depreciation ch 10

7/27/2019 Depreciation Ch 10

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(c) 2001 Contemporary EngineeringEconomics

1

Chapter 10

Depreciation Asset Depreciation

Factors Inherent to

Asset Depreciation Book Depreciation

Tax Depreciation

Depletion

Repairs orImprovements toDepreciable Assets


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Depreciation

Definition: Loss of value for a fixed assetExample: You purchased a car worth $15,000 at

the beginning of year 2000.

Depreciation

End of

Year

Market

Value

Loss of

Value

0

1

2

34

5

$15,000

10,000

8,000

6,0005,000

4,000

$5,000

2,000

2,0001,000

1,000


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Why Do We Need to Consider

Depreciation?Gross Income -Expenses:

(Cost of goods sold)

(Depreciation)(operating expenses)

Taxable Income

- Income taxes

Net income (profit)

Business

Expense:

Depreciation isviewed as part

of business

expenses that

reduce taxable

income.


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Depreciation Concept

Economic Depreciation

Purchase PriceMarket Value

(Economic loss due to both physicaldeterioration and technological obsolescence)

Accounting Depreciation

A systematic allocation of cost basis over a

period of time.


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5

Asset Depreciation

Depreciation

Economic depreciation

the gradual decrease in

utility in an asset with

use and time

Accounting depreciation

The systematic allocation

of an assets value in

portions over its

depreciable lifeoften

used in engineering

economic analysis

Physical

depreciation

Functional

depreciation

Book

depreciation

Tax

depreciation


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Factors to Consider in Asset

Depreciation

Depreciable life (how long?)

Salvage value (disposal value)

Cost basis (depreciation basis)

Method of depreciation (how?)


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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?


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Cost Basis

Cost of new hole-punching

machine (Invoice price) $62,500

+ Freight 725

+ Installation labor 2,150

+ Site preparation 3,500

Cost basis to use in

depreciation calculation

$68,875


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Cost Basis with Trade-In Allowance

Old hole-punching machine (book value) $4,000

Less: Trade-in allowance 5,000

Unrecognized gains $1,000

Cost of new hole-punching machine $62,500

Less: Unrecognized gains (1,000)

Freight 725

Installation labor 2,150

Site preparation 3,500

Cost of machine (cost basis) $67,875


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10

Asset Depreciation Range ADRs (years)

Assets Used Lower Limit Midpoint Life Upper Limit

Office furniture, fixtures, and equipment 8 10 12

Information systems (computers) 5 6 7

Airplanes 5 6 7

Automobiles, taxis 2.5 3 3.5

Buses 7 9 11

Light trucks 3 4 5

Heavy trucks (concrete ready-mixer) 5 6 7Railroad cars and locomotives 12 15 18

Tractor units 5 6 7

Vessels, barges, tugs, and water transportation

system14.5 18 21.5

Industrial steam and electrical generation and or

distribution systems17.5 22 26.5

Manufacturer of electrical and nonelectrical

machinery8 10 12

Manufacturer of electronic components, products,

and systems5 6 7

Manufacturer of motor vehicles 9.5 12 14.5

Telephone distribution plant 28 35 42


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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 inthe context of tax depreciation


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Book Depreciation Methods

Purpose: Used to report net income tostockholders/investors

Types of Depreciation Methods:Straight-Line Method

Declining Balance Method

Sum of the Years Digits MethodUnit Production Method


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StraightLine (SL) Method

Principle

A fixed asset as providing its service in a uniform

fashion over its life

Formula

Annual Depreciation

Dn = (IS) /N, and constantfor all n.

Book Value

Bn =In (D)whereI= cost basis

S= Salvage value

N= depreciable life


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Example 10.3Straight-Line Method

n Dn B

n

1 1,600 8,400

2 1,600 6,8003 1,600 5,200

4 1,600 3,600

5 1,600 2,000

I= $10,000

N= 5 Years

S= $2,000

D = (I - S)/N

D1

D2

D3

D4

D5

B1

B2

B3

B4B5

$10,000

$8,000

$6,000

$4,000

$2,000

00 1 2 3 4 5

Totaldepreciat

ionatend

oflife

n

Annual Depreciation

Book Value


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Declining Balance Method

Principle:A fixed asset as providing its service in a

decreasing fashion

Formula

Annual Depreciation

Book Value

1 nn BD 1)1( n

nB )1( where 0 < < 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.


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Example 10.4Declining Balance Method

n

0

1

23

4

5

Dn

$4,000

2,4001,440

864

518

Bn

$10,000

6,000

3,6002,160

1,296

778

I

N

S

D B

I

B I

n n

n

n

n

= $10,

= years

= $778

=

= ( -

000

5

11

1

1

( )

D1

D2

D3

D4

D5

B1

B2

B3

B4 B50

0 1 2 3 4 5

Totaldepreciat

ionatend

oflife

n

$10,000

$8,000

$6,000

$4,000

$2,000

Annual Depreciation

Book Value


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Example 10.5

DB Switching to SL

SL Dep. Rate = 1/5

(DDB rate) = (200%) (SL rate)

= 0.40

Asset: Invoice Price $9,000

Freight 500

Installation 500

Depreciation Base $10,000Salvage Value 0

Depreciation 200% DB

Depreciable life 5 years


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n Depreciation

Book

Value

12

3

4

5

10,000(0.4) = 4,0006,000(0.4) = 2,400

3,600(0.4) = 1,440

2,160(0.4) = 864

1,296(0.4) = 518

$6,0003,600

2,160

1,296

778

n

Book

Depreciation Value

12

3

4

5

4,000 $6,0006,000/4 = 1,500 < 2,400 3,600

3,600/3 = 1,200 < 1,440 2,160

2,160/2 = 1,080 > 864 1,080

1,080/1 = 1,080 > 518 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

depreciations tax deferring benefits.

Case 1: S = 0


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Case 2: S = $2,000

End of Year Depreciation Book Value

1 0.4($10,000) = $4,000 $10,000 - $4,000 = $6,000

2 0.4(6,000) = 2,400 6,0002,400 = 3,600

3 0.4(3,600) = 1,440 3,6001,440 = 2,160

4 0.4(2,160) = 864 > 160 2,160160 = 2,000

5 0 2,0000 = 2,000

Note: Tax law does not permit us to depreciate assets below

their salvage values.


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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 ValueSOYDnNSIDn /)1)((

n

j jnDIB

1where SOYD=N(N+1)/2


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Example 10.7Sum-of-years digits method

D1

D2

D3

D4

D5

B1

B2

B3

B4 B5

$10,000

$8,000

$6,000

$4,000

$2,000

00 1 2 3 4 5

Totaldepreciat

ionatend

oflife

Annual Depreciation

Book Value

I= $10,000

N= 5 years

S= $2,000

SOYD = 15

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

n


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Units-of-Production Method

Principle

Service units will be consumed in a non

time-phased fashion

Formula

Annual Depreciation

Dn = Service units consumed for yeartotal service units (I- S)


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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


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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


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MACRS Property Classifications

Recovery Period ADR Midpoint Class Applicable Property

3-year Special tools for manufacture of plastic

products, fabricated metal products, and motor

vehicles.(ADR =Asset Depreciation Range)

5-year Automobiles, light trucks, high-tech equipment,

equipment used for R&D, computerized

telephone switching systems

7-year Manufacturing equipment, office furniture,fixtures

10-year Vessels, barges, tugs, railroad cars

15-year Waste-water plants, telephone- distribution

plants, or similar utility property.

20-year Municipal sewers, electrical power plant.

27.5-year Residential rental property

39-year Nonresidential real property including elevators

and escalators

ADR 4

4 10 ADR

10 16 ADR

16 20 ADR

20 25 ADR

25 ADR


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(c) 2001 Contemporary EngineeringEconomics 26

MACRS Table


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MACRS Rate Calculation

Example 10.9

Asset cost = $10,000

Property class = 5-year

DB method = Half-year convention, zero salvage value,

200% DB switching to SL

20%

$2000

32%

$3200

Full

19.20%

$1920

Full

11.52%

$1152

Full

11.52%

$1152

Full

5.76%

$576

1 2 3 4 5 6

Half-year Convention

Y ( ) C l l i i % MACRS (%)


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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 (%)

DDBDDB

DDB

SL

SL


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Conventional DB Switching to SL

MACRS with half-year convention

2,000 3,200 1,920 1,152 1,152 576

4,000 2,400 1,440 1,080 1,080


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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%


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Percentage Depletion vs. Cost Depletion

Gross income from sale of

45,000 ounces

$16,425,000

Depletion percentage

Computed percentagedepletion

$2,463,750

15%

Gross income from sale of

45,000 ounces

$16,425,000

Less mining expenses 12,250,000

Taxable income from mine 4,175,000

Deduction limitation

Maximum depletion deduction $2,088,000

50%

Cost depletion= ($30,000,000/300,000)(45,000)

= $4,500,000

Allowable deduction

= $2,088,000

Select cost depletion

with $4,500,000

Percentage Depletion

(Example 10.12)


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Calculating the Allowable Depletion

Deduction


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Percentage Depletion Allowances for Mineral

Properties

Deposits Percentage

Oil and gas wells (only for certain domestic and gas production) 15

Sulfur and uranium, and, if from deposits in the United States,

asbestos, lead, zinc, nickel, mica, and certain other ores and

minerals

22

Gold, silver, copper, iron ore, and oil shale, if from deposits in the

United States

15

Coal, lignite, and sodium chloride 10

Clay and shale to be used in making sewer pipe or bricks 7.5

Clay (used for roofing tile), gravel, sand, and stone 5

Most other minerals; includes carbon dioxide produced from a well

and metallic ores.

14


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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.


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Summary

The entire cost of replacing a machine cannot beproperly charged to any one years production;rather, the cost should be spread (orcapitalized)

over the years in which the machine is in service.

The cost charged to operations during a particularyear is called depreciation.

From an engineering economics point of view, ourprimary concern is with accounting depreciation;The systematic allocation of an assets value overits depreciable life.


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Accounting depreciation can be broken into twocategories:

1. Book depreciationthe method of depreciationused for financial reports and pricing products;

2. Tax depreciationthe method of depreciationused for calculating taxable income and incometaxes; it is governed by tax legislation.

The four components of information required tocalculate 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.


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Because it employs accelerated methods of

depreciation and shorter-than-actual depreciablelives, the MACRS (Modified Accelerated CostRecovery System) gives taxpayers a break: Itallows them to take earlier and faster advantageof the tax-deferring benefits of depreciation.

Many firms select straight-line depreciation forbook depreciation because of its relative ease ofcalculation.


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Depletion is a cost allocation method used

particularly for natural resources. Cost depletionis based on the units-of-production method ofdepreciation. 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 whateverpercentages, depreciable lives, and salvage values

mandated at the time an asset is acquired.


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Component

of

Depreciation

Book Depreciation Tax depreciation (MACRS)

Cost basis Based on the actual cost

of the asset, plus all

incidental costs such as

freight, site preparation,

installation, etc.

Same as for book depreciation

Salvage

value

Estimated at the outset of

depreciation analysis. If

the final book value does

not equal the estimated

salvage value, we mayneed to make adjustments

in our depreciation

calculations.

Salvage value is zero for all

depreciable assets


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( ) 2001 C E i i 40

Component

of

Depreciation

Book Depreciation Tax depreciation (MACRS)

Depreciablelife Firms may select theirown estimated useful lives

or follow government

guidelines for asset

depreciation ranges

(ADRs)

Eight recovery periods3,5,7,10,15,20,27.5,or 39 years

have been established; all

depreciable assets fall into one of

these eight categories.

Method of

depreciation

Firms may select from the

following:

Straight-line

Accelerated methods

(declining balance, doubledeclining balance, and

sum-of- years digits)

Units-of-proportion

Exact depreciation percentages are

mandated by tax legislation but are

based largely on DDB and straight-

line methods. The SOYD method is

rarely used in the U.S. except for

some cost analysis in engineering

valuation.

depreciation ch 10

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