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DEPRECIATION AND ACCOUNTING CONCEPTS

DEPRECIATION AND ACCOUNTING CONCEPTS . CASH FLOW THROUGH A PROJECT . BASED ON THE LIFE OF THE PROJECT PRIMARY COMPONENTS ARE CAPITAL AND OPERATING COSTS. CAPITAL COSTS . CAPITAL INVESTMENT FROM TAXED SOURCES FIXED CAPITAL WORKING CAPITAL

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DEPRECIATION AND ACCOUNTING CONCEPTS

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  1. DEPRECIATION AND ACCOUNTING CONCEPTS

  2. CASH FLOW THROUGH A PROJECT • BASED ON THE LIFE OF THE PROJECT • PRIMARY COMPONENTS ARE CAPITAL AND OPERATING COSTS

  3. CAPITAL COSTS • CAPITAL INVESTMENT FROM TAXED SOURCES • FIXED CAPITAL • WORKING CAPITAL • SALVAGE (S) = VALUE OF CAPITAL AT THE END OF THE PROJECT LIFE AND IS DERIVED AS A POSITIVE CASH FLOW FROM THE PROJECT

  4. OPERATING CASH FLOW COMPONENTS • REVENUES (R) = PRICE * VOLUME • PROFIT = REVENUES - COSTS OF MANUFACTURE (COM) • COM = RAW MATERIALS, UTLITILIES, LABOR AND ALL OTHER CONVERSION COSTS

  5. CAPITAL RECOVERY • CAPITAL RECOVERY = DEPRECIATION (D) • THIS IS THE METHOD TO RECOVER PREVIOUSLY TAXED INVESTED CAPITAL • WORKING CAPITAL IS EXCLUDED BECAUSE IT IS LIQUID • CAPITAL INVESTMENT (CAP) = NEW CAPITAL INVESTED IN THE SUBJECT YEAR

  6. ANNUAL CASH FLOW CALCULATION • CASH BEFORE TAXES (Cb) = R - COM • PROFIT BEFORE TAXES (Pb) = Cb - D • PROFIT AFTER TAXES (Pa) = Pb*(1 - TAX) • CASH AFTER TAXES (Ca) = Pa + D - CAP

  7. CALCULATION OF DEPRECIATION • EQUIPMENT INITIAL COST, INITIAL BOOK VALUE, (BVo) EQUIPMENT COST ESTIMATE COMES FROM DESIGN BASED ESTIMATE • EQUIPMENT FINAL VALUE IS THE SALVAGE (S) • FINAL VALUE IS NORMALLY BASED ON THE MATERIAL COST (SALVAGED MATERIALS) • EQUIPMENT LIFE (n) - (TAX LIFE, NOT NECESSARILY ACTUAL LIFE) • EQUIPMENT LIFE IS BASED ON METHODS DEFINED BY CONGRESS (SEE TABLE 7-8 FOR EXAMPLES FROM 1997) • DEPRECIATION METHOD (FORMULA TO CALCULATE DEPRECIATION) • SEE IRS DOCUMENT “Publication 946 (2005), How To Depreciate Property “ FOR SPECIFIC CRITERIA (http://www.irs.gov/pub/irs-pdf/p946.pdf)

  8. DEPRECIATION METHODS • CONTROLLED WITH SEVERAL GENERAL RULES • SIMPLEST METHOD IS LINEAR (STRAIGHT LINE) OVER THE LIFE OF THE EQUIPMENT • NO METHOD CAN HAVE AN ANNUAL PERCENTAGE GREATER THAN TWICE STRAIGHT LINE • METHODS CAN BE CHANGED AS LONG AS THE CHANGE IS TO A RATE EQUAL TO OR LOWER THAN THE PREVIOUS METHOD

  9. DEPRECIATION METHODS • STRAIGHT LINE: • THE DEPRECIATION FACTOR: • EQUAL AMOUNTS ARE DEPRECIATED IN EACH YEAR

  10. DEPRECIATION METHODS • DOUBLE DECLINING BALANCE (DDB) • THE DEPRECIATION FACTOR IS DOUBLE THE RATE OF THE STRAIGHT LINE • ALTERNATELY FOR YEAR j • DDB METHOD LEAVES A REMAINDER IN THE LAST YEAR THAT MUST BE DEPRECIATED AT THAT TIME

  11. DEPRECIATION METHODS • MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) • COMBINED METHOD THAT COMBINES DDB AND STRAIGHT LINE TO AVOID A LARGE REMAINDER • SEE TABLE 7-9 FOR VALUES • NOTE THE FIRST DEPRECIATION IS TAKEN AT THE END OF YEAR 1 • RESIDUAL IS TAKEN IN THE YEAR FOLLOWING THE NOMINAL PERIOD

  12. MACRS CRITERIA • CLASS LIVES AND RECOVERY PERIODS ARE IN THE TAX CODE • THERE ARE TWO METHODS • General Depreciation System (GDS) • Alternative Depreciation System (ADS) • RECOVERY PERIODS ARE GENERALLY LONGER UNDER ADS THAN UNDER GDS

  13. MACRS ADS RECOVERY PERIOD EXAMPLES • http://www.irs.gov/pub/irs-pdf/p946.pdf

  14. DEPRECIATION METHODS • SUM OF THE YEAR DIGITS, SOYD • CALCULATES THE DEPRECIATION RATE BASED ON THE YEAR OF DEPRECIATION • THE DEPRECIATION FACTOR IS BASED ON THE FACTORIAL OF n:

  15. DEPRECIATION METHODS • SOYD CALCULATIONS • AS AN ARITHMETIC PROGRESSION: • DEPRECIATION: • THIS METHOD DOES NOT HAVE A RESIDUAL

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