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TOPIC: Let's look at depreciation

Let's look at depreciation 9 months 4 weeks ago #6977

  • Michael
  • Michael's Avatar
Hello Everyone,
This is my first time posting on the PrepCast forums. I have been answering PrepCast daily email questions for a few weeks now and was stumped on one that recently came through.

I will paste the email, question and then go into my question.

There are a number of ways to depreciate an asset. Not all of them are needed on the exam, but here are the two most popular ones: straight-line depreciation and the double-declining-balance method. But let's start at the beginning... what's depreciation?

Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time. For instance if your company purchases a machine at 500,000 that has a 10 year life-span, the simplest form of depreciation is to assume that it loses 10% of it's value every year.

In some cases, depreciation is much faster. For instance, after you purchase your new car and drive off the dealership's parking lot, your car immediately depreciates by about 33%. And your new computer that was just delivered to you has just lost 100% of it's value because a newer, faster model has come on the market. But of course I am only joking in both examples. Or am I...?

For the PMP Exam you need to know about straight-line depreciation and the double-declining-balance method. Straight-line is simple: You depreciate the same percentage every year based on the life-span of the asset. Just as in the example above where we depreciate 10% every year for a 10-year life-span. If it were a 20-year life-span we would depreciate how much? Exactly... 5%.

In the double-declining-balance method you depreciate double this percentage from the balance of the asset. In our example we would depreciate 20% every year from the balance. So in the first year we would depreciate 20% of 500,000. That is a 100,000 depreciation, and we have 400,000 left. In the second year, we would depreciate 20% of the balance of 400,000. That would be 80,000 and we are left with a balance of 320,000.

Let's see if you can do this with today's question below.

Question:
Your company owns an asset with an original value of $1,000. This asset will be depreciated using the double declining balance method over the period of 5 years. What is the dollar value of the annual depreciation in year 2?

A.) $300
B.) $145
C.) $240
D.) $86.50

The correct answer is C.
In the examples provided, they provided straight-line (which was 10%) and then 20% for double-decline (which is doubled from 10%). This gives me the impression that the percentage was already doubled and did not have to be double again.

Furthermore, the question had no reference of any starting percentage. So I used the 20% from the example provided and was incorrect. 40% was actually used.

My question is, why? What am I missing here? Is 40% always used when you are basing it off of 5 year depreciation? What rule of thumb do I need to use for my exam?

Thank you!
Michael

Let's look at depreciation 9 months 4 weeks ago #6982

  • Tracey South
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Hi Michael:

Remember that part of this equation is the straight line depreciation. (1/# of years) = 1/5 =.20 or 20%.

For double declining depreciation, you double the straight line depreciation (.20×2) =.4 or 40%.
Hope this helps.
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Let's look at depreciation 9 months 4 weeks ago #6983

  • Tracey South
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To complete the equation:

2 * straight line depreciation * book value

Year one book value = 1000
Straight line depreciation = 1 / 5 = .2 or 20%

Depreciation Year 1: 2 * .2 * 1000 = $400

Year two book value = 1000 - 400 = $600

Depreciation Year 2 : 2 * .2 * 600 = $240

Hope this helps.
Tracey
Community Moderator
Last Edit: 9 months 4 weeks ago by Tracey South. Reason: Typo
The following user(s) said Thank You: Cecil D'Souza

Let's look at depreciation 9 months 4 weeks ago #6984

  • Michael
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Both of those examples explain perfectly.

It seems the question was missing that valuable piece of information.

Thanks to all!

Michael
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