1. Asset Depreciation Lecture No. 30 Chapter 9
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010

2. Depreciation Definition: Loss of value for a fixed asset
Example: You purchased a vehicle worth $25,000 at the beginning of year 2010.
Changes in Market Value
End of Year
Market
Value
Loss of 1 2 3 4 5
$25,000
19,000
16,000
14,000
12,000
10,000
$6,000
3,000
2,000
Depreciation
Contemporary Engineering Economics, 5th edition, © 2010

3. Classification of Types of Depreciation
Economic Depreciation: (financial position)
Economic depreciation = Purchase price – market value
Accounting Depreciation:
Based on matching concept – a fraction of the cost of the asset is chargeable as an expense in each of the accounting period
Figure: 09-01
Contemporary Engineering Economics, 5th edition, © 2010

4. Why Do We Consider Depreciation?
Business Expense: Depreciation is viewed as a part of business expenses that reduce taxable income.
Gross Income -Expenses:
(Cost of goods sold)
(Depreciation)
(operating expenses)
Taxable Income
- Income taxes
Net income (profit)
Contemporary Engineering Economics, 5th edition, © 2010

5. Factors to Consider in Asset Depreciation (preliminary determinations for depreciating an asset)
Depreciable life (how long?)
Salvage value (disposal value)
Cost basis (depreciation basis)
Method of depreciation (how?)
Contemporary Engineering Economics, 5th edition, © 2010

6. What Can Be Depreciated?
Assets used in business or held for production of income
Assets having a definite useful life and a life longer than one year (you can never depreciate land)
Assets that must wear out, become obsolete or lose value
A qualifying asset for depreciation must satisfy all of the three conditions above.
Ex: buildings, machinery, equipment, vehicles etc.
Contemporary Engineering Economics, 5th edition, © 2010

7. Cost Basis
Without Trade-In Allowance
Cost basis of an asset represents the total cost that is claimed as an expense over the asset’s life. It includes actual cost of the asset and all other incidental expenses like freight, site preperation, and installation.
Contemporary Engineering Economics, 5th edition, © 2010

8. With Trade-In Allowance (if an asst is purchased by trading a similar asset)
Trade in allowance: a reduction in the price of a new item when an old item is given as part of the deal.
Consider book value – trade in allowance
Contemporary Engineering Economics, 4th edition, © 2007

9. Useful Life and Salvage Value
Useful life – how many years will an asset be useful to a company?
Service life of an asset – determining is difficult, uncertainty in estimates
Disputes between taxpayers and Internal Revenue Service (IRS)
Adopt the Asset Depreciation Ranges (ADR) published by the Internal Revenue Service (IRS).
Salvage value – Asset’s estimated value at the end of its useful life. Every effort should be made to estimate a reasonable residual value of the asset, but if not possible, a 10% rule (10% of the initial value) could be adopted for depreciation purpose.
Contemporary Engineering Economics, 5th edition, © 2010

10. Contemporary Engineering Economics, 4th edition, © 2007

11. Types of Depreciation Most firms calculate depreciation in 2 ways depending on whether the calculation is intended for financial reports or IRS
Book Depreciation
In reporting net income to investors/stockholders (balance sheet and income statement)
In pricing decision
Tax Depreciation
In calculating income taxes for the IRS
In engineering economics, we use depreciation in the context of tax depreciation
Contemporary Engineering Economics, 5th edition, © 2010

12. Summary
The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service.
The cost charged to operations during a particular year is called depreciation.
From an engineering economics point of view, our primary concern is with accounting depreciation; The systematic allocation of an asset’s value over its depreciable life.
Contemporary Engineering Economics, 5th edition, © 2010

13. Accounting depreciation can be broken into two categories:
1. Book depreciation—the method of depreciation used for financial reports and pricing products;
2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation.
The four components of information required to calculate depreciation are:
(a) cost basis, (b) salvage value, (c) depreciable life , and (4) depreciation method.
Contemporary Engineering Economics, 5th edition, © 2010