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Depreciation Methods: Definition, Importance, and Types

This chapter explores the definition, importance, and types of depreciation methods used in engineering economy. It covers book and tax depreciation, as well as the concept of book value and basis of an asset.

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Depreciation Methods: Definition, Importance, and Types

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  1. Mc Graw Hill ENGINEERING ECONOMYFifth Edition Blank and Tarquin CHAPTER 16 DEPRECIATION METHODS Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  2. 16 Preliminary Statement • The material presented in this chapter applies to the current (2001) U.S. Federal Corporate Income Tax Code relating to depreciation. • As such, which changing legislation, parts of this chapter could be modified by legislation enacted after publication of this text. • Students are encouraged to research the current depreciation rules as they may pertain to the material in this chapter. • The IRS web site { www.irs.gov } should be accessed for IRS Publication 946 for the current rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  3. 16.1 Depreciation – Definition • Depreciation is the reduction of an asset’s value over time. • Brought on by: • Wear and tear, use; • Deterioration; • Obsolescence. • Economic View: • Depreciation represents a “ratable” using up of devaluation of a productive asset. • The asset must have a finite life span that can be reasonably estimated. • Deprecation represents a proper charge against future income produced by the asset in question. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  4. 16.1 Importance of Depreciation • Federal tax law defines the concept of “taxable income” as: • Gross Income – Real Cash Expenses – interest – Depreciation amounts. • Tax Due = • {Taxable Income}(Tax Rate). • Taxes and after-tax cash flows are presented in Chapter 17. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  5. 16.1 Non-Cash Flow Amounts • Depreciation and depletion amounts represent “non-cash flow” amounts within an accounting period. • Federal and state tax laws recognize various forms of depreciation amounts and depletions amounts to be “tax- deductible amounts,” but are not real cash flows per se. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  6. 16.1 After-Tax Cash Flows • All “for profit” firms seek to minimize legally their respective income tax liabilities. • Depreciation and depletions amounts will lower the taxable income amount and hence the tax liability if claimed. • This chapter focuses on the various forms of depreciation and depletion calculations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  7. 16.1 Types of Depreciation • Book Depreciation • Used by a firm for internal financial and managerial management. • Tax Depreciation • Used by a firm for state and federal income tax reporting. • Follows strict rules and regulations. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  8. 16.1 Book Depreciation • Value of the asset on the firm’s accounting records at any given point in time. • Management is free to use any method they so choose to compute book depreciation amounts. • Can be any methods such as Straight Line, Declining Balance, Sum-of-the-years digits, or Other. • Defines the reduced investment in an asset based upon usage pattern and an assumed life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  9. 16.1 Tax Depreciation • Tax Depreciation: • Must follow current state and federal law pertaining to acceptable methods for computing depreciation for income tax purposes. • Federal Lever (2001) • MACRS Methods • General Depreciation System (GDS). • Alternate Depreciation System (ADS). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  10. 16.1 Book Value of an Asset • Book value: • Accounting Term, • Reflects the undepreciated (value) on the firm’s books at a given point in time. • May or may not reflect the true market value of the asset at a point in time. • Market value of an asset is what a willing buyer and willing seller agree to consummate a sale or exchange. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  11. 16.1 Terminology: BASIS of an Asset (B) • The Basis of an asset is: • Purchase cost plus, • Delivery costs plus, • Installation costs and, • Any other costs associated with installing and preparing the asset for use. • To be eligible for depreciation, the asset MUST be placed in-service and ready for use. • Symbol: B for “Basis” – a dollar amount. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  12. 16.1 Terminology: Book Value of an Asset (BVt) • The remaining, undepreciated capital investment on the firm’s books after the accumulated amounts of depreciation have been subtracted from the original cost basis. • BV’s are usually updated at the end of the firm’s accounting year. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  13. 16.1 Terminology: Recovery Period - n • Recovery Period (in years) is the depreciable life nof the asset in years. • Often there are different n values for book and tax depreciation. • Both of these values may be different from the asset's estimated productive life. • Also known as the Depreciable Life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  14. 16.1 Terminology: Market Value (MVt) • Market value, a term also used in replacement analysis, is the estimated amount realizable if the asset were sold on the open market. • Because of the structure of depreciation laws, the book value and market value may substantially differ. • For example, a commercial building tends to increase in market value, but the book value will decrease as depreciation charges are taken, and a computer workstation may have a market value much lower than its book value due to rapidly changing technology. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  15. 16.1 Terminology: Salvage Value –S • Salvage value is the estimated trade-in or market value at the end of the asset's useful life. It may be positive, zero, or negative due to dismantling and carry-away costs. • Salvage values are estimated “up-front” – at the time of the original purchase. • As an estimated value, the actual salvage value out at time t = n may or may not reflect the original estimate. • Generally speaking, one cannot depreciate an asset below its estimated salvage value. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  16. 16.1 Terminology: Depreciation Rate –dt • Depreciation rate or recovery rate is the fraction of the first cost removed by depreciation each year. • This rate, denoted by dt, may be the same each year, which is called the straight-line rate, or different for each year of the recovery period. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  17. 16.1 Terminology: Personal Property • Personal property, is the income-producing, tangible possessions of a corporation used to conduct business. • Not to be confused with an individual’s personal property like clothes, furniture, etc. • Included are most manufacturing and service industry property vehicles, manufacturing equipment, materials handling devices, computers, and networking equipment, telephone equipment office furniture, refining process equipment, and much more. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  18. 16.1 Terminology: Real property • Real property includes: real estate and all improvements, office buildings, manufacturing structures, test facilities, warehouses, apartments, and other structures. • Land itself is considered real property, but it is not depreciable because it has an infinite life – land can never be depreciated for tax purposes. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  19. 16.1 Terminology: The Half-Year Convention • During a tax year, assets are purchased and installed throughout the first year. • Under past laws, the first year of depreciation had to be prorated by the number of months remaining in the tax year. • Under current federal tax law the first year is handled using the half-year convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  20. 16.1 Terminology: The Half-Year Convention • The half-year convention assumes that assets are placed in service or disposed of in midyear, regardless of when these events actually occur during the year. • This convention is utilized in this text and in most U.S.-approved tax- depreciation methods. • There are also mid-quarter and mid-month conventions. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  21. 16.1 Terminology: Section “38” Property • Often the term “Section 38,” or Section 1238,” is used: • Section 1238 (from the IRS Code, Section 1238) is defined as: • Tangible personal property (but not buildings or their structural components) that is eligible for depreciation under the federal tax code. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  22. 16.1 Terminology: Code Section 1250 Property • Under the IRS Code, Section 1250 property is “real” property: • Buildings and structures eligible for depreciation. • Summary: • Section 1238 – Personal Property, • Section 1250 – Real Property. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  23. 16.1 Depreciation Models • Basic (traditional) models are: • Straight-Line Method (SL), • Sum-of-the-Years Digits Method (SYD), • Declining Balance Method (DB). • Today, the MACRS Method (a form of declining balance-modified). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  24. 16.1 History of Depreciation Methods • Before 1981 – U.S. code recognized the classical methods. • 1981 and after: • Classical methods were disallowed for federal tax purposes and replaced with a system termed ACRS – Accelerated Capital Recovery System • In 1986 ACRS was replaced with MACRS – Modified Accelerated Capital Recovery System. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  25. 16.1 Today…. • U.S. Federal Corporate Income Taxes must be computed using the MACRS system! • States that have corporate income tax laws generally permit all or part of the classical methods to be used for state corporate tax analysis. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  26. 16.1 Book Value vs. Time: General Case • In general, a book value plot will look like: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  27. 16.1 Book Value Plot for Classical Methods • For SL, DB, and MACRS we have: Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  28. 16.1 Accelerate Depreciation • SL book values decline in a linear fashion down to a specified salvage value. It writes off the asset in equal amounts over the recovery period. • The DB method allows the book value to accelerate faster since the DB plot of book value is below the SL book values. It permits greater depreciation amounts in the early years, and hence reduces the book value faster than the SL method. • MACRS also permits accelerated book values, but is not as good as the pure DB method permits. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  29. 16.1 Keeping Up • All engineers engaged in the analysis of industrial projects need to be reasonably informed regarding the current Federal Tax law regarding depreciation. • The law does change! • Must keep up with the changes! • IRS Web site: www.irs.gov • Check it out for downloadable publications Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  30. 16.2 Straight-Line: The Standard (SL) • SL depreciation is the standard from which all other plans are compared. • Assumes the book value declines in a uniform manner down to a specified salvage value – S over n time periods. • Assume n years for an asset’s life: • The depreciation rate –dt is then: • Dt = 1/n Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  31. 16.2 SL Example • Notation (to be followed herein) • t = the year (t = 1,2, …, n) • Dt = Annual depreciation charge, • B = The first cost or unadjusted basis, • S = Estimated Salvage Value at t = n, • n = The Recovery Period, • d = The Depreciation Rate = 1/n Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  32. 16.2 Straight-Line Method • Compute the Basis minus the estimated salvage value and divide by n [16.1] [16.2] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  33. 16.2 SL Example • B = $50,000; • “n” = 5 years; • S = $10,000 at t = 5; • Dt for each year is: • ($50,000 - $10,000)/5 = $8,000/year Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  34. 16.2 SL Example: Tabulation Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  35. 16.3 Declining Balance Method (DB) • DB is an accelerated depreciation method; • Provides greater depreciation amounts in the early time periods over the SL method. • Is more complex that the SL method. • Requires assuming a DB rate – normally taken to equal 2 x SL rate. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  36. 16.3 DB Rate • Given the DB rate, • Dt for year t is found by multiplying the beginning of time period book value by the rate. • The maximum DB rate set by law is: • dMAX = 2(1/n), or twice what the straight rate would be. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  37. 16.3 DB Equations Depr. For year “t” [16.5] [16.6] Depr. Rate Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  38. 16.3 DB if BVt-1 Not Known • If BV at the end of the preceding year is not known, then apply: [16.7] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  39. 16.3 DB: Book Value Determination • BVt can be determined in two ways: • 1. Using the rate d and the basis, B or, • 2. Subtracting the current year’s depreciation from the previous year’s book value. • BVt from d and B: • Apply: [16.8] [16.9] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  40. 16.3 DB: Implied Salvage Value • Note: From equations 16.4 – 16.9 there is no mention of the salvage value – S! • DB does not directly use the estimated salvage value. • DB has its own implied salvage value. • The pure DB method will never depreciate an asset down to a 0 salvage value unless you solve for a d rate ( Eq. 16.11). Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  41. 16.3 DB: Implied Salvage Value • The implied salvage value built into the DB method is: [16.9] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  42. 16.3 Implied SV for DB Depreciation • Permissible range for d is: 0 < d < (2/n) • To force a prescribed salvage value – S apply: • Implied d = 1 – (S/B)1/n [16.11] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  43. 16.3 DB rate –d • By law, the maximum rate for DB is specified to =: • Twice the SL rate for a given n. • This is called “The Double Declining Balance Rate.” • If d = 1.5 (SL rate), it is termed the 150% DB rate. • d can never exceed 2(1/n), but can be less! Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  44. 16.3 Example 16.3 • B = $80,000; • n = 10 years; • S = $10,000; • Apply the DB and DDB methods to compute the depreciation amounts and associated BV’s. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  45. 16.3 Example 16.3 DB approach • The DB method first computes the implied salvage value from: • d = 1 – (10,000/80,000)1/10 = 0.1877 • d = 18.77% will target the $10,000 SV at t = 10. • See Table 16-1 on page 515. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  46. 16.4 MACRS Method • MACRS was derived from the 1981 ACRS system and went into effect in 1986. • Defines statutory recovery (depreciation) percentages. • Percentages were derived from the DB method with a switch to SL at the optimal time and, • Incorporates the half-year convention. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  47. 16.4 MACRS Salvage Value • The MACRS approach assumes a salvage value of “0” even though that might not be the case! • By current law – MACRS assumes all assets depreciated by this method will have a “0” salvage value at the end of the recovery life. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  48. 16.4 MACRS Actual Depreciation • Depreciation for year “t” is: • Dt = dt(B) [16.12] • dt = a depreciation rate (per cent) applicable for the t-th year. • The dt’s are published percentage rates and cannot be changed. Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  49. 16.4 MACRS Book Values • MACRS book values are determined from: • BVt = BVt-1 – Dt [16.13] • Or, • BVt = Basis – sum of accumulated depreciation. [16.14] Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

  50. 16.4 Observations • Under MACRS: • The entire Basis (B) is fully depreciated (recovered) over a specified number of years (recovery periods). • A “0” salvage value is, by law, a functional part of the MACRS system. • In reality, there may be a positive, “0”, or negative salvage value at some point in time. • Adjustments will have to be made at that time. (Disposal Analysis) Blank & Tarquin: 5th edition. Ch.16 Authored by Dr. Don Smith, Texas A&M University

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