Lecture Note 5


●An analysis of costs and profits for any business operation requires recognition of the fact that physical assets decrease in value with time. This decrease in value may be due to;
physical deterioration
technology advances
economic changes
other factors which will cause the retirement of the property.
The reduction in value due to any of these causes is a measure of the depreciation. The economic function of depreciation, therefore, can be employed as a means of distributing the original expense for a physical asset over the period during which the asset is in use.
●Because the engineer thinks of depreciation as measure of the decrease in value of property with time, depreciation can immediately be considered from a cost viewpoint. Therefore, a part of the cost is to be charged during each year of usage.
●The land purchased to locate a plant is not included in depreciation charges. However, a garden of fruit trees, mining reserves and petroleum wells are considered for depreciation.
●From the viewpoint of the design engineer, the total cost due to depreciation is the original or new value of a property minus the value of the same property at the end of the depreciation period. The original value is usually taken as the total cost of the property at the time it’s ready for initial use. The total depreciation period is assumed as the length of the property’s useful life and the value at the end of the useful life is assumed to be the probable scrap or salvage value of the components making up the particular property.
●It should be noted here that the engineer cannot wait until the end of the depreciation period to determine the depreciation costs. Therefore, it’s necessary to estimate the final value of property together with its useful life.
The word depreciation is defined as a decrease in value. From the standpoint of economic analysis value refers either to “market value” or “value to owner”
●increased maintenance due to age
●failure of parts
●the quality of output is decreased
Another aspect of depreciation is caused by “obsolescence”. A machine is called obsolete when function it performs can be done in some better manner. A machine can be obsolete although it is in excellent working condition.
●The depreciation amount for any property is determined by “Maliye Bakanlığı” at each year. The rates are sometimes increased or decreased depending on economic conditions.
Buildings 4 % related with operation
2 % administrative, medical, cafeteria
Machine & equip. 20 %
Fuel tanks 5 %
Automobiles 20 %
and in some cases increased as twice of normal values
Types of depreciation
●Physical depreciation
Physical depreciation is the term given to the measure of the decrease in value due to changes in the physical aspects of the property. Wear & tear, corrosion, accidents, detoriation due to age etc. are the causes of physical depreciation. With this type of depreciation, the serviceability of the property is reduced because of physical changes.
●Functional depreciation
Depreciation due to all other causes is known as functional depreciation. The causes of functional depreciation are;
1.Obsolescence caused by technological advances or developments. Even though the property has suffered no physical charge, its economic serviceability is reduced because it is inferior to improved types of similar assets that have been made available through advancements in technology.
2.Change in demand fort he service rendered by the property, such as a decrease in the demand fort he product involved because of saturation of the market.
3.Shift of population center.
4.Changes in requirements of public authority.
5.Inadequacy or insufficient capacity fort he service required.
6.Termination of the need for type of service rendered.
7.Abandonment of the enterprise.
Capacity loss due to materials actually consumed is measured as depletion. The reason for depletion is essentially the same as the reason for depreciation. The owner of natural resources is consuming his capital investment as the natural resources are being removed and sold. Thus a portion of the gross income should be considered a return of the capital investment.
●Cost for Maintenance and Repairs
The term maintenance conveys the idea of constantly keeping a property in good condition; repairs means the replacing or mending of broken or worn parts of property. The costs for maintenance and repairs are direct operating expenses which must be paid form income.
The extent of maintenance and repairs may have an effect on depreciation cost, because the useful life of any property ought to be increased if it is kept in good condition. However, a definite distinction should always be made between costs for depreciation and costs for maintenance and repairs.
●Service Life
The period during which the use of a property is economically feasible is known as the service life of the property. Both physical and functional depreciation are taken into consideration in determining service life (economic life, useful life ).
In estimating the probable service life, it is assumed that a reasonable amount of maintenance and repairs will be carried out at the expense of the property owner.
●Salvage Value
Salvage value is the net amount of money obtainable from the sale of used property. If a property is capable of further service, its salvage value may be high. However, some other factors are also important;
●location of the property
●existing price levels
●market supply and demand
●difficulty of dismantling
The term salvage value implies that the asset can give some type of further service.
If the property cannot be disposed of as a useful unit, it can often be dismantled and sold as junk to be used again as a manufacturing raw material. The profit obtainable from this type of disposal is known as the scrap or junk value.
Salvage value, scrap value and service life are usually estimated n the basis of conditions at the time the property is put in use. These factors cannot be predicted with absolute accuracy but improved estimates can be made as the property increases in age. It’s advisable, therefore, to make new estimates from time to time during the service life and make any necessary adjustments in the depreciation costs.
Because of the difficulties involved in making reliable estimates of salvage and scrap values, engineers often neglect the small errors involved and designate these values as zero.
●Present Value
The present value of an asset may be defined as the value of the asset in its condition at the time of valuation. There are several different types of present values and differences should be distinguished.
1. Book Value or Unamortized Cost
The difference between the original cost of a property and all the depreciation charges made to date is defined as the book value. It represents the worth of the property as shown on the owner’s accounting records.
2. Market Value
The price which could be obtained for an asset if it were placed on sale in the open market is designated as the market value. The use of this tem conveys the idea that the asset is in good condition and that a buyer is readily available.
3. Replacement Value
The cost necessary to replace an existing property at any given time with one at least equally capable of rendering the same service is known as the replacement value.
It’s quite possible for the market value, replacement value and book value of a property to be widely different from one another because of unrealistic depreciation allowances or changes in economic and technological factors
Depreciation costs can be determined by a number of different methods. In general, depreciation accountings methods may be divided into two classes;
1.arbitrary methods giving no consideration to the interest costs.
2.Methods taking into account interest on the investment.
1- Straight – Line Method
In the straight – line method for determining depreciation, it is assumed that the value of the property decreases linealy with time. Equal amounts are charged for depreciation each year throughout the entire service life of the property.
The annual depreciation cost may be expressed as;
d: annual depreciation, $ / year
V: original value at the start of the service life ( ready to use ), $
Vs: salvage value of property at the end of service life, $
n: service life, years
The asset value of the equipment at any time during the service life may be determined from the following equation:
Va: asset or book value, $
a: number of years in actual use.
●Because of its simplicity, the straight – line method is widely used for determining depreciation costs. However, since it is impossible to estimate exact service lives and salvage values when a property is first put into use, it is sometimes desirable to re-estimate these factors from time to time during the life period of the property. If this done, straight – line depreciation can be assumed during each of the periods and the overall method is known as multiple straight – line depreciation.
●Example: If a packaging machine is to be purchased for $ 900 and its useful life is 5 years with a salvage value of $ 70, compute the straight – line depreciation schedule for this situation.
●2- Declining – Balance or Fixed Percentage Method
When the declining balance method is used, the annual depreciation cost is fixed percentage of the property value at the beginning of the particular year. The declining balance or fixed percentage factor remains constant throughout the entire service life of the property, while the annual cost for depreciation is different each year.
If the depreciation cost fort he first year of the property’s life is Vf , where f represents the fixed – percentage factor.
book value,
at the end of second year;
at the end of the n years, at the end of service life
The textbook relationship presented in this equation is seldom used in actual practice, because it places too much emphasis on the salvage value of the property and is certainly not applicable if the salvage value is zero. To overcome this disadvantage,
1.the value of the fixed – percentage factor is often chosen arbitrarily using a sound economic basis.
2.it is sometimes desirable to switch from the declining – balance to the straight – line method after a portion of the service life has expired. This is known as the “combination method”.
●Compared with the straight – line method, declining – balance depreciation permits the investment to be paid off more rapidly during the early years of life. The increased depreciation costs in the early years are very attractive to concerns just starting in business because the income – tax load is reduced at the time when it is most necessary to keep all pay – out costs at a minimum.
●The main advantage of the declining – balance and the combination methods is that they permit greater depreciation allowances in the early life of the property than in the later life. They are particularly applicable for units in which the greater proportion of the production occurs in the early part of the useful life or when operating costs increase markedly with.
●Example: The original value of a piece of equipment is $ 22 000, completely installed and ready for use. Its salvage value is estimated to be $ 2000 at the end of a service life estimated to be 10 years. Determine the book value of the equipment at the end of 5 years using;
a. Straight – line method
b. Declining – balance method
c. Double declining – balance method
●In some applications of declining – balance method a constant depreciation rate is applied to the book value of the property. Two rates are 150 % and 200 % of the straight – line rate. Since 200 % is twice the straight – line rate, it’s called “double declining balance”.
●for 150 % declining balance depreciation the two factors of the equations would be replaced by “1.50”
●3. Sum of the Years Digits Method
The sum of the years method is an arbitrary process for determining depreciation which gives results similar to those obtained by the declining – balance method. Larger costs for depreciation are allotted during early – life years than during the later years. This method has the advantage of permitting the asset value to decrease to zero or a given salvage value at the end of the service life.
In the application of the sum of the years digits method, the annual depreciation is based on the number of service – life years remaining and the sum of the arithmetic series of numbers from 1 to n, where n represents the total service life.
The yearly depreciation factor is the number of useful service life years remaining divided by the sum of the arithmetic series. This factor times the total depreciable value at the start of the service life gives the annual depreciation cost.
●Example: Consider the case of a piece of equipment costing $ 20 000 when new. The service life is estimated to be 5 years and the scrap value $ 2000. Calculate the depreciation cost with sum of the years digits method.
The sum of the arithmetic series of numbers from 1 to n is; 1 + 2 + 3 + 4 + 5 = 15
The total depreciable value at the start of the service life is; 20 000 – 2 000 = $ 18 000
4. Sinking – Fund Method
The use of compound interst is involved in the sinking – fund method. It is assumed that the basic purpose of depreciation allowances is to accumulate a sufficient fund to provide fort he recovery of the original capital invested in property. An ordinary annuity plan is set up wherein a constant amount of money should theoretically be set aside each year. At the end of the service life, the sum of all the deposits plus accured interest must equal the total amount of depreciation.
According to the annuity equation
where, i is the annual interest rate expressed as a fraction
R: uniform annual payments made at the end of each year ( this is the annual depreciation cost ).
V-Vs : total amount of the annuity accumulated in an estimated service life of n years.
●The amount accumulated in the fund after a years of useful life must be equal to the total amount of depreciation up to that time. This is the same as the difference between the original value of the property V at the start of the service life and the book ( asset ) value at the end of a years. Therefore,
●total amount of depreciation after a years = V-Va
●Since the value of R represents the annual depreciation cost, the yearly cost for depreciation is constant when the sinking – fund method is used. This method results in book values which are always greater than those obtained wit the straight – line method. Because of the effects of interest in the sinking fund methods. The annual decrease in asset value of property is less in the early – life years than in the later years.
Although the sinking – fund viewpoint assumes the existence of a fund into which regular deposits are made, an actual fund is seldom maintained. Instead, the money accumulated from the depreciation charges is used for financing other investment or projects and the existence of the hypothetical fund merely serves as a basis fort his method of depreciation accounting.
This method would be applicable for depreciating any property that did not undergo heavy service demands during it’s early life and have little chance of becoming obsolete or losing service value due to other functional causes.
In depreciation accounting procedures, assets may be depreciated on the basis of individual units or on the basis of various types of property groups or classifications.
Single – unit method
The single unit method requires keeping records on each individual asset. Although the application of this method is simple, the large number of detailed records required makes the accounting expenses very high. For the accounting system used in our country only single unit method is allowed. Group depreciation methods are not allowed. To simplify the accounting procedures, many concerns combine their various assets into groups for depreciation purposes. The types of group accounts are;
Composite account
A composite account includes all depreciable assets in one single group and overall depreciation rate is applied ate is applied to the entire account. With this method, the composite depreciation rate must be redetermined when important changes ocur in the relative distribution of the service lives of the individual assets.
Classified account
Instead of including all assets in a single depreciation account, it is possible to classify properties into general types, such as machinery and equipment, Office furniture, buildings and transportation equipment. The records for these groups are known as classified accounts.
Vintage – group accounts
In vintage – group accounts, the assets with approximately same service lives are included in each account group. A separate record is kept for each group and the same depreciation rate is applied to all the items included in each account. If a large number of groups are used, the results become more accurate since the average service lives are almost equal to real service lives.

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