Chapter 10 - Depreciation Click here for Streaming Audio To Accompany Presentation (optional)

EGR 403 Capital Allocation Theory

Dr. Phillip R. RosenkrantzIndustrial & Manufacturing Engineering Department

Cal Poly Pomona

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EGR 403 - The Big Picture• Framework: Accounting & Breakeven Analysis• “Time-value of money” concepts - Ch. 3, 4• Analysis methods

– Ch. 5 - Present Worth– Ch. 6 - Annual Worth– Ch. 7,7A,8 - Rate of Return (incremental analysis)– Ch. 9 - Benefit Cost Ratio & other methods

• Refining the analysis– Ch. 10, 11 - Depreciation & Taxes– Ch. 12 - Replacement Analysis

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Basic Aspects of Depreciation• An important component in computing income

taxes.• For tax purposes:

Depreciation is the systematic allocation of the cost of an asset spread over its depreciable life.

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DepreciationDefinition - A decrease in value.

• In an economic context– Market value– Value to the owner

• In an accounting context a systematic allocation of the cost of an asset over its depreciable life. Depreciable life is related to– Deterioration– Obsolescence

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Depreciation and Expenses• Expenses - subtracted from business revenues as

they occur (time frame < one year).– Labor – Utilities– Materials– Insurance, etc.

• Depreciation - subtracted from business expenses over time as the asset is used up (applies to assets with > 1 year useful life).– Machinery– Installation costs

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Depreciation for Tax Purposes• Depreciable life - the period over which an asset is

depreciated (recovery period).• Depreciation is a non-cash cost - money does not

change hands during the recovery period. (Note: The asset is already paid for or money has been borrowed and principal & interest payments are being made.)

• Depreciation is used to allocate an asset’s loss of value over time.

• Depreciation is deducted from revenue and reduces the taxable income of a business over time which produces a cash flow on an after tax-basis.

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A Property is Depreciable If

• The property is used for business purposes in the production of income.

• The property has a useful life that can be determined, and the useful life is longer than one year.

• The property decays, gets used up, wears out, becomes obsolete or loses value from natural causes.

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Classification of Property• Tangible - can be seen, touched, and felt.

– Real - land, buildings, and things growing on, or attached to the land.

– Personal - equipment, furnishings, vehicles, office machinery, or not defined as real property.

• Intangible - has value but cannot be seen or touched, examples include patents, copyrights, and trade marks. In general buildings and equipment are

depreciable; land is not.

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Depreciation Methods• Historical methods

– Straight line

– Sum-of-years digits

– Declining balance

– Declining balance switching to straight line

• Modified accelerated cost recovery system (MACRS)

Over the years the US Government has used each of these systems in turn to determine allowable depreciation for tax purposes . MACRS is now the system used for most depreciable property.

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Example

• Consider the following example:– Cost basis of an asset (B) = $900– Useful life in years (N) = 5– Salvage value (S) = $70

• Notes:– Cost basis includes installation and other “one-

time” costs associated with making the asset ready for use

– Salvage value (if used) is estimated or based on accounting practices and procedures

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Straight Line Depreciation

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Straight Line Depreciation

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Accelerated Depreciation

• The rest of the methods discussed are called “Accelerated Depreciation” methods.

• These methods deduct larger depreciation expenses in the early years and less at the end.

• The large early deductions result in tax savings that are realized sooner.

• A basic principle of the time value of money:

“Money now is better than money later”

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Sum-of-Years-Digits (SOYD)

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SOYD Calculations

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SOYD

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Double Declining Balance (DDB)

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DDB Calculations

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DDB

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DDB With Conversion to SLat the Most Desirable Time

• Since DDB does not use a value for Salvage, we have three possible scenarios at time of disposal:– Over depreciation: Book Value < Salvage Value. Tax

savings realized early. Small gain upon sale of the asset and taxes on the gain.

– Exact depreciation: Book value = Salvage value. There are no tax consequences upon sale of the asset.

– Under depreciation: Book Value > Salvage Value. Did not deduct as much as you could have and lost tax savings.

• To allow companies the advantage of all the depreciation charges they are entitled to, they can switch from DDB to straight line at the most favorable time.

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DDB Is the Preferred Approach

• Using the DDB approach provides the greatest PW (tax savings).

• The DDB approach does not fully depreciate an item unless a switch to straight line is accomplished in the latter years.

• The question is which is the most advantageous year to switch to SL.

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MACRS Modified Accelerated Cost Recovery System

• MACRS is the system presently used by the US government.

• General Method (IRS FORM 4562):– Determine item cost.– Determine item property class.– Use table to find percent depreciation.– Multiple percentage by cost.

•The US tax code requires that many special issues be considered that go beyond the general view presented here.

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MACRS• Removed controversial issues between tax

accountants and IRS. Fixed many practices and procedures but mostly favorable.

• DDB with conversion to SL in the favorable year.

• Assumes asset acquired in the middle of the first year, regardless of when actually acquired.

• See example 10-8 for a comparison

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Modified Accelerated Cost Recovery System

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Modified Accelerated Cost Recovery System

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MACRS Depreciation Schedules(partial table)

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Gains & Losses upon sale of an asset

• Three cases of interest affect taxes at the end of the life of the asset. These consequences affect the after tax cash flow

• Example in next chapter

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Item is sold for more than Book Value - Ordinary Gain

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Item is sold for below Book Value - Ordinary Loss

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Item sold for more that what was paid for it - Ordinary & Capital Gain