And today
Depreciation Accounting
William F. Bentz
1
Depreciation--definition
Depreciation is the process by which the
cost of property, plant & equipment is
either matched with revenues, or allocated
to the periods of benefit. As an allocation
process, the primary emphasis is on
income measurement and reporting, and
secondarily on the valuation of depreciable
assets for SFP purposes.
William F. Bentz
2
Principles
The
total depreciation to be taken is
equal to the cost of an asset less its
value at the end of its useful life.
The method used to depreciate an
asset should reflect the stream of the
benefits derived by using the asset
and the resulting net book values
over the life of the asset.
William F. Bentz
3
Principles
At
any point in the life of a
depreciable asset, the net book value
of the asset should be less than or
equal to the undiscounted cash flows
that can be derived from that asset
through its use or sale. This principle
constrains the use of the
depreciation method used.
William F. Bentz
4
Depreciation considerations
The
allocation process must be
systematic and rational. I interpret
rational to mean we should
communicate clearly to investors any
changes in expected profitability.
William F. Bentz
5
★★★★ 4 criteria to consider
Relationship
of the usage of an asset
to the decline in its remaining
economic life
Impact on profitability measures
Total amount of depreciation taken
Resulting valuation of the asset
William F. Bentz
6
Models in preference order
Where
there is a cause-effect
relationship between a measure of
work done and the resulting decline
in the economic life of a depreciable
asset, then that relationship should
be used to compute depreciation
expense. [i.e., use the production
method]
William F. Bentz
7
Cause-effect examples
Operation
of a jet engine which by
regulation must be overhauled after a
certain number of hours of use.
Cutting and drilling tools replaced
after a specified amount of use to
avoid problems caused by wear.
Any equipment that wears out with
usage.
William F. Bentz
8
Bottom-line...
When
a measurable cause-effect
relationship exists, use it to
depreciate the associated assets.
William F. Bentz
9
Profitability impact (2nd. best)
Equalize
(average) the reported
gross margin generated by the asset
over the useful life of the asset
(formula methods)
Equalize the accounting rate of
return on net book value over the life
of the asset (interest--aka. annuity-method)
William F. Bentz
10
Implications of the above
 The
most appropriate method is contextspecific
 There is no “best” method of depreciation
 From a financial reporting perspective, the
total depreciation is what counts.
 In each situation, several methods may
be equally appropriate
William F. Bentz
11
Practice issues
The
most difficult issue is
predicting useful lives
Many assets cannot be related
directly to any revenue-generating
activities
Some companies are more
aggressive than others in reporting
income.
William F. Bentz
12
Notation we will use
Let C = the portion of the
cost of a depreciable asset
that may be capitalized,
 Di = the depreciation expense
for year i,
 S = the residual or net scrap
value of the depreciable
asset,

n
= the planned economic
life of the depreciable
William F. Bentz
13
Production method
Formula


C S
Di  
 Current production

 Total expected production 
With
the production method,
depreciation expense varies with
the amount of production.
William F. Bentz
14
Straight-line method
Formula:
D
i
=
1
(C
n
- S) ,
If
C, S, and n do not change, the
annual depreciation is constant
over the life of an asset.
William F. Bentz
15
Sum-of-the-years’ digits (SYD)
 Formula:
2(n - i + 1)
(C - S)
Di =
n(n + 1)
 For the SYD method, the rate
declines linearly and the base
remains constant, so the depreciation
expense declines linearly.
William F. Bentz
16
Declining balance (DB) method
Formula:
i -1
Di = rC(1 - r )
In the DB method, the depreciation rate
is unchanged, but the base declines
exponentially. The resulting depreciation
expense declines exponentially.
William F. Bentz
17
DB method rates
There are three rates, two arbitrary and
one calculated rate that can be used with
the DB method:
 2 times the st.-line rate r = 2(1/n)
 1.5 times the st.-line rate r = 1.5(1/n)
 a calculated rate r, where
n
r = 1 - S/C
William F. Bentz
18
St.-line/DB hybrid method
In
addition to the above methods,
the St.-line/declining balance
hybrid balance method involves the
use of one of the arbitrary-rate DB
methods and a switch to straightline during the first year the
depreciation is greater with the
straight-line method.
William F. Bentz
19
The interest method
Formula
Di = Cf i - r (C -  D j )
i -1
j =1
Interest
method depreciation is a
function of the IRR “r” and the cash
flows. Depreciation can even be
negative for one or more periods.
William F. Bentz
20
THE END
William F. Bentz
21