book values of an asset at the end of the fourth and seventh year using the straight line ‘method are RM 24000 and RM 15000 respectively. Find the annual depreciation of the asset. BY,,=Fm2U,000 rma Pepleciatohs Tatel deprecation (10 Vufe ta) Bg = FM 15,000 eae v= eco 3 AD= Fm3/000 Exercise 2: ee a a A machine costing RM 30000 has a life expectancy of four years and zero salvage value. Using the straight line method, calculate the annual depreciation. Annual Depreciation = C-SV (Ka) 7 = 30000 -90 4 = RMN7500 Exercise 3: Construct a depreciation schedule using the straight line method for a new truck that costs ee and has a salvage value of RM10000 at the end of five years. iy » 8 sv n Ronuel Depreciction= ES = 600b0 - 10600 - pmio,o00 5 Depreciation Schedule: Book Value Annual Deprew: Page | 104Chapter 6: Depreciation Iris an accelerated method in which higher deprecation occurs in the early life of the asset. For instance, the first year has the highest deprecation whereas the last year has the lowest depreciation, ¥ « Yn = Book value of certain year (RM) ‘ost of asset (RM) 1 = rate of depreciation(9%) n= number of years Formula for the Book Value: Formula for the Annual Rate of Depreciation: HY] rat where: ‘£ (6.8) S= Salvage value (RM) C = Cost of asset (RM) nnual rate of depreciation(%) n= useful life (year) a ‘aa “ Formula for the Accumulated Depreciation, Dgup to n years: HEE] Formula for the Total Depreciation (using 6.1) Depreciation of a certain year, D, Page| 105Chapter 6: Depreciation Example 2: v or ‘A new equipment costing RM 10,000 is purchased. Using a declining balance rate of 12%, find the book value at the end of five years. Solution: *y C=RM10,000 = r=0.12 n=5 BVn=C(1-r)" BVs = RM10,000(1 - 0.12) Exercise 4: “e PAN oN The cost of an asset is RM 15,000. Its useful life is 4 years and the scrap value is RM 3,000. Based on reducing balance method, find a. the annual rate of depreciation b. the 3° year depreciation c. the book value at the end of the second year d the accumulated depreciation for the first 3 years 4 ) rsu'/B /2900_ = 0.3313 = 32.131 (+) 4S000 b) Der xB, wa) =e Meenas D3 = 0.3313 x (15000(1~ 03313)°) “ RM 2222-Ib 9 By= CCi-r)” (6-1) BY, = 15,000(1~ 3313)" = PMGTOT. 40g 4) Uge CCU)” bv) Ds = 'S000- ts008(1~0.3313)> 2 Fmlosiu- tb Page | 106Chapter 6: Depreciation 62.3 Sum-of-Year Digits Meth It is another accelerated method. The rate of depreciation is based on the sum of digits representing the number of years of the asset’s useful life. Example: Hf the asset has a useful life of three years, the sum of digits is 14243 S=6 Since S is an arithmetic progression, S can be calculated with the formula: (6.11) where: sum of years’ digits n= useful life (year) * Depreciation of a certain year, D, where: n-t+1 a s TD =C-sv Page| 107Chapter 6: Depreciation n wv i pox. Example 3: C z A machine costing RM 50,000 has a life expectancy of five years and a salvage value of RM 10,000. Using the sum-of-year digits method, calculate the book value at the end of two years. Solution: C = RMS50,000 n=5 SV = RM10,000 _n(n+1) « u 2 =528 rye Salt seas S \ : pv =c- AceD, (SY Aa? SE ae wyec- (rta}{to) = c- [eral -g BV» = Rw50,000~ (==) (RMSO. 00 ~ RH10,000) BV; = RM50,000 — (2) (RM40,000) Therefore, BV2 is RM 26000 Exercise 5: “c eo ov ‘A machine is purchased for RM 50,000. Its life expectancy is 4 years with zero trade-in value (scrap value). Using the sum-of-year digits method, a. Find the annual depreciation for€acH)of the year b. Prepare a depreciation schedule ) ana of | 3s = MoH) YOM) 10 y ‘ s yer wea = a) OF rE xTD 1 = att qo 2 3D,= Yai = Ao1H sooo] Pma6,o00, Dat ASH 4 [emo 2]* RMS, 000 D3 = 4-3H [0,004] =Ra 10,000 oa fs Bye Whe “= + {60,000-0]]= Ra 5.000, END OF CHAPTER Page | 108