Depreciation And Income Taxes

CHAPTER 7

Created By : Eng.Maysa

Gharaybeh

Depreciation

Decrease in value of physical properties with passage of

time and use.

More specifically:

Accounting concept establishing annual deduction against

before-tax income to reflect effect of time and use on asset’s

value in firm’s financial statements

to match yearly fraction of value used by asset in production

of income over asset’s economic life

Property Is Depreciable if it Meets These

Requirements :

be used in business or held to produce income.

have a determinable useful life which is longer than one year

wear out, decay, get used up, become obsolete, or lose value from natural causes

not be inventory, stock in trade, or investment property

Depreciable Property (Tangible , Intangible )

Tangible : can be seen or touched

personal property(االموال المنقولة) : includes assets such as

machinery, vehicles, equipment, furniture, etc...

real property(االموال غير المنقولة) : anything erected on, growing

on, or attached to land

(Since land does not have a determinable life itself, it

is not depreciable)

Intangible : personal property, such as copyright, patent( براءات

(إعفاء معين,امتياز)or franchise (االختراع

When Depreciation Starts And Stops

Depreciation starts when property is placed in service for

use in business or for production of income.

Property is considered in service when ready and available

for specific use, even if not actually used yet.

Depreciation stops when cost of placing it in service has

been recovered or when it is soled, whichever occurs first.

Additional Definitions

Basis, or cost basis : (unadjusted cost ) initial cost of purchase

an asset, plus sales tax, transportation, and normal costs of

making asset serviceable

Adjusted cost basis : allowable adjustment (increase or

decrease) to original cost basis, used to calculate depreciation

deductions

Improvement of the asset increases the original cost basis

Casualty or theft loss decrease the original cost basis

Additional Definitions

Book Value (BV) : Worth of depreciable property as shown on company records

Represents amount of capital remaining invested in property and must be recovered in future through accounting process

(Book Value)k= k

adjusted cost basis - Σ (depreciation deduction)j

j=1

Additional Definitions

Market Value (MV) : Amount paid by willing buyer to willing

seller for property where no advantage and no compulsion to

transact

approximates present value of what will be received through

ownership of property, including time-value of money (or profit)

Additional Definitions Recovery Period :Number of years over which basis of property

is recovered through accounting process.

Normally the useful life for classical methods

Property class for General Depreciation System (GDS)

under MACRS

Class Life for Alternative Depreciation System (ADS)

Recovery Rate :Percentage for each year of MACRS recovery

period used to calculate an annual depreciation deduction.

Additional Definitions Salvage Value (SV) : Estimated value of property at the end of

useful life.

expected selling price of property when asset can no longer be

used productively

net salvage value used when expenses incurred in disposing of

property; cash outflows must be deducted from cash inflows for

final net salvage value

with classical methods of depreciation, estimated salvage value is

established and used

with MACRS, the salvage value of depreciable property is defined

to be zero

Additional Definitions

Useful Life : Expected (estimated) period of time property will be

used in trade or business or to produce income; sometimes referred to

as depreciable life.

The Classical Depreciation Methods

N = depreciable life of the asset in years

B = cost basis, including allowable adjustments

d k = annual depreciation deduction in year k (1< k <N)

d k* = cumulative depreciation through year k

BV k = book value at the end of year k

BV N = book value at the end of the depreciable (useful) life

SV N = salvage value at the end of year N

R = the ratio of depreciation in any one year to the BV at the beginning of the

year

Straight-Line (SL) Method

Simplest depreciation method

Assumes constant amount is depreciated each year over depreciable

(useful) life

N = depreciable life

B = cost basis

dk = depreciaton in k

BVk = book value at end of k

SVN = salvage value

Declining Balance (DB) Method Sometimes called constant percentage method or Matheson formula

Assumed annual cost of depreciation is fixed percentage of BV at

beginning of year

R is constant R = 2 / N when 200% declining balance OR R = 1.5 / N

when 150% declining balance used

d 1 = B ( R )

d k = B ( 1 - R ) k - 1 ( R )

d k* = B [ 1 - (1 - R ) k ]

BV k = B ( 1 - R ) k

BV N = B ( 1 - R ) N

Because declining balance method never reaches BV = 0, it’s

permissible to switch from this to straight-line method so asset’s SVN

will be zero or other desired value

Units-of-Production Method

Not based on the idea that decrease in value of property is a

function of time

Decrease in value is mostly a function of use

Method results in cost basis (minus final SV) being allocated

equally over the estimated number of units produced during useful

life of asset.

Depreciation per unit of production =

DB with Switchover to SL

DB method will NEVER reach BV =0

You can switch from DB to SL

The switch over occurs in the year in which a larger

depreciation amount is obtained from SL method

Table 7-1 page 328

d k = ( B - SVN ) / N

But the basis B from

Col(1)Changed every year and N is

the remaining years As followes :

Year (3)

1 4,000/10 years =400

2 3,200/9 year = 355.65

3 2,560/8years = 320

And so on

We select the largest depreciation

amount .

Taxable Income

(Before Taxable Income)

taxable income =

gross income - all expenses - depreciation

The disposal of a depreciable asset

can result in a gain or loss based on

the sale price (market value) and the

current book value

A gain is often referred to as depreciation recapture,

and it is generally taxed as the same as ordinary

income. A loss is a capital loss. An asset sold for

more than it’s cost basis results in a capital gain.

After Tax Economic Analysis

Rk = revenues (and savings from the project: cash inflow from project

during period ‘k’

Ek = cash outflows during year k for deductible expenses and interest

dk = depreciation

t = effective income tax rate on ordinary income (federal, state and other);

assumed to remain constant during the study period

Tk= income taxes paid during year ‘k’

BTCFk = Before Tax Cash Flow for year k

ATCFk = After Tax Cash Flow for year k

The taxable income = ( Rk – Ek- dk )

The income tax: Tk = - t ( Rk – Ek – dk )

BTCFk = Rk – Ek

ATCFk = BTCFk + Tk

= (Rk – Ek ) - t ( Rk – Ek – dk )

= (1 – t)(Rk – Ek ) + t dk

Example: An asset is expected to produce a net cash inflows of 70,000

per year for the six year period , where the cost basis is

260,000 and the market value is 20,000. MARR is 10% use

SL method …..

A) develop BTCF

B)develop ATCF

C) Calculate the PW for both CFs

BTCF 0 -260,000

1 70,000

2 70,000

3 70,000

4 70,000

5 70,000

6 70,000

6 20,000

PW= -260,000 + 70,000 (P/A,10%,6)+

20,000(P/F,10%,6) =

-260,000 +70,000(4.3553) +20,000 (0.5645)=56,161

PW >0 it is acceptable alternative

SL = (260,000 -20,000)/6 =

40,000 per year

ATCF EOY A

BTCF

B

Depreciation

Deduction

C=A – B

Taxable

Income

D= - 0.4C

Income Tax

E= A+D

ATCF

0 -260,000 -260,000

1 70,000 40,000 30,000 -12,000 58,000

2 70,000 40,000 30,000 -12,000 58,000

3 70,000 40,000 30,000 -12,000 58,000

4 70,000 40,000 30,000 -12,000 58,000

5 70,000 40,000 30,000 -12,000 58,000

6 70,000 40,000 30,000 -12,000 58,000

6(market

value)

20,000 20,000 20,000

PW= -260,000 + 58,000 (P/A,10%,6)+

20,000(P/F,10%,6) =

-260,000 +58,000(4.3553) +20,000 (0.5645)=

3,897.4

PW >0 it is acceptable alternative