Depreciation Methods

Depreciation Terminology
Definition: Book (noncash) method to represent decrease in value of

a tangible asset over time
Two types: book depreciation and tax depreciation
Book depreciation: used for internal accounting to track value of assets
Tax depreciation: used to determine taxes due based on tax laws
In USA only, tax depreciation must be calculated using MACRS;

book depreciation can be calculated using any method
Common Depreciation Terms
First cost P or unadjusted basis B: Total installed cost of asset
Book value BVt: Remaining undepreciated capital investment in year t
Recovery period n: Depreciable life of asset in years
Market value MV: Amount realizable if asset were sold on open market
Salvage value S: Estimated trade-in or MV at end of asset’s useful life
Depreciation rate dt: Fraction of first cost or basis removed each year t
Personal property: Possessions of company used to conduct business

Real property: Real estate and all improvements (land is not depreciable)
Half-year convention: Assumes assets are placed in service in midyear
Straight Line Depreciation
Book value decreases linearly with time
B
Dt = n- S Where: Dt = annual depreciation charge
t = year
B = first cost or unadjusted basis
S = salvage value
n = recovery period
BVt = B - tDt Where: BVt = book value after t years
SL depreciation rate is constant for each year: d = dt = 1/n

Example: SL Depreciation
An argon gas processor has a first cost of $20,000 with a

$5,000 salvage value after 5 years. Find (a) D3 and (b) BV3
for year three. (c) Plot book value vs. time.
Solution: (a ) D3 = (B – S)/n
= (20,000 – 5,000)/5 (c) Plot BV vs. time
= $3,000 BVt
20,000
(b) BV3 = B – tDt 11,000

= 20,000 – 3(3,000) 5,000
= $11,000
0 3 5 Year, t
Declining Balance (DB) and
Double Declining Balance (DDB) Depreciation
Determined by multiplying BV at beginning of year by fixed percentage d
Max rate for d is twice straight line rate, i.e., d ≤ 2/n

Cannot depreciate below salvage value
Depreciation for year t is obtained by either relation:

Dt = dB(1 – d)t-1 = dBVt-1
Where: Dt = depreciation for year t
d = uniform depreciation rate (2/n for DDB)
B = first cost or unadjusted basis
BVt -1 = book value at end of previous year
Book value for year t is given by:
BVt = B(1 – d)t
Example: Double Declining Balance
A depreciable construction truck has a first cost of $20,000 with a

$4,000 salvage value after 5 years. Find the (a) depreciation, and
(b) book value after 3 years using DDB depreciation.
Solution: (a) d = 2/n = 2/5 = 0.4

D3 = dB(1 – d)t-1
= 0.4(20,000)(1 – 0.40)3-1
= $2880
(b) BV3 = B(1 – d)t

= 20,000(1 – 0.4)3
= $4320
modified accelerated cost recovery
system (MACRS Depreciation
Required method to use for tax depreciation in USA only
Originally developed to offer accelerated depreciation for economic growth
Where: Dt = depreciation charge for year t

Dt = dtB B = first cost or unadjusted basis
dt = depreciation rate for year t (decimal)
Get value for dt from IRS table for MACRS rates

j=t
BVt = B - ∑Dj Where: Dj = depreciation in year j
j=1 ∑ Dj = all depreciation through year t
MACRS Depreciation
Always depreciates to zero; no salvage value considered
Incorporates switching from DDB to SL depreciation
Standardized recovery periods (n) are tabulated
MACRS recovery time is always n+1 years;

half-year convention assumes purchase in midyear
No special spreadsheet function; can arrange VDB

function to display MACRS depreciation each year
Example: MACRS Depreciation
A finishing machine has a first cost of $20,000 with a $5,000
salvage value after 5 years. Using MACRS, find (a) D and (b) BV
for year 3.
Solution: (a) From table, d3 = 19.20

D3 = 20,000(0.1920)
= $3,840
(b) BV3 = 20,000 - 20,000(0.20 + 0.32 + 0.1920)

= $5,760
Note: Salvage value S = $5,000 is not used by MACRS and BV6 = 0

Unit-of-Production (UOP) Depreciation
 Depreciation based on usage of equipment, not time
 Depreciation for year t obtained by relation
actual usage for year t

Dt = (B – S)
expected total lifetime usage
Example: A new mixer is expected to process 4 million yd3 of concrete over

10-year life time. Determine depreciation for year 1 when 400,000 yd3 is
processed. Cost of mixer was $175,000 with no salvage expected.
Solution: D1 = 400,000 (175,000 – 0) = $17,500

4,000,000
Depletion Methods
Depletion: book (noncash) method to represent decreasing
value of natural resources
Two methods: cost depletion (CD) and percentage depletion (PD)
Cost depletion: Based on level of activity to remove a natural resource

 Calculation: Multiply factor CDt by amount of resource removed
Where: CDt = first cost / resource capacity
 Total depletion can not exceed first cost of the resource
Percentage depletion: Based on gross income (GI) from resource

 Calculation: Multiply GI by standardized rate (%) from table
 Annual depletion can not exceed 50% of company’s taxable income (TI)
Example: Cost and Percentage Depletion
A mine purchased for $3.5 million has a total expected yield of one
million ounces of silver. Determine the depletion charge in year 4 when
300,000 ounces are mined and sold for $30 per ounce using (a) cost
depletion, and (b) percentage depletion. (c) Which is larger for year 4?
Solution: Let depletion amounts equal CDA4 and PDA4

(a) Factor, CD4 = 3,500,000/ 1,000,000 = $3.50 per ounce
CDA4 = 3.50(300,000) = $1,050,000
(b) Percentage depletion rate for silver mines is 0.15

PDA4 = (0.15)(300,000)(30) = $1,350,000
(c) Claim percentage depletion amount, provided it is ≤ 50% of TI

Summary of Important Points
Two types for depreciation: tax and book
Classical methods are straight line and declining balance
In USA only, MACRS method is required for tax depreciation
Determine MACRS recovery period using either GDS or ADS

Switching between methods is allowed; MACRS switches
automatically from DDB to SL to maximize write-off
Depletion (instead of depreciation) used for natural resources
Two methods of depletion: cost (amount resource removed
× CDt factor) and percentage (gross income × tabulated %)

Depreciation Methods

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Depreciation Terminology

Definition: Book (noncash) method to represent decrease in value of

Book depreciation: used for internal accounting to track value of assets

Tax depreciation: used to determine taxes due based on tax laws

In USA only, tax depreciation must be calculated using MACRS;

Personal property: Possessions of company used to conduct business

BVt = B - tDt Where: BVt = book value after t years

SL depreciation rate is constant for each year: d = dt = 1/n

An argon gas processor has a first cost of $20,000 with a

(b) BV3 = B – tDt 11,000

Max rate for d is twice straight line rate, i.e., d ≤ 2/n

Depreciation for year t is obtained by either relation:

A depreciable construction truck has a first cost of $20,000 with a

Solution: (a) d = 2/n = 2/5 = 0.4

(b) BV3 = B(1 – d)t

Originally developed to offer accelerated depreciation for economic growth

Where: Dt = depreciation charge for year t

Get value for dt from IRS table for MACRS rates

Incorporates switching from DDB to SL depreciation

Standardized recovery periods (n) are tabulated

MACRS recovery time is always n+1 years;

No special spreadsheet function; can arrange VDB

Solution: (a) From table, d3 = 19.20

(b) BV3 = 20,000 - 20,000(0.20 + 0.32 + 0.1920)

Note: Salvage value S = $5,000 is not used by MACRS and BV6 = 0

actual usage for year t

Example: A new mixer is expected to process 4 million yd3 of concrete over

Solution: D1 = 400,000 (175,000 – 0) = $17,500

Cost depletion: Based on level of activity to remove a natural resource

Percentage depletion: Based on gross income (GI) from resource

Solution: Let depletion amounts equal CDA4 and PDA4

(b) Percentage depletion rate for silver mines is 0.15

(c) Claim percentage depletion amount, provided it is ≤ 50% of TI

Classical methods are straight line and declining balance

In USA only, MACRS method is required for tax depreciation

Determine MACRS recovery period using either GDS or ADS

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