DEPRECIATION, DEPLETION and VALUATION of Properties
1.
Depreciation is the decrease or the reduction of the value of a property, an equipment such as machinery, building or other structure due to passage of time. It is that portion of the cost of the equipment which is charged off periodically as an expense in operating the business enterprise.
Depreciation is the decrease or the reduction of the value of a property, an equipment such as machinery, building or other structure due to passage of time. It is that portion of the cost of the equipment which is charged off periodically as an expense in operating the business enterprise.
Excluded from
this definition are properties whose values increase with time, such as antiques,
paintings of the masters, rare stamps, rare coins, and in most cases land.
Depreciation must always be
included in the cost of production of any product or the rendering of any
service where equipment is used for the following reasons ;
a) To
provide for the replacement of the equipment either at the end of its physical
or economic life or at the time when its operation no longer result in a
satisfactory profit.
b) To
provide for the maintenance of capital to replace the decrease in the value of
equipment caused by physical or functional causes.
2. A
natural resource such as mine, quarries,
an oil or gas well, or a piece of timber land wastes or depletes away due to
the gradual extraction of the contents of such properties and are being sold.
The corresponding reduction in the value of the resource is called depletion. To provide for the recovery
of capital invested in such assets, a depletion fund is provided. The annual
charge set aside in the fund is called depletion
cost rather than depreciation cost.
3. Valuation
is the process of determining the value of certain property for a definite reason.
Types of depreciation :
Decrease in the value of property with the passage
of time are due mainly to the following:
1. Physical
depreciation caused by the following:
(a) Deterioration
due to the effects of various chemical or mechanical factors on the materials
composing the property; i.e. rusting of metal parts, decay of wooden parts or
discoloration and cracking of plastic parts.
(b) Wear
and tear due to abrasion, friction between moving parts, impact, vibration or
fatigue of the materials that make up the property.
2. Functional
depreciation which is due to the decrease in the demand for the function of the
equipment for which it was designed. Such depreciation is caused by the following:
(a) Inadequacy
of the equipment.
(b) Obsolescence
caused by the invention of more efficient equipment and machines to perform the
same task.
(c) Change
in the method of production.
(d) Change
in style and design of the goods produced on the equipment.
(e) Transfer
of population due to various causes.
3. Change
in the price levels of similar property. If price levels rise during the life
of the property, even if the original investment has been recovered through
proper depreciation procedure, the recovered capital will be insufficient to
provide an identical replacement. Thus, it is the capital that has depreciated,
and not the property.
DEPRECIATION
COST
The depreciation cost depends upon the
physical or economic life of the equipment and its first cost.
a)
The
physical life of an equipment is the
length of time during which it is capable of performing the function for which it was designed and
manufactured.
b)
The
economic life of an equipment is the
length of time during which it will operate at a satisfactory profit. Thus,
even though the equipment can still perform its function, but it can only
operate at a loss, then it is considered economically dead. Replacement is in
order.
c)
The
first cost of any property includes
the original purchase price, freight and transportation charges to the site,
installation expense, initial taxes and permit to operate and all other
expenses needed to put the equipment into operation.
d)
The
amount to be recovered, equal to the depreciation
cost, is the difference between the first cost and the salvage value or
scrap value of the equipment.
e)
The
salvage value, sometimes called the
second-hand value is defined as the amount for which the equipment or the
machine can be sold as second hand. It implies that the machine can still
perform its function.
f)
The
scrap value or junk value is the amount that the equipment can be sold for, when
disposed off as a junk. This implies that the equipment can not be use anymore
for the function for which it was designed.
DETERMINATION
OF DEPRECIATION COST
The
methods often used to determine annual depreciation cost are the following :
1.
Straight-
line method
2.
Sinking
fund method
3.
Matheson
formula ( also known as Constant percentage method; Fixed percentage method;
Declining balance method or Diminishing balance method )
4.
Sum
of years-digits method ( SYD method )
5.
Service-output
or Production-units method
Other methods are :
1.
Straight-line
plus average Interest formula
2.
Double-rate
declining-balance method
3.
Operating
day method
4.
Retirement
method
5.
Annual
inventory method
REQUIREMENTS
FOR A DEPRECIATION METHOD
A depreciation method should fulfil the
following requirements :
1.
Payment
to the depreciation fund should be equal to the loss in the value due to
depreciation.
2.
The
method should be simple.
3.
Prior
to its adoption, approval of the method should be secured from the Bureau of
Internal Revenue ( BIR )
4.
To
be satisfactory, the actual value of the equipment should, at all times, be
equal to the book value. It will be necessary from time to time to check the
actual value against the book value, and in case the two values are not in
agreement, adjustments should be made.
VALUATION
Valuation
is the process of determining the value of certain properties for definite
reasons. Valuation is sometimes called appraisal
and the person engaged in the task of valuation is called an appraiser.
Due to their technical knowledge, engineers are
usually requested to solve problems in valuation under the following instances
:
1. When second hand structures, equipment and
machinery are to be purchased or sold.
2. When
extractive or wasting assets such as mines, oil and gas wells, timber lands,
and quarries are to be purchased or sold.
3. When
two or more going enterprises are to be
merged or consolidated.
4. When the value of a property is needed for
expropriation by the government for highways or impounding reservoirs.
5. When
the value of a property is needed for
purposes of taxation or insurance.
6. When
the rates to be charged by public utility companies are to be determined, their
properties must be correctly evaluated.
7. When
the management of an enterprise wishes to know the correct valuation of their property, in order to determine the financial
soundness of the enterprise.
8. For
the determination of penalties and or bonuses.
Terminologies related to Valuation :
1.
The
market value of a property is the
amount which a willing buyer will pay to a willing seller for the property when
neither one is under compulsion to buy or to sell.
2.
The
utility or use value of a property is what it is worth to the owner when in
actual operation. A property that is in good operating condition has a higher
value than one which is not operational.
3.
The
fair value is the value which is a
disinterested third party, different from the buyer or seller, will determine
in order to establish a price that is fair and acceptable to both the buyer and
the seller.
4. The
Book Value is the value of the
equipment as shown on the account records of the business enterprise. It is the
present value of the equipment which is the difference between the original
cost and the accrued depreciation. The book value of a property is not equal to
its actual value.
5.
Going value or going-concern value is considered to be
an intangible value which an actually operating concern has due to its
operation. It is also considered as the difference between the value of the property as it stands
ready for operation and its value as it would stand at completion of
construction as an inert assembly of physical parts.
6.
Goodwill value is that element
of value which a business has earned through the favorable consideration and patronage
of is customers arising from its well-known and well-conducted policies and operations.
Well-known trade mark and well-known products have this value to great extent. Goodwill
value is increase by good advertising, sound business policies and
courteous selling of the product or of rendering service.
7.
Salvage value of an equipment is
the amount that can be obtained from the sale of the equipment as second
hand. It is implied that the equipment has
still some utility value. It is not always equal to the book value of the
equipment at the time it is sold. It is affected by several factors relative to
the equipment, as follows:
a)
Condition
of the equipment at the time of sale. An equipment in good condition will
command a better salvage value than one in poor condition.
b)
Current
price of similar new equipment. If similar new equipment are currently being
sold at much higher price than the original cost of the original equipment,
then the salvage value will be more than the actual book value of the equipment
at the time of sale.
c)
Reason
for selling. In certain cases, the seller is very keen on selling s certain
piece of equipment because the same has not been operating economically. If the
buyer should notice this, then the salvage value will be low.
d)
Present
condition of the market. The law of supply and demand will operate in this
case. If similar goods are scarce, the salvage value of a property will be
rather high. On the contrary, if the market is glutted with similar properties,
then the salvage value will be low.
e)
Ease
or difficulty of removal of the equipment. In cases where a piece of equipment
is easily removed from the premises of the company, the salvage value maybe
fairly high. Difficulty in removing equipment from its premises will result in
a low salvage value due to the expected high cost of removal.
f)
Nature
of the equipment. A standard piece of equipment, not subject to rapid changes
in design or use, will usually command a better salvage value than a more specialized
piece of equipment.
8.
Scrap value or junk value of a machine is the amount
the machine would sell or if disposed off as junk. The utility of the machine
is considered to be zero.
9.
Rate-base value is the value
assigned to the property for the purpose of establishing rates. This is usually
applied to public utility companies.
Source : Engineering Economy, 3rd edition by Matias Arreola
chapter 7 ( pages 153 - 189 ) and chapter 8 ( pages 190 - 206 )
