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Chapter 10 Depreciation

Chapter 10 Depreciation. Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets. Depreciation. Definition : Loss of value for a fixed asset

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Chapter 10 Depreciation

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  1. Chapter 10Depreciation • Asset Depreciation • Factors Inherent to Asset Depreciation • Book Depreciation • Tax Depreciation • Depletion • Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics

  2. Depreciation • Definition: Loss of value for a fixed asset • Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics

  3. Why Do We Need to Consider Depreciation? Business Expense: Depreciation is viewed as 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) (c) 2001 Contemporary Engineering Economics

  4. Depreciation Concept • Economic Depreciation • Purchase Price – Market Value • (Economic loss due to both physical deterioration and technological obsolescence) • Accounting Depreciation • A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics

  5. 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 (c) 2001 Contemporary Engineering Economics

  6. Factors to Consider in Asset Depreciation • Depreciable life (how long?) • Salvage value (disposal value) • Cost basis (depreciation basis) • Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics

  7. 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. Can you depreciate land? (c) 2001 Contemporary Engineering Economics

  8. Cost Basis (c) 2001 Contemporary Engineering Economics

  9. Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics

  10. (c) 2001 Contemporary Engineering Economics

  11. Types of Depreciation • Book Depreciation • In reporting net income to investors/stockholders • In pricing decision • Tax Depreciation • In calculating income taxes for the IRS • In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics

  12. Book Depreciation Methods • Purpose: Used to report net income to stockholders/investors • Types of Depreciation Methods: • Straight-Line Method • Declining Balance Method • Sum of the Years’ Digits Method • Unit Production Method (c) 2001 Contemporary Engineering Economics

  13. 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 (c) 2001 Contemporary Engineering Economics

  14. Annual Depreciation Book Value D5 Example 10.3 – Straight-Line Method $10,000 D1 Total depreciation at end of life I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N $8,000 D2 $6,000 D3 D4 B1 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 $2,000 B4 B5 0 n 0 1 2 3 4 5 (c) 2001 Contemporary Engineering Economics

  15. 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. (c) 2001 Contemporary Engineering Economics

  16. Annual Depreciation Book Value 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 10.4 – Declining Balance Method $10,000 Total depreciation at end of life D1 $8,000 $6,000 D2 B1 $4,000 D3 B2 D4 $2,000 B3 B5 B4 0 n 0 1 2 3 4 5 (c) 2001 Contemporary Engineering Economics

  17. Example 10.5 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 • a (DDB rate) = (200%) (SL rate) • = 0.40 (c) 2001 Contemporary Engineering Economics

  18. 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. (c) 2001 Contemporary Engineering Economics

  19. Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics

  20. Sum-of-Years’ Digits (SOYD) Method • Principle • Depreciation concept similar to DB but with decreasing depreciation rate. • Charges a larger fraction of the cost as an expense of the early years than of the later years. • Formula • Annual Depreciation • Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics

  21. Annual Depreciation Book Value D5 Example 10.7 – Sum-of-years’ digits method $10,000 Total depreciation at end of life D1 I = $10,000 N = 5 years S = $2,000 SOYD = 15 $8,000 $6,000 D2 D3 B1 $4,000 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 B2 D4 $2,000 B3 B5 0 B4 n 0 1 2 3 4 5 (c) 2001 Contemporary Engineering Economics

  22. (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 (c) 2001 Contemporary Engineering Economics

  23. Tax Depreciation • Purpose: Used to compute income taxes for the IRS • Assets placed in service prior to 1981 • Use book depreciation methods (SL, BD, SOYD) • Assets placed in service from 1981 to 1986 • Use ACRS Table • Assets placed in service after 1986 • Use MACRS Table (c) 2001 Contemporary Engineering Economics

  24. Modified Accelerated Cost Recovery Systems (MACRS) • Personal Property • Depreciation method based on DB method switching to SL (see page 468) • Half-year convention • Zero salvage value • Real Property • SL Method • Mid-month convention • Zero salvage value (c) 2001 Contemporary Engineering Economics

  25. MACRS Property Classifications (c) 2001 Contemporary Engineering Economics

  26. MACRS Table (c) 2001 Contemporary Engineering Economics

  27. 11.52% $1152 Full 20% $2000 32% $3200 Full 19.20% $1920 Full 11.52% $1152 Full 5.76% $576 1 2 3 4 5 6 Half-year Convention MACRS Rate CalculationExample 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics

  28. Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%)20% (0.4)(100%-20%)32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%)19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%)11.52% SL = (1/1.5)(17.28%)11.52% SL = (0.5)(11.52%)5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics

  29. Conventional DB Switching to SL 4,000 2,400 1,440 1,080 1,080 MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 (c) 2001 Contemporary Engineering Economics

  30. MACRS for Real Property • 27.5-year (Residential) • 39-year (Commercial) • SL Method • Zero salvage value • Mid-month convention • Example: placed an asset (residential property) in March • D1 = (9.5/12)(100%/27.5) • = 2.879% (c) 2001 Contemporary Engineering Economics

  31. Percentage Depletion vs. Cost Depletion (Example 10.12) Percentage Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 (c) 2001 Contemporary Engineering Economics

  32. Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics

  33. Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics

  34. Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics

  35. Summary • The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service. • The cost charged to operations during a particular year is called depreciation. • From an engineering economics point of view, our primary concern is with accounting depreciation; The systematic allocation of an asset’s value over its depreciable life. (c) 2001 Contemporary Engineering Economics

  36. Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation. • The four components of information required to calculate depreciation are: 1. The cost basis of the asset, 2. The salvage value of the asset, 3. The depreciable life of the asset, and 4. The method of its depreciation. (c) 2001 Contemporary Engineering Economics

  37. Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax-deferring benefits of depreciation. • Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. (c) 2001 Contemporary Engineering Economics

  38. Depletion is a cost allocation method used particularly for natural resources. Cost depletion is based on the units-of-production method of depreciation. Percentage depletion is based on a prescribed percentage of the gross income of a property during a tax year. • Given the frequently changing nature of depreciation and tax law, we must use whatever percentages, depreciable lives, and salvage values mandated at the time an asset is acquired. (c) 2001 Contemporary Engineering Economics

  39. (c) 2001 Contemporary Engineering Economics

  40. (c) 2001 Contemporary Engineering Economics

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