Hacettepe University Faculty Of Economics And Aministrative Sciences
Department Of Business Administation
Consideration Of
Depreciation And Income
Taxes
Papers Created By:
ÖZPARLAK,Ayşegül 20312383
ÖZGÜN,Aysun 20212445
EROL,Cem Umut 20311219
AYANOĞLU,Faik Uras 20211712
NARİN,Müşerref Özlem 20211214
LECTURER:
Dr. ARSLAN,Özgür
In the Division Of Finance-Accounting
0
Table of Contents
PLOT OUTLINE .................................................................................................................... 2
WHAT IS DEPRECIATION? .................................................................................................. 3
WHICH ASSETS ARE DEPRECIATED? ............................................................................... 3
CAUSES OF DEPRECIATION .............................................................................................. 4
1. PHYSICAL DETERIORATION ....................................................................................... 5
2. FUNCTIONAL OBSOLESCENCE .................................................................................. 5
3.ECONOMIC OBSOLESCENCE ...................................................................................... 6
MEASURING DEPRECIATION ............................................................................................. 6
COST ................................................................................................................................ 7
ESTIMATED USEFUL LIFE ..............................................................................................10
ESTIMATED RESIDUAL VALUE ......................................................................................13
METHODS & USAGE OF DEPRECIATION .........................................................................13
STRAIGHT-LINE METHOD ..............................................................................................13
DECLINING-BALANCE METHOD ....................................................................................15
UNITS OF PRODUCTION METHOD ................................................................................19
COMPARING DEPRECIATION METHODS .........................................................................21
DEPRECIATION AND INCOME TAXES .............................................................................24
MODIFIED ACCELERATED COST RECOVERY SYSTEM ..............................................24
ACRS ...............................................................................................................................25
MACRS.............................................................................................................................25
WHAT IS ECONOMIC VALUE ADDED (EVA)?....................................................................27
Stern Stewart & Company.................................................................................................28
EVA Basic Premise ..............................................................................................................28
EVA Simplified Calculation ...................................................................................................30
EVA in Comparison with Other Economic Measurements .................................................32
Why is EVA also useful for small companies?
(even with less than 100 employees) .......33
WHAT’S NEEDED TO CALCULATE COMPANY’S ECONOMIC VALUE ADDED?(EVA) ....33
EVA Implementation by a Small Company ...........................................................................33
CONCLUSION .....................................................................................................................34
TERMINOLOGY ...................................................................................................................35
BIBLIOGRAPHY...................................................................................................................37
1
PLOT OUTLINE
 Depreciation
 What is Depreciation?
 Which Assets will be Depreciated?
 Causes of Depreciation
o Physical Depreciation
o Functional Depreciation
o Technological Depreciation
o Depletion
o Monetary Depreciation
 Functions of Depreciation
o In Economy
o In Finance
o In Accounting
o In Cost Determination
 Measuring Depreciation
o Cost
o Estimated Useful Life
o Estimated Residual Value
 Depreciation Methods
 Straight-Line (SL) Method
 Declining Balance (DB) Method
 Units-of-Production (UOP) Method
 Comparing Depreciation Methods
 Depreciation and Income Taxes
 Modified Accelerated Cost Recovery System (MACRS)
 Economic Value Added (EVA)
EVA = Net Operating Profit – (Capital x The Cost of Capital)
After Tax (NOPAT)
2
WHAT IS DEPRECIATION?
Depreciation is the allocation of the cost of a plant asset to expense over its
useful (service) life in a rational and systematic manner. Depreciation accounting
matches the asset’s cost (expense) against the revenue earned by the asset, as the
matching principle directs.
If we want to contrast what depreciation accounting is with what it is not.
1.
Depreciation is not a process of asset valuation. Businesses do
not record depreciation based on the market (sales) value of their plant assets
at the end of each year. Instead, businesses allocate an asset’s cost to
expense during the period of its use.
2.
Depreciation does not mean that the business sets aside cash to
replace an asset when it is used up. Establishing a cash fund is entirely
separate from depreciation, and depreciation does not represent cash.
WHICH ASSETS ARE DEPRECIATED?
Plant assets are tangible resources that are used in the operations of a
business and are not intended for sale to customers. They are also called property,
plant, and equipment; plant and equipment; or fixed assets. These are generally
long-lived. They are expected to provide services to the company for a number of
years. Plant assets are often subdivided into four classes:
3
1.
Land, such as a bulding site.
2.
Land improvements, such as driveways, parking lots, fences,
and underground sprinkler systems.
3.
Buildings, such as stores, offices, factories, and warehouses.
4.
Equipment, such as store check-out counters, cash registers,
coolers, Office furniture, factory machinery, and delivery equipment.
Depreciation applies to three classes of plant assets: land improvements,
buildings, and equipment. Each asset in these classes is considered to be a
depreciable asset. Why? Because the usefulness to the company and revenueproducing ability of each asset will decline over the asset’s useful life. Depreciation
does not apply to land because its usefulness and revenue-producing ability
generally remain intact over time. In fact, in many cases, the usefulness of land is
greater over time because of the scarcity of good land sites. Thus, land is not a
depreciable asset.
CAUSES OF DEPRECIATION
4
Baum (1991) defines depreciation as a loss in the existing value of property
and attributes the causes to physical deterioration, functional obsolescence or
aesthetic
obsolescence.
Mansfield
(2000)
also
notes
that
property-based
depreciation is the result of two negatives processes; physical deterioration and
obsolescence. Barreca (1999) classifies depreciation into three
classes namely
physical depreciation, functional depreciation and other economic losses. These
three views of depreciation obviously have something in common and that is the fact
that depreciation is the result of physical deterioration, functional and economic
obsolescence.
1. PHYSICAL DETERIORATION
Deterioration is the decay and disintegration which takes place in structures
with the passage of time. Deterioration is caused by natural forces, by the elements,
and by use. Deterioration operates to terminate the physical life of a building.
Physical deterioration as a cause of depreciation is the result of wear and
tear with usage and deterioration with age among others. For example, physical
deterioration wears out the trucks that move merchandise from warehouses to
company stores. The stores fixtures used to display merchandise are also subject to
physical wear and tear.
2. FUNCTIONAL OBSOLESCENCE
Obsolescence refers to those changes in usefulness of structures in certain
neighborhoods which cause them to become less desirable or less useful.
It
operates to terminate the economic life of a building. Obsolescence does not affect
physical life as it does not cause deterioration. It has greater significance in valuation
than does deterioration.
5
Functional obsolescence is defined as the “loss in value of a property
resulting from changes in tastes, preferences, technical innovations, or market
standards”(IAAO 1997). Functional obsolescence is caused by
a. New inventions and discoveries;
b. Changes in the preferences and tastes of the public, with regard to
styles of architecture, geographical locations as places of residence, sizes of
rooms, heights of ceilings, the extent of mechanical equipment, such as
plumbing and heating, etc.
3.ECONOMIC OBSOLESCENCE
By definition, economic obsolescence is “a cause of depreciation that is a
loss of value as a result of impairment in utility and desirability caused by factors
outside the property’s boundaries” (IAAO 1997). Economic obsolescence is also
referred to as external or locational obsolescence.
High maintenance costs may require replacement earlier than anticipated.
There may be a better alternative, such as selling aircraft for a greater total return,
which is more cost effective than continuing to operate them. A review of market
value versus rate of return on production of assets is appropriate periodically. Where
the current market value of equipment is greater than the combined future return on
production, sale of the asset is a better alternative.
MEASURING DEPRECIATION
In measuring the amount of depreciation to recognize in a specific period there
are three variables:

Cost
6

Estimated useful life

Estimated residual value
COST
This will include all expenditures incurred by the business to bring the asset to
its required location and to make it ready for use. Thus, in addition to the costs of
acquiring the asset, any delivery costs, installation costs (e.g. plant) and legal costs
incurred in the transfer of legal title (e.g. freehold property) will be included as part of
the total cost of the asset. Similarly, any costs incurred in improving or altering an
asset in order to make it suitable for its intended use within the business will also be
included as part of the total cost.
Land Improvements
The cost of land improvements includes all expenditures needed to make the
improvements ready for their intended use. For example; the cost of a new company
parking lot will include the amount paid for paving, facing and lighting. Thus, these
costs are debited to Land Improvements. Because these improvements have limited
useful lives and their maintenance and replacement are the responsibility of the
company, they are depreciated over their useful lives.
Buildings
All necessary costs related to the purchase or construction of a building are
debited to the Buildings account. When a building is purchased, such costs include
the purchase price, closing costs (attorney’s fees, title insurance, etc.) and broker’s
comission. Costs to make the building ready for its intended use include expenditures
for remodeling and replacing or repairing the roof, floors electrical wiring, and
plumbing.
7
When a new building is constructed, cost consists of the contract price plus
payments for architect’s fees, building permits, and excavation costs. Also, interest
costs incurred to finance the project are included when a significant period of time is
required to get the building ready for use. These interest costs are considered as
necessary as materials and labor. The inclusion of interest costs is limited to the
construction period, however. When construction has been completed, subsequent
interest payments on funds borrowed to finance the construction are debited to
Interest Expense.
Equipment
The cost of equipment, such as Rent-a-Wreck vehicles, consists of the cash
purchase price plus certain related costs. These costs include sales taxes,
freight charges, and insurance during transit paid by the purchaser. They also
iclude expenditures required in assembling, installing, and testing the unit.
However, motor vehicle licenses and accident insurance on company trucks and cars
are not included in the cost of equipment. They are treated as expenses as they are
incurred. They represent annual recurring expenditures and do not benefit future
periods.
To illustrate, Dalton Engineering Ltd purchased a new motor car for its
marketing director. The invoice received from the motor car supplier revealed the
following:
8
$
New BMW 325i
Delivery charge
21,350
80
Alloy wheels
660
Sun roof
200
Petrol
$
30
Number plates
130
Road fund licence
140
1,240
22,590
Part
exchange-
1,000
Reliant Robin
Amount outstanding
21,590
The cost of the new car will be as follows:
$
New BMW 325i
Delivery charge
$
21,350
80
Alloy wheels
660
Sun roof
200
Number plates
130
1,070
22,420
These costs include delivery costs and number plates as they are a necessary
and integral part of the asset. Improvements (alloy wheels and sun roof) are also
regarded as part of the total cost of the motor car. The petrol costs and road fund
licence, however, represent a cost of operating the asset rather than a part of the
cost of acquiring the asset and making it ready for use, hence these amounts will be
charged as an expense in the period incurred (although part of the cost of the licence
may be regarded as a prepaid expense in the period incurred).
9
The part exchange figure shown is part payment of the total amount
outstanding and is not relevant to a consideration of the total cost.
ESTIMATED USEFUL LIFE
Estimated useful life is the length of the service period expected from the
asset. Useful life may be expressed in years, units of output, miles, or another
measure. For example, the useful life of a building is stated in years. The useful life of
a bookbinding machine is the number of books the machine can bind-that is, its
expected units of output. A delivery truck’s useful life can be measured in miles.
It is necessary to determine the estimated useful life of each piece of property,
plant, and equipment as it will be used in the entity involved. However, as a matter of
expediency, most organizations establish classes or groups of items and depreciate
them over a similar life. For example, furniture may be defined as a class and a
single life utilized for it. Because it is necessary to project into the future, this is not a
simple task. Useful lives of items may be far beyond what the practical or economic
life of an item will be.
Automobiles may have a useful life of ten or twelve years. However, or in a
rental car business, the practice may be to replace an automobile each year, or
within two years. Because customers expect to drive new automobiles, the economic
life in the rental car business would no more than two years. The same automobiles
used by administrative employees of the rental company may be replaced every
three or four years. Past practice should be reviewed in determining the future useful
life of the item.
Determining the estimated useful life has a significant impact on the period
expenses. Shortening the life will increase expenses in the periods. An estimated
useful life in excess of actual life understates the expenses in those periods and will
cause retirement of undepreciated assets. Therefore, careful consideration should be
given to ensuring that estimated useful life and actuals are reasonably accurate.
10
In determining the estimated useful life, consider the lives of similar items used
by the company in the past. A well-defined property record will provide that type of
information. Review with the users of the items their expected use in the future. Is it
increasing or decreasing? Determine what policies may be changed that will affect
the actual life of an item in the organization. Companies also make such estimates
from industry information and government publications.
Changing the Useful Life of a Depreciable Asset
Estimating the useful life of each plant asset poses an accounting challenge.
As the asset is being used, the business may refine its estimate on the basis of
experience and new information. The Walt Disney Company made such a change,
called a change in accounting estimate. Disney refigured depreciation for the revised
useful lives of several theme-park assets. The following note in Disney’s financial
statements reprts this change in accounting estimate:
Note 5
…[T]he Company extended the estimated useful lives of certain theme park …
assets based upon … engineering studies. The effect of this change was to decrease
depreciation by approximately $8 million (an increase in net income of
approxiamately $4.2 million … ).
Accounting changes like these are common because no one has perfect
foresight. Generally accepted accounting principles require the business to report the
nature, reason, and effect of the accounting change on net income, as the Disney
example shows. For a change in accounting estimate, the remaining book value of
the asset is spread over its remaining useful life. The new useful life may be longer or
shorter than the original useful life.
Assume that a Disney World hot dog stand cost $40,000 and that the
company originally believed the asset had an eight-year life with no residual value.
Using the straight-line method, the company would record depreciation of $5,000
each year ($40,000/8 = $5,000).
11
Suppose Disney used the asset for two years. Accumulated depreciation
reached $10,000, leaving a remaining depreciable book value (cost less accumulated
depreciation less residual value) of $30,000 (440,000 - $10,000). Suppose Disney
management believes the hot dog stand will remain useful for an additional ten
years. The company would revise the annual depreciation amount as follows:
Asset’s remaining
depreciable book value
$30,000
(New) Estimated
÷
÷
useful life remaining
10 years
(New) Annual
=
depreciation
=
$,3000
Willamette Industries, Inc., of Portland, Oregon, said in March 1999 that it
would change its accounting estimates relating to depreciation of certain assets,
beginning with the first quarter of 1999. The vertically integrated forest products
company said the changes were due to advances in technology that have increased
the service life on its equipment an extra five years. Willamette expected the
accounting changes to increase its 1999 full-year earnings by about $57 million, or
$0.52 a share. Its 1998 earnings were $89 million, or $0.80 a share. Imagine a 65
percent improvement in earnings per share from a mere change in the estimated life
of equipment!
Using Fully Depreciated Assets
A fully depreciated asset is an asset that has reached the end of its
estimated useful life. No more depreciation is recorded for the asset. If the asset is no
longer suitable for its purposes, it is disposed of. However, the company may be
unable to replace the asset. Or the asset remain useful. In any event, companies
sometimes continue using fully depreciated assets. The asset account and its
accumulated depreciation remain on the books, even though no additional
12
depreciation is recorded. For example, a fully depreciated asset has a cost of
$80,000 and zero residual value. The asset’s accumulated depreciation is $80,000
(same as the asset’s cost). If its residual value is $10,000, the asset’s accumulated
depreciation is now $70,000 ($80,000 - $10,000).
ESTIMATED RESIDUAL VALUE
Estimated residual value - also called scrap value or salvage value - is the
expected cash value of an asset at the end of its useful life. For example, a
machine’s useful life may be seven years. After seven years, the company expects to
sell the machine as scrap metal. The cash the business thinks it can sell the machine
for is its estimated residual value. Estimated residual value is not depreciated
because the business expects to receivethis amount from disposing of the asset. If
there is no residual value, then it depreciates the full cost of the asset. Cost minus
residual value is called the depreciable cost of the asset.
METHODS & USAGE OF DEPRECIATION
Actually,there are three types of methods that are used in depreciation.Theese
are straight-line (SL),declining-balance (DB),the third and the last method is unitsof-production (UOP).Here we begin to explain the first and commonly used
method,straight-line.
STRAIGHT-LINE METHOD:It is the simplest and most often used technique,
in which the company estimates the salvage value of the asset after the length of
13
time over which it will be used to generate revenues (useful life), and will recognize a
portion of that original cost in equal increments over that amount of time. The
salvage or estimated residual value is an estimate of the value of the asset at the
time it will be sold or disposed of; as just it may be zero also.Basicly in this method
,the salvage value is subtracted from the good’s cost at the time of the purchase and
then the result is divided to its useful life, in years.The reason that why this method is
commonly is used is just because of its simplicity,nothing more.
Let’s try to understand this method in an example:
Imagine a truck bought on 01.01.2001 at an amount $41,000 and a usefuful
life of 5 years or 100,000 miles can be driven.And also salvage value of the truck is
$1,000.The depreciation amount and the depreciation method is likely to be:
Data Item
Amount
Cost Of Truck...................................................................................................$41000
Less:Salvage Value.........................................................................................($1,000)
Depreciable Cost.............................................................................................$40,000
Estimeted Useful Life:
Years...........................................................................................................5 Years
Units Of Production.........................................................................100,000 Miles
Straight-Line Depreciation: (Cost-Salvage Value)/Useful Life,In Years =($41,000$1,000)/5= $8,000 per year
Date
Asset
Depreciation For The Year
Depreciation Depreciable Depreciation Accumulated
Rate
Cost
Expense
Depreciation
Cost
01.01.2001 $41,000
12.31.2001
0.20*
12.31.2002
0.20
12.31.2003
0.20
12.31.2004
0.20
12.31.2005
0.20
*1/5 year=0.20 per year
x
x
x
x
x
$40,000
$40,000
$40,000
$40,000
$40,000
$8,000
$8,000
$8,000
$8,000
$8,000
$8,000
$16,000
$24,000
$32,000
$40,000
Book
Value
$41,000
$33,000
$25,000
$17,000
$9,000
$1,000
14
DECLINING-BALANCE METHOD:Declaning-balance method also known as
reducing-balance method , is a type of accelerated depreciation because it
recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a
more realistic reflection of an asset's actual resale value, as well as the expected
benefit from the use of the asset: many assets are most useful when they are
new.Also there’s an accerelated method for declining-balance method which is
called double-declining-balance(DDB).It writes off more depreciation near the start
of an asset’s life than the straight-line does.In DDB the asset’s decreasing book
value is multiplied by a constant percentage that is 2 times bigger than DB.This
method is used just for financial reasons.But the main reason why accountants or
manegars prefer to use DB or DDB, is to postpone the tax payments.And this occurs
just because, the early profits of the organization would be less than if the
organization chooses to use any other depreciation method .
Now we’ll examine DB by the given example above:
Date
Asset
Cost
01.01.2001
12.31.2001
$41,000
Depreciation For The Year
DB
Book
Depreciation
Value
Expense
Rate
Accumulated
Depreciation
Book
Value
0.20
x $41,000
= $8,200
$8,200
$41,000
$32,800
12.31.2002
0.20
x $32,800
= $6,560
$14,760
$26,240
12.31.2003
0.20
x $26,240
= $5,248
$20,008
$20,992
12.31.2004
0.20
x $20,992
= $4,198.4
$24,206.4
$16,793.6
12.31.2005
$15,793.6*
$40,000
$1,000
*Last Year depreciation is the amount needed to reduce book value to the residual
amount($16,793.6-$1000=$15,793.6)
15
Declining-Balance
20000
15793.6
15000
10000
Series1
8200
6560
5000
5248
4198.4
0
1
2
3
4
5
Declining-Balance,
Accumulated Depreciation
50000
40000
40000
30000
20000
24206.4
20008
Series1
14760
10000
8200
0
1
2
3
4
5
As we can see the results above;the depreciation amount per yer is dropped
fairly till last year but the last year’s depreciation amount exceeds other four
years’.Actually,the aim of second depreciation technique is to allocate the
depreciable amount greater in the first years and then this amount is decreased until
the good’s book value equals to its residual amount.But as you see, using decliningbalance method in this example the fifth year’s depreciation amount exceeds greatly
than others and this is meaningless for accountants to use this method.So Double-
16
Declining-Balance Method is much more preferable.The declining balance
method is explained here just to give sight about the method and its application.
If we use DDB;the results will be then:
Date
Asset
Cost
01.01.2001
12.31.2001
$41,000
12.31.2002
12.31.2003
12.31.2004
Depreciation For The Year
DB
Book
Depreciation
Value
Expense
Rate
Accumulated
Depreciation
Book
Value
0.40
x $41,000
= $16,400
$16,400
$41,000
$24,600
0.40
0.40
0.40
x $24,600
x $14,700
x $8,856
= $9,840
= $5,904
= $3,542
$26,240
$32,140
$35,686
$14,760
$8,856
$5,314
12.31.2005
$4,314*
$40,000
$1,000
*Last Year depreciation is the amount needed to reduce book value to the residual
amount($5,314-$1000=$4,314)
Fistly we compute the depreciation rate per year.A 5-year asset has a straightline rate of 1/5, or 20% per year.A 10-year asset also has 1/10, or 10% and so on.In
double-declining balance method,we multiply the depreciation rate by 2.
DDB Rate = [1/(useful life of the asset,in year)] x 2
Then we’re going to find every year’s the depreciation amount:
DDB For The 1st Year: $41,000 x 0.40 = $16,400
DDB For The 2nd Year: ($41,000-16,400) x 0.40 = $9,840
DDB For The 3rd Year: ($41,000-$16,400-$9,840) x 0.40 = $5,904
DDB For The 4th Year: ($41,000-$16,400-$9,840-$5,904) x 0.40 = $3,542
DDB For The 5th Year: ($41,000-$16,400-$9,840-$5,904-$3,542) - $1,000
=$4,314 (Final Depreciation Year)
17
Finally be confirmed that DDB differs from the other methods in two ways:

Residual Value (Salvage Value) is ignored at the start.In the first
year,depreciation is computed on the asset’s full cost.
Final-year depreciation is the amount needed to bring the asset to residual
value.Final-year depreciation is a “plug” figure.
Double-Declining Balance
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
16400
9840
Series1
5904
4314
3542
1
2
3
4
5
Double-Declining Balance
Accumulated Depreciation
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
40000
35686
32140
26240
Series1
16400
1
2
3
4
5
18
UNITS OF PRODUCTION METHOD
The units-of-production method determines depreciation expense based on
the amount of asset is used. The length of life of an asset is expressed in a form of
productive capacity. The initial cost less any residual value is divided by productive
capacity to determine a rate of unit-of-production depreciation per units of usage.
Units of usage can be expressed in quantity of goods produced, hours used, number
of cuttings, miles driven or tons hauled, for instance. The depreciation expense of a
period is determined by multiplying usage by a fixed unit-of-production rate of usage.
This depreciation method is commonly used when asset usage varies from year-toyear.
In other words, in the units of production (UOP) method, a fixed amount of
depreciation goes with unit of output produced by the asset. Depreciable cost is
divided by useful life, in units of production. This per-unit expense is then multiplied
by the number of units produced each period to compute depreciation for that period.
The UOP depreciation equation is :
UOP Depreciation per unit of output=(Cost-Residual Value)/Useful Life In
Units Of Production
Why use this method?
The units of production (UOP) method allocates depreciation expenses
according to actual physical usage. Assets with an indefinite useful life but a limited
productive capacity are good candidates for this method. The UOP method is
particularly appropriate when the usage of a fixed asset varies greatly from year to
year.
For example, the blade of an industrial circular saw might be good for 10,000
hours of use, but it could take seven years, ten, or even fifteen to use up those
10,000 hours. In this case, the useful life is not clear, but the total productive capacity
is. Or, the saw might be used for 5,000 hours in the first two years, and only
sporadically for the next three. The UOP method helps solve these problems by
19
allocating the cost of the saw blade to the accounting periods in which it is actually
used.
Units of production relies on an estimate of the productive capacity of the fixed
asset. GAAP requires a "systematic and rational" estimate of the number of units - be
they hours, products, miles, or another measure - that the property will produce.
To find the depreciation expense for a year, a quarter, or a month, multiply the
number of units produced during that period by the UOP rate.
This is how it works:
Let’s go back to our previous exapmle.Our truck has an useful life of 100,000
miles.And assume that this truck is likely to be driven 20,000 miles the first year
30,000 the second,25,000 the third,15,000 the fourth, and 10,000 during the fifth.The
amount of UOP depreciation each period varies with the number of units the asset
produces.This procedure is shown at the diagram below.
UOP Depreciation Per Unit Of Output:
(Cost-Residual Value)/Useful Life In Units Of Production= ($41,000$1,000)/100,000 miles
=$0,40 per mile
20
Date
Asset
Cost
01.01.2001 $41,000
12.31.2001
12.31.2002
12.31.2003
12.31.2004
12.31.2005
Depreciation For The Year
Depreciation
Number
Depreciation
Per Unit
Of Units
Expense
Accumulated
Depreciation
$0,40
$0,40
$0,40
$0,40
$0,40
$8,000
$20,000
$30,000
$36,000
$40,000
X
X
X
X
X
20,000
30,000
25,000
15,000
10,000
=
=
=
=
=
$8,000
$12,000
$10,000
$6,000
$4,000
Book
Value
$41,000
$33,000
$21,000
$11,000
$5,000
$1,000
Units of time depreciation
Units of Time Depreciation is similar to units of production, and is used for
depreciation equipment used in mine or natural resource exploration, or cases where
the amount the asset is used is not linear year to year.
COMPARING DEPRECIATION METHODS
Years
Just to reinforce what we’ve learnt thus far, here’s a look at what the depreciation
charges for the same , $41,000 truck, would look like, depending upon the methods
used.
1st
2nd
3rd
4th
5th
Depreciation Methods
Straight-Line
Declining-Balance
Double-Declining
Balance
Dep.Exp. Acc.Dep. Dep.Exp. Acc.Dep.
Dep.Exp. Acc.Dep.
$8,000
$8,000
$8,200
$8,200
$16,400
$16,400
$8,000
$16,000
$6,560
$14,760
$9,840
$26,240
$8,000
$24,000
$5,248
$20,008
$5,904
$32,144
$8,000
$32,000
$4,198.4
$24,206.4 $3,542
$35,686
$8,000
$40,000
$15,793.6 $40,000
$4,314
$40,000
Units-Of-Production
Dep.Exp.
$8,000
$12,000
$10,000
$6,000
$4,000
Acc.Dep.
$8,000
$20,000
$30,000
$36,000
$40,000
21
Depreciation Amount
Straight Line Method
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1
2
3
4
5
Series1
8000
8000
8000
8000
8000
Series2
8000
16000
24000
32000
40000
Depreciation Amount
Declining Balance
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1
2
3
4
5
Series1
8200
6560
5248
4198.4
15793.6
Series2
8200
14760
20008
24206.4
40000
Depreciation Amount
Double-Declining Balance
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1
2
3
4
5
Series1
16400
9840
5904
3542
4314
Series2
16400
26240
32140
35686
40000
22
Depreciation Amount
Units-Of-Production
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1
2
3
4
5
Series1
8000
12000
10000
6000
4000
Series2
8000
20000
30000
36000
40000
Obviously, depending upon which method is used by management, the
bottom-line of a company can be seriously affected. The level of attention an investor
must give depreciation depends upon the asset intensity of the business he or she is
studying. The more asset-intensive an enterprise, the more attention depreciation
should be given.
If you have two asset intensive businesses, and they are using different
depreciation methods, and / or useful lives, you must adjust them so they are on a
comparable basis in order to get an accurate picture of how they stack up against
each other in terms of profit.
Some managements will report depreciation expense broken out as a
separate line on the income statement, while others will be more clandestine about it,
including it indirectly through SG&A expenses [for the deprecation costs of desks, for
instance]. Either way, you should be able to garner the information either through the
income statement itself or going through the annual report or 10k.
In
Security
Analysis
[the
classic
1934
edition],
Benjamin
Graham
recommended the investor answer three questions when dealing with the effects of
deprecation on a business [paraphrased]:
1.
Is
depreciation
reflected
in
the
earnings
statement?
2.
Is management using conservative and [as much as possible]
accurate depreciation rates? Accounting rules allow assets to be written off
23
over a considerable time period. Buildings, for example, can be depreciated
anywhere from ten to thirty years, resulting in large differences in charges
depending upon the time frame a particular business uses. A company’s 10k
filing should contain information on the rates employed by the company.
3.
Are the cost or base to which the depreciation rates applied
reasonable accurate? A company may set unrealistic salvage values on its
assets, thus reducing the amount of depreciation charges it must take every
year.
In conclusion, different depreciation methods produce different results,
and in some circumstances the use of a particular depreciation method is
recommended. When the use of an asset fluctuates from period to period, the unitsof-production method is recommended. For assets that decline in usefulness early,
and are subject to high maintenance costs as they age, a form of accelerated
depreciation should be used, i.e. declining-balance and the sum-of-the-yearsdigits methods. And also for some tax purposes, the straight-line, declining-balance,
sum-of-the-years-digits, and units-of-production methods of depreciation were
allowed prior to 1981. Between 1980 and 1987, either the straight-line method or the
Accelerated Cost Recovery System (ACRS) could be used. The Tax Reform Act of
1986 revised the ACRS by providing a depreciation rate schedule for eight classes of
plant assets. The use of an accelerated depreciation method reduces tax liabilities
and increases cash flows.
DEPRECIATION AND INCOME TAXES
MODIFIED ACCELERATED COST RECOVERY SYSTEM
As mentioned earlier, depreciation is the systematic allocation of the
cost of a capital asset over a period of time for financial reporting purposes, tax
purposes or both. It’s a non-cash expense and thus does not affect cash from
24
operations. But depreciation is a tax deductable expense. The higher
the
depreciation the lower income and the lower tax payment.
There are a number of alternative procedures that may be used to depreciate
capital assets. These include straight-line method
and various accelerated
depreciation methods. Most profitable firms prefer to use an accelerated depreciation
method for tax purposes-one that allows for a more rapid write off and therefore, a
lower tax bill.
Except
modified
accelerated
cost
recovery
system
(MACRS)
other
depreciation methods are mentioned above. We’ll tell accelerated cost recovery
system (ACRS) shortly; and we’ll begin to speak about MACRS.
ACRS
Prior to the Accelerated Cost Recovery System (ACRS), most capital
purchases were depreciated using a straight line technique, that allowed for the
depreciation of the asset over its useful life. ACRS was unique in three ways:
property class lives were established, calculations were based on an estimated
salvage value of zero, and shorter recovery periods were used to calculate annual
depreciation. This resulted in an accelerated write off of capital costs (in comparison
to that available using straight line depreciation) and was the source of the name.
Depreciation under ACRS = 2 x Straight Line Depreciation
MACRS
in the United States in 1986 with the passing of the Tax Reform Act (TRA-86),
as the depreciation method condoned by the IRS and is in force today.
MACRS that is replaced ACRS is a specified depreciation method that is used
only for income tax purposes. The cost of an asset, including any other capitalized
expenditure such as shipping and installation. Under MACRS the asset’s depreciable
basis is not reduced by the estimated salvage value of the asset.
Under MACRS, assets are segmented into classes by asset life.
25
MACRS GDS Property Classes Table
Property Class
Personal Property (all property except real-estate)
Special handling devices for food and beverage manufacture.
3-year property
Special tools for the manufacture of finished plastic products, fabricated metal
products, and motor vehicles
Property with ADR class life of 4 years or less
Information Systems; Computers / Peripherals
Aircraft (of non-air-transport companies)
5-year property
Computers
Petroleum drilling equipment
Property with ADR class life of more than 4 years and less than 10 years
All other property not assigned to another class
7-year property
Office furniture, fixtures, and equipment
Property with ADR class life of more than 10 years and less than 16 years
Assets used in petroleum refining and certain food products
10-year property
Vessels and water transportation equipment
Property with ADR class life of 16 years or more and less than 20 years
Telephone distribution plants
15-year property
Municipal sewage treatment plants
Property with ADR class life of 20 years or more and less than 25 years
20-year property
Property Class
27.5-year property
39-year property
Municipal sewers
Property with ADR class life of 25 years or more
Real Property (real estate)
Residential rental property (does not include hotels and motels)
Non-residential real property
26
Class Identified
Depreciation Method
by Asset Life (Years)
3
DDB
5
DDB
10
DDB
20
150% DB
27,5
SL
39
SL
Depreciation for the first classesis computed by the double declining balance
method (DDB). Depreciation for 20 year assets is computed by the %150 declining
balance method. Under 150% declining balance method the annual depreciation rate
is computed by multiplying the straight line rate by 1,50.For a 20-year asset, the
straight line rate is 0,05 x(1/20=0,5), so annual MACRS depreciation rate is 0,075
(0,05 x 1,50)..
WHAT IS ECONOMIC VALUE ADDED (EVA)?
EVA is a value-based financial performance measure reflecting the absolute
amount of shareholder value created or destroyed during each year. It is an estimate
of true economic profit after making corrective adjustments to GAAP accounting,
including deducting the opportunity cost of equity capital.
EVA is a useful tool in order to obtain effective protection against shareholder
value destruction, suitable to control operations of a firm by choosing the most
promising financial investments
27
EVA can be measured as Net Operating Profit After Taxes(or NOPAT)less the
cost of capital, equity as well as debt. The concept of Economic Profit is closely
linked to EVA. However, Economic Profit is not adjusted.
The underlying concept was first introduced by Eugen Schmalenbach, and the
current theory was formulated by Bennett Stewart and Joel M. Stern.
Stern Stewart & Company
Stern Stewart & Company owns a registered trademark for EVA™ for a brand
of software and financial consulting/training services. The proprietary component of
what Stern Stewart & Co. does is the adjustments. The amortization of goodwill or
capitalization of brand advertising and other similar adjustments are the translations
that occur to Economic Profit to make it EVA.
EVA Basic Premise
Managers are obliged to create value for their investors while investors invest
money in a company because they expect returns. There is a minimum level of
profitability expected from investors, called capital charge. Capital charge is the
average equity return on equity markets; investors can achieve this return easily with
diversified, long-term equity market investment. Thus, creating less return (in the long
run) than the capital charge is economically not acceptable (especially from
shareholders perspective). Investors can also take their money away from the firm
since they have other investment alternatives

Profits the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA. Under
conventional accounting, most companies appear profitable but many in fact are not.
Until a business returns a profit that is greater than its cost of capital, it operates at a
loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still
returns less to the economy than it devours in resources…Until then it does not
28
create wealth; it destroys it. EVA corrects this error by explicitly recognizing that
when managers employ capital they must pay for it, just as if it were a wage.
By taking all capital costs into account, including the cost of equity, EVA
shows the dollar amount of wealth a business has created or destroyed in each
reporting period. In other words, EVA is profit the way shareholders define it. If the
shareholders expect, say, a 10% return on their investment, they "make money" only
to the extent that their share of after-tax operating profits exceeds 10% of equity
capital. Everything before that is just building up to the minimum acceptable
compensation for investing in a risky enterprise.

Aligning decisions with shareholder wealth
EVA helps managers incorporate two basic principles of finance into their
decision making. The first is that the primary financial objective of any company
should be to maximize the wealth of its shareholders. The second is that the value of
a company depends on the extent to which investors expect future profits to exceed
or fall short of the cost of capital. By definition, a sustained increase in EVA will bring
an increase in the market value of a company. This approach has proved effective in
virtually all types of organizations, from emerging growth companies to turnarounds.
This is because the level of EVA isn't what really matters. Current performance
already is reflected in share prices. It is the continuous improvement in EVA that
brings continuous increases in shareholder wealth.

A financial measure line managers understand
EVA has the advantage of being conceptually simple and easy to explain to
non-financial managers, since it starts with familiar operating profits and simply
deducts a charge for the capital invested in the company as a whole, in a business
unit, or even in a single plant, office or assembly line. By assessing a charge for
29
using capital, EVA makes managers care about managing assets as well as income,
and helps them properly assess the tradeoffs between the two. This broader, more
complete view of the economics of a business can make dramatic differences.

Ending the confusion of multiple goals
Most companies use a numbing array of measures to express financial goals
and objectives. Strategic plans often are based on growth in revenues or market
share. Companies may evaluate individual products or lines of business on the basis
of gross margins or cash flow. Business units may be evaluated in terms of return on
assets or against a budgeted profit level. Finance departments usually analyze
capital investments in terms of net present value, but weigh prospective acquisitions
against the likely contribution to earnings growth. And bonuses for line managers and
business-unit heads typically are negotiated annually and are based on a profit plan.
The result of the inconsistent standards, goals, and terminology usually is incohesive
planning, operating strategy, and decision making.
EVA Simplified Calculation
EVA = OPBT - TAX - (TCE x COC) = NOPAT - (TCE x COC)
OPBT: Operating Profit Before Tax
TAX: Federal , state, county tax
NPAT = Net Operating Profit Before Tax
TCE: Total Capital Employed
30
COC: Cost of Capital
EVA Simplified Calculation Example
EVA = OPBT - TAX - (TCE x COC)
= 2,250 - 1,050 - (8,000 x 0.11)
= 320
Positive EVA indicates that this company creates value
A Simple Illustration
Assume that you have a firm with;
IA = 100 In each year 1-5, assume that
ROCA = 15% D I = 10 (Investments are at beginning of each year)
WACCA = 10% ROCNew Projects = 15%
WACC = 10%

Assume that all of these projects will have infinite lives.
After year 5, assume that

Investments will grow at 5% a year forever

ROC on projects will be equal to the cost of capital (10%)
Firm Value using EVA Approach
Capital
EVA
Invested
from
Assets
in
in
Place
Assets
=
(0.15
in
Place
-
0.10)
=
(100)/0.10
$
=
100
$
50
+ PV of EVA from New Investments in Year 1 = (0.15 - 0.10)(10)/0.10 = $ 5
31
+ PV of EVA from New Investments in Year 2 = [(0.15 - 0.10)(10)/0.10]/(1.1)2 = $
4.55
+ PV of EVA from New Investments in Year 3 = [(0.15 - 0.10)(10)/0.10]/(1.1)3 = $ 4.13
+ PV of EVA from New Investments in Year 4 = [(0.15 - 0.10)(10)/0.10]/(1.1)4 = $
3.76
+ PV of EVA from New Investments in Year 5 = [(0.15 - 0.10)(10)/0.10]/(1.1)5 = $
3.42
Value of Firm = $ 170.86
EVA Implementation
Stern Stewart & Co., the trademark owner of EVA, supports approximately 250 large
companies around the world. EVA implementation results are highly correlated with
stock prices. This measure can be maximized. Shareholders of the company will
receive a positive value added when the return from the capital employed in the
business operations is greater than the cost of that capital As a result EVA is an
estimator for company’s true economic value creation, unlike the traditional measures
has focus on shareholder value creation. Also it is a good basis for management
compensation systems to motivate managers to create shareholder value.
EVA in Comparison with Other Economic Measurements
Economic Value Added is a tool more useful than rate of return (ROI) in
controlling and steering day-to-day operations. EVA has not steering failures like ROI
and EPS (maximizing these measures might lead to not optimal outcome; not max.
shareholder value). At all, it is a concept practically the same as Economic Profit
(EP), Residual Income (RI) and Economic Value Management (EVM)
32
Why is EVA also useful for small companies?
(even with less than 100 employees)
Traditional performance measures used by small companies, such as sales or
profits alone, are unable to describe the company’s true business results and
sometimes lead to wrong business decisions. Whereas EVA calculation is simple and
the EVA concept is easy to understand and easy to use, since only main data
contained in income statement and balance sheet is needed. Because EVA reflects
company’s performance in dollars, positive EVA indicates value creation while
negative EVA indicates value destruction. Series of negative EVA is a signal that
restructuring in a company may be needed
EVA helps to understand the concept of profitability even by persons not
familiar with finance and accounting. In a small company, managers can make the
EVA concept transparent to all employees in a short time and this helps to convert a
small company’s strategy into objectives tangible for all employees.
Moreover, because managers having deeper knowledge about capital and
capital cost are able to make better decisions, the EVA concept integrated in a small
company’s decisions making process improves its business performance. As a result,
EVA is a useful tool for allocation of a small company’s scarce capital resources
WHAT’S NEEDED TO CALCULATE COMPANY’S ECONOMIC VALUE
ADDED?(EVA)
Only following the information is needed for a calculation of a company’s EVA:

Company’s Income Statement

Company’s Balance Sheet
EVA Implementation by a Small Company
When we consider EVA as not easy to use and too complicated for small
business environments, even if little information is enough to calculate it, some
deficiencies of this implementation can be observed. For example, to transform
33
traditional income statements into EVA ones, up to 164 adjustments need to be
made
For small businesses EVA recommends inexpensive debts in order to reduce
Cost of Capital (COC) ; which is a very questionable strategy. While it is a passive
accounting tool because it measures past performance and because the business
environment for small companies changes extremely quickly, a frequently financial
evaluation is essential.
The following are the important concepts when implementing EVA in a small
company in order to avoid from its deficiencies:
Management should remember that EVA calculation is just a starting point
Permanent EVA improvement has to be the main objective
EVA has to be calculated periodically (at least every three months)
Changes in EVA have to be analyzed
EVA development is the basis for a company’s financial and business policy
The following are the recommendations for the small companies in order to
improve EVA:
Try to improve returns with no or with only minimal capital investments
Invest new capital only in projects, equipment, machines able to cover capital
cost while avoiding investments with low returns
Identify where capital employment can be reduced
Identify where the returns are below the capital cost; divest those investments
when improvements in returns are not feasible
CONCLUSION
EVA is an appropriate management tool for small business because is easyto-calculate. Periodical EVA calculation and analysis can be done with minimal effort
because only few basic data have to be entered in a common spreadsheet. Its
implementation in a small company will result in a better business performance,
34
because of better understanding the objectives (especially near the floor/operating
activities)
EVA calculation is just a starting point for improvement in financial and
business policy. Scarce capital resources of a small company can be more efficiently
allocated using EVA than using intuition or traditional methods. Since EVA helps the
organization to realize that capital is a costly resource the most immediate effect of
EVA implementation is in most cases dramatic improvement in capital efficiency
(improved capital turnover)
Compared to conventional measures, EVA is an epochal measure since it can
be maximized: it is the better the bigger EVA is. With traditional measures that is not
the case, since ROI can be increased with ignoring below average projects and
EPS/Operating Profit/Net profit can be increased simply investing more money in the
company.
In conclusion, EVA helps enormously the management and employees to see
what should be real objective of the company, since it makes clear to all what
profitability really is.
TERMINOLOGY
Basis: The full cost of placing a fixed asset in service, used to calculate
depreciation expense.
Book value: Basis less accumulated depreciation
Cost: It will include all expenditures incurred by the business to bring the
asset to its required location and to make it ready for use.
Depreciable assets: The assets whose usefulness to the company and
revenue-producing ability will decline over their useful life like land improvements,
buildings, and equipment.
Depreciation: The allocation of the cost of a plant asset to expense over its
useful (service) life in a rational and systematic manner
35
Deterioration: The decay and disintegration which takes place in structures
with the passage of time. Deterioration is caused by natural forces, by the elements,
and by use.
Economic obsolescence: “A cause of depreciation that is a loss of value as
a result of impairment in utility and desirability caused by factors outside the
property’s boundaries”.
Earnings Per Share (EPS): The net income of a company divided by the total
number of shares it has outstanding.
Economic Value Management (EVM): A management approach towards
managing the shareholder ‘value’ in an organization.
Economic Value Added (EVA): A value-based financial performance
measure reflecting the absolute amount of shareholder value created or destroyed
during each year.
Estimated residual value - also called scrap value or salvage value: The
expected cash value of an asset at the end of its useful life.
Estimated useful life: The length of the service period expected from the
asset. Useful life may be expressed in years, units of output, miles, or another
measure.
Fixed Asset: Property used in a productive capacity which will benefit the
enterprise for longer than one year
Fully depreciated asset: An asset that has reached the end of its estimated
useful life. No more depreciation is recorded for the asset.
Functional obsolescence: The “loss in value of a property resulting from
changes in tastes, preferences, technical innovations, or market standards”.
Market value: What the property could be sold for today.
Obsolescence: The changes in usefulness of structures in certain
neighborhoods which cause them to become less desirable or less useful.
36
Physical deterioration: Cause of depreciation is the result of wear and tear
with usage and deterioration with age among others.
Plant assets: Tangible resources that are used in the operations of a
business and are not intended for sale to customers. They are also called property,
plant, and equipment; plant and equipment; or fixed assets.
Rate Of Return (ROI): The amount of profit (return) based on the amount of
resources (funds) used to produce it. Also the ability of a given investment to earn a
return for its use.
Residual Income (RI): The amount of profit that a segment has made after
charging a notional amount of interest based on the business’s investment in that
segment.
BIBLIOGRAPHY
Horngren, Charles T.; Harrison Jr., Walter T.; Bamber, Linda Smith; “Accounting”,
Prentice Hall, 5th Edition, 2002, page 386-402
Atrill, Peter; Mclaney, Eddie; “Accounting and Finance for Non-Specialists”, Prentice
Hall, 2nd Edition, 1997, page 61
Weygandt, Jerry S.; Kieso, Donald E.; Kimmel, Paul D.; “Accounting Principles”, John
Wiley & Sons, Inc., 6th Edition, 2002, page 400-405
Hermanson, Roger H.; Edwards, James Don; Salmonson R.F.; “Accounting
Principles” Business Publications, Inc., Revised Edition, 1983, page 365-372
37
Canada, R.S.; Sullivan, W.A.; White, J.A.; Kulonda, D.; “Capital Investment Analysis
for Engineering and Management”, Pearson Prentice Hall, …
Levy, Haim; Sarnat, Marshall; “Capital Investment and Financial Decisions”, Prentice
Hall International, 3rd Edition, 1986, page 123-140
Horne, James C. Van; Wachowicz John M.; “Fundamentals of Financial
Management”, Prentice Hall International, 10th Edition, page 15-21, 309-310
Collins, Stephen J.; Forrester, Robert T.; “Recognition of Depreciation by Not-ForProfit Institutions”, NACUBO, 1988, page 39-58
Peterson, Raymond H.; “Accounting for Fixed Assets”, John Wiley & Sons, Inc.,
1994, page 99-103
Monks, Robert A.G.; Minow, Nell; “Corporate Governance” Blackwell Business, 2nd
Edition, 2001, page 53-54
Grant, James L., “Foundations of Economic Value Added”, Published by Frank J.
Fabozzi Associates,1997
Salmi, Timo; Ilkka, Virtanen; “Economic Value Added: A simulation analysis of the
trendy, owner-oriented management tool.” Acta Wasaensia No. 90, 2001, page 33
Internet Resources:
Economic Value Added, its Computation and in Comparison with NPV,DCF Valuation
EVA Introduction to EVA, Overview, Calculating NOPAT and Invested Capital and
Conclusion
http://www.fig.net/pub/accra/papers/ts24/ts24_02_gyamfiyeboah_ayitey.pdf
http://www.accesskansas.org/kcaa/reports/mercury.pdf
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html
http://www.investopedia.com/university/EVA/default.asp
38
http://www.pitt.edu/~roztocki/evasmall/index.htm
http://www.pitt.edu/~roztocki/abceva/index.htm
http://www.sternstewart.com/evaabout/whatis.php
http://en.wikipedia.org/wiki/Economic_Value_Added
http://www.valuatum.com/valuation/valuation_tutorial_tiedostot/frame.htm#slide0132.
htm
http://www.ensc.sfu.ca/undergrad/courses/ENSC301/Unit11/lecture11.html
http://beginnersinvest.about.com/cs/investinglessons/l/blcompdeprec.html
http://www.imaginecorp.com/depreciation.htm
http://en.wikipedia.org/wiki/Depreciation
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html
http://www.investopedia.com/university/EVA/default.asp
39