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CONSIDERATION OF DEPRECIATION AND INCOME TAXES

CONSIDERATION OF DEPRECIATION AND INCOME TAXES. DEPRECIATION DEPRECIATION METHODS DEPRECIATION AND INCOME TAXES ECONOMIC VALUE ADDED (EVA). What is Depreciation?.

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CONSIDERATION OF DEPRECIATION AND INCOME TAXES

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  1. CONSIDERATION OF DEPRECIATION AND INCOME TAXES

  2. DEPRECIATION • DEPRECIATION METHODS • DEPRECIATION AND INCOME TAXES • ECONOMIC VALUE ADDED (EVA)

  3. 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.

  4. Process of cost allocation, not asset valuation.

  5. 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.

  6. Plant assets are subdivided into four classes: 1. Landsuch as a building site 2. Land improvementssuch as driveways, parking lots… 3. Buildingssuch as stores, offices, factories and warehouses. 4. Equipmentsuch as office furniture, factory machine, delivery equipment…

  7. Depreciation applies to three classes of plant assets: • Land improvements, • Buildings, Depreciable • Equipment Assets • Land is not a depreciable asset.

  8. Causes of Depreciation • Physical deterioration • Functional obsolescence • Economic obsolescence

  9. Deterioration • Deterioration is the decay and disintegration which takes place in structures with the passage of time. • Deterioration operates to terminate the physical life of a building

  10. Physical Deterioration • Physical deterioration as a cause of depreciation is the result of wear and tear with usage and deterioration with age among others. • wear and tear • rust, rot and decay

  11. Obsolescence • Obsolescence refers to those changes in usefulness of structures in certain neighborhoods which cause them to become less desirable or less useful. • Obsolescence operates to terminate the economic life of a building.

  12. Functional Obsolescence • Functional Obsolescence is loss in value of a property resulting from changes in tastes, preferences, technical innovations, or market standards. • new technology • inadequacy

  13. Economic Obsolescence • Economic obsolescence is a loss of value as a result of impairment in utility and desirability caused by factors outside the property’s boundaries. • External or Locational obsolescence.

  14. MeasuringDepreciation • Cost • Estimated Useful Life • Estimated Salvage Value (residual value or scrap value)

  15. COST Cost will include all expenditures incurred by the business to bring the asset to its required location and to make it ready for use.

  16. COST • The acquisition cost of land improvements, buildings, and equipment includes all costs of acquisition and preparation for use • Sales tax • Transportation • Installation • Repair cost prior to use

  17. ESTIMATED USEFUL LIFE Estimated useful life is the length of the service period expected from the asset. • years, • units of output, • miles, or • another measure.

  18. Changing the Useful Life of a Depreciable Asset • Estimating the useful life of each plant asset poses an accounting challenge. • Generally accepted accounting principles require the business to report the nature, reason, and effect of the accounting change on net income.

  19. Willamette Industries, Inc. 1998 Due to technologic advances 1999 $89 million, $146million or or $0.80 a share $1,32 a share • 65 percent improvement in earnings per share!

  20. ESTIMATED SALVAGE VALUE Estimated salvage value - also called scrap value or residual value - is the expected cash value of an asset at the end of its useful life.

  21. FactorsinMeasuringDepreciation Cost Useful Life Salvage Value

  22. METHODS & USAGE OFDEPRECIATION There are three types of methods used in depreciation.These are: Straight-Line (SL) Declining-Balance (DB) Units-of-Production(UOP)

  23. METHODS & USAGE OF DEPRECIATION • STRAIGHT-LINE METHOD:The simplest and most often used technique, in which the company estimates the salvage value of the asset, after the length of 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.

  24. METHODS & USAGE OF DEPRECIATION • 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. 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

  25. METHODS & USAGE OF DEPRECIATION • Straight-Line Depreciation: (Cost-Salvage Value)/Useful Life,In Years • =($41,000-$1,000)/5=$8,000 per year

  26. METHODS & USAGE OF DEPRECIATION • 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. • Also there’s an accerelated method for declining-balance method that is calleddouble-declining-balance(DDB).InDDBthe asset’s decreasing book value is multiplied by a constant percentage that is 2 times bigger than DB.

  27. METHODS & USAGE OF DEPRECIATION Declining-Balance

  28. METHODS & USAGE OF DEPRECIATION

  29. METHODS & USAGE OF DEPRECIATION Let’s have a look at how these depreceiation amounts are calculated: Fistly we compute the depreciation rate per year.A 5-year asset has a straight-line 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)] x2 Then we’re going to find every year’s the depreciation amount: • DDB For The 1st Year: $41,000x0.40=$16,400 • DDB For The 2nd Year:($41,000-16,400) x0.40=$9,840 • DDB For The 3rd Year:($41,000-$16,400-$9,840) x0.40=$5,904 • DDB For The 4th Year:($41,000-$16,400-$9,840-$5,904) x0.40=$3,542 • DDB For The 5th Year: ($41,000-$16,400-$9,840-$5,904-$3,542) - $1,000 =$4,314 (Final Depreciation Year)

  30. METHODS & USAGE OF DEPRECIATION Double-Declining Balance

  31. Units Of Production Method (UOP) • The UOP method determines depreciation expense based on the amount the asset is used. • In the UOP, a fixed amount of depreciation goes with unit of output produced by the asset.

  32. Units Of Production Method (UOP) • The length of life of an asset is expressed in a form of productive capacity. • Units of usage can be expressed in quantitiy of goods produced, hours used, miles driven, for instance

  33. Units Of Production Method (UOP) • The depreciation expense of a period is determined by mutliplying usage by a fixed UOP rate of usage.

  34. Units Of Production Method (UOP)

  35. Units Of Production Method (UOP) • 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.

  36. Units Of Production Method (UOP) • 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

  37. Comparing Depreciation Methods • Straight-Line Method:

  38. Comparing Depreciation Methods • Declining Balance Method

  39. Comparing Depreciation Methods • Double-Declining Balance Method

  40. Comparing Depreciation Methods • Units of Production Method

  41. Comparing Depreciation Methods • Many businesses use the straight line method in their financial statements and accelerated methods in their income tax returns. • Accelerated methods result in higher depreciation expenses, thus a lower reported income.

  42. Comparing Depreciation Methods • Most publicy owned companies want to appear as profitable as possibleas thier competitors. Therefore, majority of these companies straight-line method.

  43. Comparing Depreciation Methods • For income tax purposes, finance experts usually want to report the lowest income to pay the lowest tax amount. • Accelerated depreciation methods can reduce taxable income and so the tax payments decrease.

  44. Conclusion • Accounting principles and income tax laws both permit companies to use different depreciation methods in their financial statements and their income tax returns. Therefore, many companies use straight-line method in their financial statements and accelerated methods in their income tax returns.

  45. DEPRECIATION AND INCOME TAXES DEPRECIATION • Systemmatic allocation of the cost of a capital asset over a period of time for financial reporting purposes,tax purposes os both. • A noncash expense and thus does not affect cash from operations. • A tax deductable expense

  46. DEPRECIATION AND INCOME TAXES • The higher the depreciation the lower income and the lower tax payment.

  47. Depreciation Methods • Straight-Line Method • Declining Balance Method (DB) • Units-of-Production Method (UOP) • Accelerated Cost Recovery Method (ACRS) • Modified Accelerated Cost Recovery Method (MACRS)

  48. 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

  49. MACRS • Used only for income tax purposes • Cost of asset ,including any other capitalized expenditures such as shipping and installation. • The asset’s depreciable basis is not reduced by the estimated salvage value of the asset.

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