Lecture12
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Topics to be Covered: - Depreciation and Depreciation Accounting - Reasons for Depreciation - Value of an Asset - Straight-Line Depreciation - Declining-Balance Depreciation
Lecture 12
- Elements of Financial Accounting - Measuring the Performance of a Firm - The Balance Sheet - The Income Statement - The Statement of Changes in Financial Position - Estimated Values in Financial Statements - Financial Ratio Analysis - Financial Ratios
Depreciation and Financial Accounting
1
Engineering Economy 85-313-(01 & 02)
2
Engineering Economy 85-313-(01 & 02)
Reasons for Depreciation
Depreciation Assets begin to lose value as soon as they are purchased. Something bought for $10,000 today may be worth $8,000 next week, $3,000 five years later and $100 in ten years.
- Use-related physical loss: As things are used, they wear out. For example, the surface of a die will wear out a certain amount each time it produces a part. Use-related physical loss is often measured in units of production. This measurement could be kilometers traveled, thousands of cycles, or hours of use.
This loss in value is called depreciation.
3
Engineering Economy 85-313-(01 & 02)
4
Engineering Economy 85-313-(01 & 02)
1
- Time-related physical loss: Some things deteriorate over time whether or not they are being used.
- Functional loss: Losses may occur without physical changes.
This could be due to environmental factors affecting them or other physical factors.
Things may go out of style (fashion), become technologically obsolete, or may be affected by legislative changes (pollution control devices).
For example, an unused tool may rust, and thus lose value over time.
This type of loss is usually expressed simply in terms of the particular unsatisfied function.
This type of loss is expressed in units of time
5
Engineering Economy 85-313-(01 & 02)
6
Engineering Economy 85-313-(01 & 02)
Value of an Asset Depreciation models can be used to estimate the loss in value of an asset, as well as the remaining value of that asset at any point in time. This remaining value can have several names. - Market Value: The actual value an asset can be sold for in an open market. Unless the asset is actually sold, market value can only be estimated.
- Book Value: The depreciated value of an asset for accounting purposes. Book value can be more or less than market value. The depreciation model used to arrive at a book value may be controlled by regulations, such as tax rules, or may be governed by a choice based on the ease of calculation of one method over another.
Depreciation models may be used to estimate market value.
7
Engineering Economy 85-313-(01 & 02)
8
Engineering Economy 85-313-(01 & 02)
2
Why Bother with Depreciation? - Scrap Value: can either be the actual value of an asset at the end of its physical life (when it is scrapped for material recovery) or a calculated estimate of scrap value using a depreciation model. - Salvage value: can either be the actual value of an asset when it is sold at the end of its useful life (when it is sold), or an estimate of the salvage value calculated using a depreciation model.
To assist in decision-making: it may be necessary to know the value of owned assets. To assist in planning: e.g. deciding which equipment to refurbish or replace. Tax calculation: since the treatment of the depreciation of assets directly affects expenses and it also affects profit, hence taxes. The government provides depreciation rules.
9
Engineering Economy 85-313-(01 & 02)
Depreciation Methods
- Double-declining balance
- Straight Line
Depreciation rate is calculated as 2/N with a service life of N years
Book value diminishes by an equal amount each year - Declining Balance
- 150% declining balance:
Book value diminishes by an equal proportion each year - Sum-of-the-year’s-digits
Depreciation rate is calculated as 1.5/N with a service life of N years - Units-of-production:
The depreciation rate is calculated as the ratio of remaining years of life to the sum of the digits of the remaining life 11
Engineering Economy 85-313-(01 & 02)
10
Engineering Economy 85-313-(01 & 02)
Depreciation rate is determined per unit of production by distributing initial cost over the estimated lifetime of the production capacity 12 Engineering Economy 85-313-(01 & 02)
3
Straight-Line Depreciation
Straight-Line Depreciation P
Dsl(n)= (P - S)/N Dsl(n) = depreciation amount for period n P
= purchase price
S
= salvage value
N
= useful life, in periods
S
Book Value
Assumes the rate of loss in value of an asset is constant over the useful life
BVsl(n) = P - n[(P - S) / N ]
Time
0
N
BVsl(n) = book value at the end of period n 13
Engineering Economy 85-313-(01 & 02)
14
Engineering Economy 85-313-(01 & 02)
Declining-balance depreciation
Example 6.1 ( p. 176): A laser cutting machine was purchased four years ago. Its purchase price was $380,000. In two years, its salvage value will be $30,000. Using straight line depreciation, calculate its current book value
Assumes the rate of loss in value of an asset as a constant proportion (constant percentage) over the useful life Ddb(n) = BVdb(n-1) x d Ddb(n) = the depreciation amount in period n
Solution:
BVdb(n) = the book value at the end of period n
P = $380,000, S = $30,000, N = 6, n = 4 BVsl(4) = 380,000 - 4[ (380,000-30,000) / 6 ] BVsl(4) = $146,667
P
= purchase price or current market value
d
= the depreciation rate
BVdb(0) = P 15
Engineering Economy 85-313-(01 & 02)
16
Engineering Economy 85-313-(01 & 02)
4
Declining-balance depreciation BVdb(n) = P (1-d)n - Given P and S, the declining balance rate can be estimated as follows: BVdb(n) = S = P (1-d)n (1 − d ) = n
S P
Value
P
S Time
d = 1− n
S P 17
Engineering Economy 85-313-(01 & 02)
N
18
Engineering Economy 85-313-(01 & 02)
Example 6.2 (p. 177): Paquita wants to estimate the scrap value of a smokehouse twenty years after purchase. She feels the depreciation is best represented using the declining-balance method, but she doesn’t know what depreciation rate to use. She observes that the purchase price of the smokehouse was $245,000 three years ago, and an estimate of its current salvage value is 180,000. What is a good estimate of the of the smokehouse after 20 years?
19
Engineering Economy 85-313-(01 & 02)
5
Lecture 12
- Elements of Financial Accounting - Measuring the Performance of a Firm - The Balance Sheet - The Income Statement - The Statement of Changes in Financial Position - Estimated Values in Financial Statements - Financial Ratio Analysis - Financial Ratios
Depreciation and Financial Accounting
1
Engineering Economy 85-313-(01 & 02)
2
Engineering Economy 85-313-(01 & 02)
Reasons for Depreciation
Depreciation Assets begin to lose value as soon as they are purchased. Something bought for $10,000 today may be worth $8,000 next week, $3,000 five years later and $100 in ten years.
- Use-related physical loss: As things are used, they wear out. For example, the surface of a die will wear out a certain amount each time it produces a part. Use-related physical loss is often measured in units of production. This measurement could be kilometers traveled, thousands of cycles, or hours of use.
This loss in value is called depreciation.
3
Engineering Economy 85-313-(01 & 02)
4
Engineering Economy 85-313-(01 & 02)
1
- Time-related physical loss: Some things deteriorate over time whether or not they are being used.
- Functional loss: Losses may occur without physical changes.
This could be due to environmental factors affecting them or other physical factors.
Things may go out of style (fashion), become technologically obsolete, or may be affected by legislative changes (pollution control devices).
For example, an unused tool may rust, and thus lose value over time.
This type of loss is usually expressed simply in terms of the particular unsatisfied function.
This type of loss is expressed in units of time
5
Engineering Economy 85-313-(01 & 02)
6
Engineering Economy 85-313-(01 & 02)
Value of an Asset Depreciation models can be used to estimate the loss in value of an asset, as well as the remaining value of that asset at any point in time. This remaining value can have several names. - Market Value: The actual value an asset can be sold for in an open market. Unless the asset is actually sold, market value can only be estimated.
- Book Value: The depreciated value of an asset for accounting purposes. Book value can be more or less than market value. The depreciation model used to arrive at a book value may be controlled by regulations, such as tax rules, or may be governed by a choice based on the ease of calculation of one method over another.
Depreciation models may be used to estimate market value.
7
Engineering Economy 85-313-(01 & 02)
8
Engineering Economy 85-313-(01 & 02)
2
Why Bother with Depreciation? - Scrap Value: can either be the actual value of an asset at the end of its physical life (when it is scrapped for material recovery) or a calculated estimate of scrap value using a depreciation model. - Salvage value: can either be the actual value of an asset when it is sold at the end of its useful life (when it is sold), or an estimate of the salvage value calculated using a depreciation model.
To assist in decision-making: it may be necessary to know the value of owned assets. To assist in planning: e.g. deciding which equipment to refurbish or replace. Tax calculation: since the treatment of the depreciation of assets directly affects expenses and it also affects profit, hence taxes. The government provides depreciation rules.
9
Engineering Economy 85-313-(01 & 02)
Depreciation Methods
- Double-declining balance
- Straight Line
Depreciation rate is calculated as 2/N with a service life of N years
Book value diminishes by an equal amount each year - Declining Balance
- 150% declining balance:
Book value diminishes by an equal proportion each year - Sum-of-the-year’s-digits
Depreciation rate is calculated as 1.5/N with a service life of N years - Units-of-production:
The depreciation rate is calculated as the ratio of remaining years of life to the sum of the digits of the remaining life 11
Engineering Economy 85-313-(01 & 02)
10
Engineering Economy 85-313-(01 & 02)
Depreciation rate is determined per unit of production by distributing initial cost over the estimated lifetime of the production capacity 12 Engineering Economy 85-313-(01 & 02)
3
Straight-Line Depreciation
Straight-Line Depreciation P
Dsl(n)= (P - S)/N Dsl(n) = depreciation amount for period n P
= purchase price
S
= salvage value
N
= useful life, in periods
S
Book Value
Assumes the rate of loss in value of an asset is constant over the useful life
BVsl(n) = P - n[(P - S) / N ]
Time
0
N
BVsl(n) = book value at the end of period n 13
Engineering Economy 85-313-(01 & 02)
14
Engineering Economy 85-313-(01 & 02)
Declining-balance depreciation
Example 6.1 ( p. 176): A laser cutting machine was purchased four years ago. Its purchase price was $380,000. In two years, its salvage value will be $30,000. Using straight line depreciation, calculate its current book value
Assumes the rate of loss in value of an asset as a constant proportion (constant percentage) over the useful life Ddb(n) = BVdb(n-1) x d Ddb(n) = the depreciation amount in period n
Solution:
BVdb(n) = the book value at the end of period n
P = $380,000, S = $30,000, N = 6, n = 4 BVsl(4) = 380,000 - 4[ (380,000-30,000) / 6 ] BVsl(4) = $146,667
P
= purchase price or current market value
d
= the depreciation rate
BVdb(0) = P 15
Engineering Economy 85-313-(01 & 02)
16
Engineering Economy 85-313-(01 & 02)
4
Declining-balance depreciation BVdb(n) = P (1-d)n - Given P and S, the declining balance rate can be estimated as follows: BVdb(n) = S = P (1-d)n (1 − d ) = n
S P
Value
P
S Time
d = 1− n
S P 17
Engineering Economy 85-313-(01 & 02)
N
18
Engineering Economy 85-313-(01 & 02)
Example 6.2 (p. 177): Paquita wants to estimate the scrap value of a smokehouse twenty years after purchase. She feels the depreciation is best represented using the declining-balance method, but she doesn’t know what depreciation rate to use. She observes that the purchase price of the smokehouse was $245,000 three years ago, and an estimate of its current salvage value is 180,000. What is a good estimate of the of the smokehouse after 20 years?
19
Engineering Economy 85-313-(01 & 02)
5
