Calculating an Asset Depreciation - Essay Example

QUANTITATIVE OPERATIONAL RESEARCH – DEPRECIATION There are various methods for calculating the depreciation of an asset based on either the level of use or on the passage of time. The depreciation value of the six pumps and back up generating units at the pumping station can be determined by the following three popular techniques. 1. Straight-Line Method. This is the most commonly used technique. The method depreciates the cost of a fixed asset evenly throughout its useful life. It is achieved by deducting the salvage time from the purchase price of an asset and then dividing the result by the total useful lifetime of the asset. Depreciation per annum = (Buying price - Residual Value) / Useful Life 2. Declining Balance Depreciation Method. This is an accelerated depreciation technique that calculates twice the value of the asset every year as an expense as compared to the straight-line method. The method is precise when the asset is expected to generate large revenues in its early life. The book value used in this method at the beginning of the depreciation year is the original cost of the asset while later in the year it is equivalent to the original cost less the accumulated depreciation. Depreciation for a period=2 X (straight line depreciation percent) X [(book value at beginning of period-salvage value)-accumulated depreciation)] 3. Sum of the Years Digits (SYD) Method. This is also an accelerated technique for calculating the depreciation of an asset. It involves summing up the expected life of the asset for each consecutive depreciating year. For n years, the formula would be SYD = n (n + 1)/2. The depreciation is then calculated by multiplying the total depreciable amount of useful life of the asset by the remaining useful life divided by the SYD. Annual depreciation = ((Original Cost - Salvage Value) X Remaining Useful Life) / SYD a) Straight-line method Deduction per year = (Buying Price- Residual value) / Useful life Depreciation = (£18,000,000-£500,000) / 8= £2,187,500 Year Book Value at the Beginning Depreciation Rate Depreciation Expense Book Value at the Year-End 1 £18 000 000 12.5% £2 250 000 £15 750 000 2 £15 750 000 12.5% £1 968 750 £13 781 250 3 £13 781 250 12.5% £1 722 656.25 £12 058 593.75 4 £12 058 593.75 12.5% £1 507 324.22 £10 551 269.53 5 £10 551 269.53 12.5% £1 318 908.69 £9 232 360.84 6 £9 232 360.84 12.5% £1 154 045.11 £8 078 315.74 7 £8 078 315.74 12.5% £1 009 789.47 £7 068 526.27 8 £7 068 526.27 12.5% £883 565.78 £6 184 960.49 b) Declining Balance Depreciation Method Straight line depreciation 1/8 = 12.5% Depreciation for a period=2 X 12.5% = 25% per annum. Year   Book Value Year Start Depreciation Percent Depreciation Expense Accumulated Depreciation Book Value Year End 1 18,000,000 25.00% 4,500,000 4,500,000 13,500,000 2 13,500,000 25.00% 3,375,000 7,875,000 10,125,000 3 10,125,000 25.00% 2,531,250 10,406,250 7,593,750 4 7,593,750 25.00% 1,898,438 12,304,688 5,695,313 5 5,695,313 25.00% 1,423,828 13,728,516 4,271,484 6 4,271,484 25.00% 1,067,871 14,796,387 3,203,613 7 3,203,613 25.00% 800,903 15,597,290 2,402,710 8 2,402,710 25.00% 600,677 16,197,968 1,802,032 c) Sum of the Years Digits SYD = 8+7+6+5+4+3+2+1=36 Depreciable Base = £18 000 000 - £500 000 = £17 500 000 Year Book Value Year start £ Total Cost Depreciable £ Depreciation Percent % Depreciation Expense £ Accumulated Depreciation £ Book Value Year End £ 1 18,000,000 17,500,000 22 (8/36) 3,888,889 3,888,889 14,111,111 2 15,812,500 17,500,000 19 (7/36) 3,402,778 7,291,667 10,708,333 3 13,625,000 17,500,000 17 (6/36) 2,916,667 10,208,333 7,791,667 4 11,437,500 17,500,000 14 (5/36) 2,430,556 12,638,889 5,361,111 5 9,250,000 17,500,000 11 (4/36) 1,944,444 14,583,333 3,416,667 6 7,062,500 17,500,000 8 (3/36) 1,458,333 16,041,667 1,958,333 7 4,875,000 17,500,000 6 (2/36) 972,222 17,013,889 986,111 8 2,687,500 17,500,000 3 (1/36) 486,111 17,500,000 500,000 The straight-line method is different from the other two techniques in that the amount of the deduction for depreciation is similar for each year of the life of the asset. This ensures that the method prevents bias in situations in which the depreciation pattern or the economic benefits of the asset are difficult to estimate. Hence it is most applicable where the useful life of the asset is long and when the economic benefits of the asset are difficult to estimate. The declining balance depreciation method is also referred to as double declining balance rate and it varies from the other methods in that it allows for larger amounts of depreciation during the early life of the asset as compared to later. It is most applicable when the asset is expected to generate a greater income during its early useful life. The Sum of the Years Digits (SYD) Method is different from the other two methods in that the numbers assigned to the consecutive useful years of the asset are summed up. For ‘n’ useful years, the sum of the year’s digits (SYD) would be n (n+1)/2. This technique is best applicable where the number of useful years is considerably large to use the other two methods. Relevance of Depreciation in Relation to Infrastructure Asset Management Infrastructure asset management can be defined as a systematic process of effectively preserving, elevating and using infrastructure assets, integrating engineering principles with effective business practice, as well as providing necessary tools to ensure a more organised and flexible decision making approach that would achieve the expectations of the public (NAMS Group 2006). Asset management entails the various phases of the asset useful life. The first phase is the identification of a need for the asset due to a requirement by the community. The asset is then provided and maintenance practices are carried out on the asset to meet the continuing needs of the community. The third phase is the useful operation of the asset and finally the asset is disposed after exhausting its useful life. This could be due to the eradication of its need or the exhaustion of its usefulness. An estimate of the depreciation is an important aspect in the cost approach to the valuation of an asset. Depreciated replacement methods are utilised to assess the value of specialised assets such as infrastructure to enable financial reporting where the direct market evidence is limited. Infrastructure is composed of several components with different useful service lives which are important in accounting for the depreciation of the asset. Depreciation in accounting is defined as the proportion of an asset that is consumed during an accounting period. Infrastructure usually has a useful life extending beyond more than a single accounting period such as a year. Accumulated depreciation therefore accounts for the loss of the potential of an asset to provide useful service from the acquisition or construction time. Hence depreciation in infrastructure asset management is an important tool for assessing the net cost of an infrastructure asset over a duration of time. References Bragg, S. M. (2013). The ultimate accountants reference including GAAP, IRS and SEC regulations, leases, and more (Unabridged. ed.). Hoboken, N.J.: Wiley. Brechner, R. A. (2012). Contemporary mathematics for business and consumers, 6th ed. Australia: South-Western/Cengage Learning. Gilbertson, C. B., & Lehman, M. W. (2009). Fundamentals of accounting (9th ed.). Mason, Ohio: South-Western/Cengage Learning. IASB, (2003), International Financial Reporting Standards 2003; Incorporating International Accounting Standards and Interpretations, London, International Accounting Standards Board. Ingenium / NAMS Group, (2006), International Infrastructure Management Manual; International Edition 2006, Wellington; New Zealand, National Asset Management Steering Group. NAMS Group, (2006), New Zealand Infrastructure Asset Valuation and Depreciation Guidelines -edition 2.0. Wellington; New Zealand, National Asset Management Steering Group. Read More