Business organization acquires fixed assets to be used in their business operation. It helps in improving and developing the not just the physical structure of the business itself, but also its capacity on income generation. It comprises of buildings, machineries, motor vehicles, furniture and fixtures, various leasehold improvements, and other equipment. The said property and equipment are depreciable in nature, except for land since in most cases it appreciates its value over time, and it is very useful to the business indefinitely.

Even though the said properties are purchased on its excellent quality, it is undeniable to say that these does not last indefinitely and will eventually lose its value over time. Accounting recognize the degrading of its value as depreciation.

Depreciation is the manner of expensing a portion of the value of property and equipment. This applies to depreciable assets that normally depreciate the value due to the following:

• Physical Depreciation:

Property and Equipment shall eventually meet its ultimate retirement due mainly on the following:

1. Time – Property and Equipment is not permanent. They can also get old and rusty due to the passage of time.
2. Wear and Tear – due to frequent usage, it normally reduces the capacity and usefulness of the asset.
3. Natural Elements such as wind, air, fire, dust, rain, etc. – can also an intervening factor in cases where assets are not currently used or idle.

• Functional or Economic Depreciation

This is the form of depreciation wherein the asset is no longer on its full or normal efficiency. It can also be subjected to obsolescence if there are other assets that are capable of performing the same task more efficiently. 

Factors to consider in computing depreciation:

Acquisition Cost/Historical Cost – is the initial value or cost of the asset paid upon acquisition. The acquisition cost consists of purchase price, freight in, net of discounts, if any, and other relevant costs incidental to acquisition.

Estimated Useful or Economic life – is the estimated life span of the asset. It is usually measured in years’ time.

Scrap or Residual Value – is the estimated amount after the end of its useful life.

Other Terms associated with depreciation:

Depreciable Value – It is the value used in computing depreciation expense. It is derived by deducting the residual value from the acquisition cost.

Book Value or Carrying Value – is the net amount after deducting the accumulated depreciation from the acquisition cost. Carrying Value is the considered an accurate value of the fixed asset for valuation purposes.

Some of the commonly used depreciation methods are the following:

A.   Straight Line Method

It is one of the most commonly used depreciation method since it is easy to apply. The depreciation is expensed uniformly throughout the useful life of the asset. The annual depreciation can be computed by using the formula:

Example 1: Clips Corporation acquires a service vehicle for the use of company’s executives. It has a total acquisition cost of ₱ 1,500,000.00 which is paid in cash and has a useful life of 5 years. In addition, it is estimated that it can be sold for ₱ 150,000.00 after its useful life. How much is the depreciable value, annual depreciation, and the net book value for the year 2020?

Solution:

First, you have to determine how much the depreciable value is:

After computing for the depreciable value, divide it by the useful life of the asset:

The net book value or the carrying amount for the year ended 2020 is ₱ 1,230,000.00 which is computed by deducting the accumulated depreciation from the acquisition cost. In this case, the accumulated depreciation is ₱ 270,000.00 which is also the amount or the depreciation expense for the year since it is the first (1^st) year of its useful life.

To account the entry of the service vehicle for the year 2020:

Upon Acquisition on January 1, 2020:

Service Vehicle                   1,500,000.00

                Cash                                     1,500,000.00

Upon Adjusting Entry for Annual Depreciation on December 31, 2020:

Depreciation Expense    270,000

                Accumulated Depreciation            270,000

It is to take note that annual depreciation is applied on the next years onwards until the end of its service life of 5 years. In this case the usefulness of the service vehicle is until December 31, 2024. To know for the value of the asset in the next years, you can refer to the depreciation table below:

As you have noticed, the depreciation is applied uniformly and the total depreciation after the end of useful life is equivalent to the depreciable value of ₱ 1,350,000. Also, the value at the year ended December 31, 2024 is ₱ 150,000.00 or its salvage value correspondingly.

B.   Output Method / Unit of Production

It is mostly used for production equipment based on its estimated total production capacity or how much it can possibly produce during its entire production life. As the name suggest, the depreciation is measured based on the output it can produce throughout the operation.

Example 2: Peyper Company is a paper production company. Recently, they purchased machinery equipment worth that can speed up their production process. It is bought for ₱ 2,500,000 with the residual value of ₱ 150,000. It is estimated that the machinery can produce a total of 250,000 units during its entire service. One unit of production is equivalent of 1 box of with 8 rims of paper sheets in it. The following is the production over the years:

How much is the depreciation charge per unit and prepare a depreciation schedule.

Solution: The depreciation charge per unit is ₱ 9.40 computed by dividing the depreciable value of 2,350,000 (2,500,000-150,000) by the total output capacity of 250,000 units.

Depreciation charge per output produced is useful in evaluating the depreciation expense every year as it able to produce.

C.   Accelerated Depreciation

It is a method of charging higher depreciation during the initial years and gradually reduces depreciation charge on the later years.

Under this method of depreciation are SYD (Sum of Year’s Digit) Method and Double Declining Balance Method.

• SYD or Sum of the Year’s Digit – is a fractional method of depreciation whereby it allocates a fractional portion as depreciation expense according to the useful life of the asset.

Where n = is the useful life of the asset

Example 3: Assuming on the same of example on example 1 except that is follows SYD Method:

Solution: all are the same in application except in computing for annual depreciation which is based on a fractional basis:

To compute for the denominator, the formula is used:

  SYD = 15

Notice that in computing for the depreciation expense for the first (1^st) year, the depreciable value is multiplied by the fraction of (5/15) until it reaches (1/15) on the fifth (5^th) year. The annual depreciation charge is gradually reducing in amount as it reaches its end of useful life.

• Double Declining Balance Method – is another example of accelerated depreciation wherein the depreciation charge is twice the rate of the straight line method of depreciation. It is applied to those assets that will give most of the benefit during its initial years of service.

Example 4: Assuming on the same of example on example 1 except that is follows Double Declining Balance Method:

To compute for the rate of the annual depreciation charge:

100/5 years = 20% x 2 = 40%

On the table above, the depreciation expense every year is based on the carrying value of the previous periods multiplied by the depreciation rate of 40%. Unlike for SYD Method, it does not follow depend of the depreciable value for annual depreciation computation. On the last year of its useful life, the amount is adjusted to arrive at the residual value of ₱150,000 and is no longer computed using the depreciation rate.

These examples are for you to know the difference of one method to another and what best fits your business. It is still better to seek advice from accountants for proper valuation of property, plant and equipment so that you don’t only meet the accounting standards, but as well mitigate possible discrepancies on tax implications.