Transcript Depreciation and Depreciation Accounting

Depreciation and Depreciation Accounting
6.1 Introduction
• Engineering projects often involve
investment in equipment or other
assets. These assets lose value,
or depreciate, over time.
• The first part of Chapter 6 deals
with the concept of depreciation
and methods of estimating
depreciation.
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6.2 Depreciation
•
Assets depreciate for a variety of reasons:
•
Use related physical loss, e.g. tire wear on a
car. This type of loss is usually measured as a
function of units of production, miles driven,
or other measures of use.
•
Time related physical loss: e.g., rusting of
cars. This type of loss is usually measured in
units of time.
•
Functional loss : e.g., style changes, changes
in safety device requirements. This is usually
measured in terms of the function lost.
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6.2.2 Value of an Asset
•
•
Depreciation models are commonly
used to model (estimate) the value of
an asset at any point in time.
The remaining value of an asset may
be measured in a number of ways,
depending on the circumstances:
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6.2.2 Market Value
•
•
Market Value: taken as the value of an
asset in the open market, i.e. if it were
for sale.
Since we can only determine the
market value by selling the asset, the
market value usually refers to an
estimate of the market value.
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Book Value
•
Book value: the value of an asset calculated
with a depreciation model for accounting
purposes.
– This value may be different from the
market value.
– There may be several book values given
for the same asset, depending on the
purpose. e.g. for taxation vs. shareholder
reports.
•
The historical cost of the asset is commonly
used as its initial book value.
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Value of an Asset
•
Other terminology:
•
Salvage Value: either the actual or
estimated value of an asset at the end
of its useful life (i.e. when it is sold).
•
Scrap value: A special case of Salvage
Value. Either the actual or estimated
value of an asset at the end of its
physical life (when it is broken up for
parts, or sold to a recycler).
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Why Estimate Asset Values?
•
We need to estimate the value of an asset for
a variety of reasons:
•
Making managerial decisions: we need to
know asset values. e.g., for negotiating a
loan.
•
Planning purposes: e.g. asset replacement
decisions.
•
Complying with Tax regulations: The
Canadian Government regulates how much
depreciation can be claimed on assets.
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Depreciation Models
•
To match the way in which assets depreciate
and to meet regulatory requirements, several
depreciation models have been developed.
•
Two of the most common in Canada are:
•
Straight line depreciation – simple, easy to
calculate;
Declining balance depreciation - required by
Canadian tax laws.
•
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6.2.3 Straight Line Depreciation
•
Straight line depreciation (SLD) assumes that
the rate of loss of an asset’s value is constant
over its useful life.
– i.e. the value of an asset is linearly
decreasing over its useful life.
P = purchase price
S = salvage value at the end of N periods.
N = useful life of asset
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Straight Line Depreciation (con’t)
S
Book Value
P
0
Time
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N
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Straight Line Depreciation (con’t)
•
Depreciation in period n using SLD:
P S
Dsl (n ) 
N
•
Book value of the asset at the end of period n:
P S 
BVsl (n )  P  n

 N 
•
Accumulated Depreciation at the end of period n:
P S 
P  BVsl (n )  n

 N 
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Example 6-1: (important)
•
An asset was purchased 7 years ago for
$10 000. It was estimated to have a 10 year
service life and a salvage value of $2000 at
the end of its service life.
•
If SLD is a good model of asset value, what
its book value today?
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Example 6-1: Answer
•
Given : n = 7, P = $10 000, N = 10, S = $2000
P S 
BVsl (7)  P  n

 N 
 10 000 - 2000 
= 10 000 - 7

10


= 10 000 - 7 * 800
= 4400.
•
SLD estimates the book value of the asset at
$4400
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Comments on the Straight Line
Depreciation Method:
•
SLD’s advantage is that it is easy to calculate
and understand.
•
The main problem with SLD is that many
assets do not, in fact, depreciate at a
constant rate.
•
Thus, market values often differ from book
values when SLD is used.
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6.2.4 Declining Balance Depreciation
•
The declining balance method of depreciation
models the loss in value of an asset in a
period as a constant proportion of the asset’s
current value.
•
DBD often matches the decline in value of an
asset well.
•
DBD must be used for reporting depreciation
expenses under Canadian Tax law.
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Declining Balance Depreciation
Value
P
S
Time
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N
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Declining Balance Depreciation
•
•
d = depreciation rate
P = purchase price
•
Initial book value:
BVdb (0)  P
•
Book value at the end of period n using DBD
BVdb (n )  P (1  d )n
•
Depreciation in period n using DBD
Ddb (n)  BVdb (n 1) d
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Example 6-2
•
A new press brake costs Medicine Hat Steel
$780 000. It is expected to last 20 years, with
a $60 000 salvage value.
•
What rate of depreciation for the decliningbalance method will produce a book value
after 20 years that equals the salvage value
of the press?
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Example 6-2: Answer
•
P = $780 000, N = 20 years, S = $60 000
780 000(1 – d)20 = 60 000
(1 – d)20 = 1/13
d = 1 – (1/13)1/20 = 1 – 0.8796 = 0.1204
•
A depreciation rate of about 12% will produce
a book value in 20 years equal to the salvage
value of the press.
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Example 6-3
•
An asset was purchased 7 years ago for
$10000. It was estimated to have a 10 year
service life and a salvage value of $2000 at
the end of its service life.
•
If the value of the asset is believed to be
depreciating at a constant rate each year,
what is its book value today if depreciation is
calculated using the Declining Balance
Method (DBD)?
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Example 6-3: Answer
BVdb(n) = P(1-d)n
BVdb(10) = 10,000(1-d)10 = S
S = 10,000(1-d)10
2000 = 10,000(1-d)10
d = 1- (2000/10000)1/10
d = 0.1487 or 14.87% (approx)
At the end of 7 years:
BVdb(7) = 10,000(1-.1487)7
BVdb(7) = $3240 (approx)
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Summary
•
Depreciation and Depreciation Accounting
– Reasons for Depreciation
– Value of an Asset
– Straight Line Depreciation
– Declining Balance Depreciation
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