L22: Book Depreciation

1. L22: Book Depreciation ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. Chapter 8 Accounting for Depreciation and Income Taxes • Asset Depreciation • Book Depreciation • Tax Depreciation • How to Determine “Accounting Profit” • Corporate Taxes

3. Depreciation • Definition: Loss of value for a fixed asset • Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation

4. Why Do We Consider Depreciation? Business Expense: Depreciation is viewed as a part of business expenses that reduce taxable income. Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit)

5. Depreciation Concept • Economic Depreciation • Purchase Price – Market Value • (Economic losses due to both physical deterioration and technological obsolescence) • Accounting Depreciation • A systematic allocation of the cost basis over a period of time. Accounting depreciation is a way of writing off the investment on fixed assets by prorating over a certain period.

6. Asset Depreciation Physical depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Functional depreciation Depreciation Book depreciation Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Tax depreciation

7. Factors to Consider in Asset Depreciation • Depreciable life (how long?) • Salvage value (disposal value) • Cost basis (depreciation basis) • Method of depreciation (how?)

8. What Can Be Depreciated? • Assets used in business or held for production of income • Assets having a definite useful life and a life longer than • one year • Assets that must wear out, become obsolete or lose value • A qualifying asset for depreciation must satisfy all of the three conditions above.

9. Cost Basis Cost basis: Total cost claimed as expense over asset’s life

10. Cost Basis with Trade-In Allowance

11. Asset Depreciation Ranges as determined by IRS (Tax Offices)

12. Types of Depreciation • Book Depreciation • In reporting net income to investors/stockholders • In pricing decision • Tax Depreciation • In calculating income taxes for the IRS (Tax Offices) • In engineering economics, we use depreciation in the context of tax depreciation

13. Book Depreciation Methods • Purpose: Used to report net income to stockholders/investors • Types of Depreciation Methods: • Straight-Line Method • Declining Balance Method • Unit Production Method

14. Straight – Line (SL) Method • Principle • A fixed asset as providing its service in a uniform • fashion over its life • Formula • Annual Depreciation • Dn = (I – S) / N, and constantfor all n. • Book Value • Bn = I – n (D) • where I = cost basis • S = Salvage value • N = depreciable life

15. Example 8.2 – Straight-Line Method Annual Depreciation $10,000 Book Value Total depreciation at end of life D1 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N $8,000 D2 $6,000 D3 B1 D4 nDnBn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 $4,000 B2 B3 D5 B4 $2,000 B5 0 1 2 3 4 5 n

16. Declining Balance Method • Principle: • A fixed asset as providing its service in a • decreasing fashion • Formula • Annual Depreciation • Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method.

17. n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D5 Example 8.3 – Declining Balance Method Annual Depreciation $10,000 Book Value Total depreciation at end of life D1 $8,000 $6,000 D2 B1 $4,000 B2 D3 $2,000 D4 B3 $778 B5 0 B4 1 2 3 4 5 n

18. Example 8.4 DB Switching to SL Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years • SL Dep. Rate = 1/5=0.2 • a (DDB rate) = (200%) (SL rate) • = 0.40

19. Dn=(Bn-Salvage Value)/Remaining useful life Dn is depreciation under straight line depreciation for year n Case 1: S = 0 (a) Without switching (b) With switching to SL Note: Without switching, we have not depreciated the entire cost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits.

20. Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values.

21. (I - S) Units-of-Production Method • Principle • Service units will be consumed in a non • time-phased fashion • Formula • Annual Depreciation • Dn = Service units consumed for year • total service units

22. Example 8.5 • Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles • Solution: