Chapter 10 - Depreciation
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EGR 403 Capital Allocation Theory
Dr. Phillip R. Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona
EGR 403 - The Big Picture
• Framework: Accounting & Breakeven Analysis
• “Time-value of money” concepts - Ch. 3, 4
• Analysis methods
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Ch. 5 - Present Worth
Ch. 6 - Annual Worth
Ch. 7,7A,8 - Rate of Return (incremental analysis)
Ch. 9 - Benefit Cost Ratio & other methods
• Refining the analysis
– Ch. 10, 11 - Depreciation & Taxes
– Ch. 12 - Replacement Analysis
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Basic Aspects of Depreciation
• An important component in computing income
taxes.
• For tax purposes:
Depreciation is the systematic allocation of
the cost of an asset spread over its
depreciable life.
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Depreciation
Definition - A decrease in value.
• In an economic context
– Market value
– Value to the owner
• In an accounting context a systematic
allocation of the cost of an asset over its
depreciable life. Depreciable life is related
to
– Deterioration
– Obsolescence
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Depreciation and Expenses
• Expenses - subtracted from business revenues as
they occur (time frame < one year).
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Labor
Utilities
Materials
Insurance, etc.
• Depreciation - subtracted from business expenses
over time as the asset is used up (applies to assets
with > 1 year useful life).
– Machinery
– Installation costs
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Depreciation for Tax Purposes
• Depreciable life - the period over which an asset is
depreciated (recovery period).
• Depreciation is a non-cash cost - money does not
change hands during the recovery period. (Note: The
asset is already paid for or money has been borrowed
and principal & interest payments are being made.)
• Depreciation is used to allocate an asset’s loss of value
over time.
• Depreciation is deducted from revenue and reduces the
taxable income of a business over time which produces
a cash flow on an after tax-basis.
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A Property is Depreciable If
• The property is used for business purposes in the
production of income.
• The property has a useful life that can be
determined, and the useful life is longer than one
year.
• The property decays, gets used up, wears out,
becomes obsolete or loses value from natural
causes.
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Classification of Property
• Tangible - can be seen, touched, and felt.
– Real - land, buildings, and things growing on,
or attached to the land.
– Personal - equipment, furnishings, vehicles,
office machinery, or not defined as real
property.
• Intangible - has value but cannot be seen or
touched, examples include patents, copyrights, and
trade marks. In general buildings and equipment are
depreciable; land is not.
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Depreciation Methods
• Historical methods
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Straight line
Sum-of-years digits
Declining balance
Declining balance switching to straight line
• Modified accelerated cost recovery system (MACRS)
Over the years the US Government has used each of these
systems in turn to determine allowable depreciation for tax
purposes . MACRS is now the system used for most depreciable
property.
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Example
• Consider the following example:
– Cost basis of an asset (B) = $900
– Useful life in years (N) = 5
– Salvage value (S) = $70
• Notes:
– Cost basis includes installation and other “onetime” costs associated with making the asset
ready for use
– Salvage value (if used) is estimated or based on
accounting practices and procedures
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Straight Line Depreciation
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Straight Line Depreciation
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Accelerated Depreciation
• The rest of the methods discussed are called
“Accelerated Depreciation” methods.
• These methods deduct larger depreciation
expenses in the early years and less at the end.
• The large early deductions result in tax savings
that are realized sooner.
• A basic principle of the time value of money:
“Money now is better than money later”
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Sum-of-Years-Digits (SOYD)
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SOYD Calculations
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SOYD
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Double Declining Balance (DDB)
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DDB Calculations
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DDB
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DDB With Conversion to SL
at the Most Desirable Time
• Since DDB does not use a value for Salvage, we have
three possible scenarios at time of disposal:
– Over depreciation: Book Value < Salvage Value. Tax
savings realized early. Small gain upon sale of the asset and
taxes on the gain.
– Exact depreciation: Book value = Salvage value. There are
no tax consequences upon sale of the asset.
– Under depreciation: Book Value > Salvage Value. Did not
deduct as much as you could have and lost tax savings.
• To allow companies the advantage of all the depreciation charges
they are entitled to, they can switch from DDB to straight line at
the most favorable time.
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DDB Is the Preferred Approach
• Using the DDB approach provides the greatest
PW (tax savings).
• The DDB approach does not fully depreciate
an item unless a switch to straight line is
accomplished in the latter years.
• The question is which is the most
advantageous year to switch to SL.
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MACRS
Modified Accelerated Cost Recovery System
• MACRS is the system presently used by the
US government.
• General Method (IRS FORM 4562):
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Determine item cost.
Determine item property class.
Use table to find percent depreciation.
Multiple percentage by cost.
•The US tax code requires that many special issues be considered that go
beyond the general view presented here.
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MACRS
• Removed controversial issues between tax
accountants and IRS. Fixed many practices
and procedures but mostly favorable.
• DDB with conversion to SL in the favorable
year.
• Assumes asset acquired in the middle of the
first year, regardless of when actually
acquired.
• See example 10-8 for a comparison
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Modified Accelerated Cost Recovery System
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Modified Accelerated Cost Recovery System
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MACRS Depreciation Schedules
(partial table)
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Gains & Losses upon sale of an
asset
• Three cases of interest affect taxes at the
end of the life of the asset. These
consequences affect the after tax cash flow
• Example in next chapter
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Item is sold for more than Book
Value - Ordinary Gain
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Item is sold for below Book
Value - Ordinary Loss
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Item sold for more that what was
paid for it - Ordinary & Capital Gain
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