Depreciation
Our purpose in studying
depreciation is to understand its
impact on taxes so that this
impact can be included in our
economic analysis.
What are the tax effects on the
cash flow diagram?
1
Depreciation
• The cost of fixed assets must be recorded as
expenses on a firm’s balance sheet and income
statement.
• Unlike costs such as labor, maintenance, and
material, the costs of fixed assets are not
treated simply as expenses to be accounted for
in the year that they are acquired.
• Instead, they are capitalized.
• Their costs are distributed by subtracting them
as expenses from gross income – one part at a
time over a number of periods.
2
Depreciation
• Depreciable Life – the period of time
over which the asset is capitalized.
• Matching Concept – A fraction of the
cost of the asset is chargeable as an
expense in each of the accounting
periods in which the asset provides
service to the firm.
• Depreciation is NOT a real cash flow!
3
Depreciable Assets
By U.S. tax law, depreciable property:
1. Must be used in business or held for
production of income.
2. Must have a definite service life, and
that life must be longer than 1 year.
3. Must be something that wears out,
decays, gets used up, becomes
obsolete, or loses value from natural
causes.
You can NEVER depreciate land!
4
Cost Basis
Cost Basis – the total cost claimed as
an expense over an asset’s life.
Includes:
• Actual Cost
• Some incidental expenses:
 Freight
 Site Preparation
 Installation
These are the costs req’d to put the asset into service!
5
Cost Basis
• Used in figuring depreciation
deductions.
• Used in calculating the gain or
loss to the firm if the asset is
sold or salvaged.
6
Cost Basis
•
If the asset is purchased by trading in a
similar asset, the difference between the
book value and trade in allowance must
be considered in determining the cost
basis of the new asset.
•
If the trade-in allowance exceeds the book
value, the difference (unrecognized gain)
needs to be subtracted from the cost
basis of the new asset.
•
If the book value exceeds the trade-in
allowance, the difference (unrecognized
loss) needs to be added to the cost basis
of the new asset.
7
Depreciation Methods
We will cover five methods:
• Straight Line
• Declining Balance
• Sum of Years Digits
• Units of Production
• MACRS – Modified
Accelerated Cost Recovery
System
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Notation
I = Cost Basis; Initial Price plus
installation expenses.
S = Salvage Value
Dn = Depreciation in Year n
Bn = Book Value in Year n
N = estimated years of useful life
n = the year currently under
consideration
9
Computer PBX Example
Initial Cost = $8,000
Installation = $2,000
Salvage = $1,000
Useful Life = 4 years
MACRS Property Class = 5 years
10
Straight Line Method
Dn = ( I – S )
N
Bn = I – Dn (n)
Where:
I = Cost Basis; Initial Price plus installation
expenses.
S = Salvage Value
Dn = Depreciation in Year n
Bn = Book Value remaining in Year n
N = estimated years of useful life
n = the year currently under consideration
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Declining Balance Method
=
1
(Multiplier)
N
= % reduction each year
Dn =  I (1–)n–1
Bn = I (1–)n
Typical multipliers are 150% and 200%.
200% is also called Double Declining Balance (DDB).
12
Sum of Years Digits Method
SOYD = 1 + 2 + 3 + … + N
= N(N+1)
2
Dn = ( N – n + 1 ) ( I – S )
SOYD
Bn = Bn–1 – Dn
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Units of Production Method
Dn = Service Units Consumed During Year n ( I – S )
Total Service Units
n
Bn = I –  Service Units Consumed During Year n ( I – S )
Total Service Units
14
MACRS
• Prior to 1981, taxpayers could
choose among several methods
when depreciating assets for tax
purposes.
• With the Economic Recovery Act
of 1981, ACRS was required and
MACRS was instituted in 1986.
• MACRS is a simpler, more rapid
depreciation method.
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MACRS Property Classes
Recovery
Period
(years)
ADR Class
Midpoint
3
ADR ≤ 4
Special tools for plastic / fabricated
metal parts mfg; motor vehicles
5
4 < ADR ≤ 10
Autos, light trucks, high-tech / R&D
equip., computerized phone switches
7
10 < ADR ≤ 16
Mfg equip., office furniture, fixtures
10
16 < ADR ≤ 20
Vessels, barges, tugs, railroad cars
15
20 < ADR ≤ 25
Waste-water plants, telephone
distribution plants, other utilities
20
25 ≤ ADR
Municipal sewers, electric power plants
Applicable Property
27.5
Residential rental property
39
Non-residential real property, elevators
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MACRS Depreciation Schedule
Class:
3
5
7
10
15
Year
200% DB
200% DB
200% DB
200% DB
150% DB
1
33.33
20.00
14.29
10.00
5.00
2
44.45
32.00
24.49
18.00
9.50
3
14.81*
19.20
17.49
14.40
8.55
4
7.41
11.52*
12.49
11.52
7.70
5
11.52
8.93*
9.22
6.93
6
7.54
8.92
7.37
6.23
7
8.93
6.55*
5.90*
8
4.46
6.55
5.90
9
6.56
5.91
10
6.55
5.90
11
3.28
5.91
12
13
14
15
16
5.90
* MACRS switches to straight line depreciation.
Table values shown are percentages.
5.91
5.90
5.91
2.95
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MACRS
Dn = (Year n MACRS Class Table Value)( I )
n
Bn = ( I )[1 – ( Year n MACRS Class Table Values )]
j=1
NOTE: If selling an asset BEFORE the final year of depreciation:
•
Selling year depreciation is ½ Dn value lower, and …
•
Selling year book value is ½ Dn value higher!
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