Transcript Depreciation

Developed By:
Dr. Don Smith, P.E.
Department of Industrial
Engineering
Texas A&M University
College Station, Texas
Executive Summary Version
Chapter 16
Depreciation Methods
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16-1
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LEARNING OBJECTIVES
1. Depreciation
terms
2. Straight line
3. Declining
Balance
4. MACRS
5. Recovery Period
6. Depletion
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Sct 16.1 Depreciation Terminology
 Depreciation is the
reduction in value
over time of an asset.
 Brought on by:
 Depreciation – Original
Reason:
 Purely economic!
 Economic View:
 Depreciation represents
a “ratable” using up of
devaluation of a
productive asset.
 The asset must have a
finite life span that can
be reasonably estimated.
 Deprecation represents a
proper charge against
future income produced
by the asset.
 Wear and tear, use;
 Deterioration;
 Obsolescence.
 Other definitions
follow:
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16-3
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Tax Deductions
 Federal tax law permits
the reduction of Gross
Income (GI) by a category
of elements termed
“deductions”.
 Most deductions are real
cash flows:






 Depreciation (and
depletion) amounts
represent “non-cash
flow” amounts within an
accounting period.
 Federal and state tax
laws recognize various
forms of depreciation
amounts to be “tax
deductible” – but are not
real cash flows per se.
Wages and salaries;
Cost of materials;
Utilities;
Interest paid on debt;
State and local taxes paid;
etc.
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Depreciation Amounts
 Federal tax law states that:
 Any productive asset with
a finite life (greater than
one year) must be
depreciated for tax
purposes rather than
“expensed” in the year of
purchase.
 Depreciation amounts
represent a prorated amount
per year that can be treated
as an “expense” (deduction)
but is not a real cash flow.
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 Depreciation amounts
represent a form of tax
savings to the
profitable firm.
 Assume a tax rate of
say 30% of taxable
income.
 For every $1 of eligible
deductions the
resultant tax savings is:
 (0.30)($1.00) = $0.30.
 $1 of additional
deductions saves the
firm $0.30.
16-5
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Important Terms
 First Cost or Unadjusted Basis - B
 Salvage Value - S
 Initial purchase price + all costs
incurred in placing the asset in
service
 Book Value - BV
 Remaining undepreciated capital
investment on the accounting
books
 BV - sum of all depreciation claimed
in the past
 Recovery Period – n
 Estimated trade-in value or
market value at the end the
asset’s useful life
 Depreciation Rate - dt
 The fraction of the first cost
removed by depreciation each
year
 Personal Property
 All property except real estate
use in the pursuit of profit or
gain
 Depreciable life of the asset in
question – often set by law
 Market Value - MV
 Amount realized by sale on the
open market
 Real Property
 Real estate and improvements,
buildings and certain structures
Land is Real Property, but by law is NOT depreciable for tax purposes
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Tax Depreciation
 Tax Depreciation:
 Must follow current state
and federal law pertaining
to acceptable methods for
computing depreciation
for income tax purposes.
 US Federal Law (2001)
 MACRS Methods
 General Depreciation
System (GDS).
 Alternate Depreciation
System (ADS).
 By US Federal Tax Law, all assets
placed in service and eligible for
depreciation MUST use the current
MACRS methods of calculation of
depreciation amounts. ( 1980, 86 … )
 Tax Law permits states to have their
own respective depreciation methods
for state income tax purposes
(complicating factor)
MACRS – Modified Accelerated Cost Recovery System
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General Book value Curves for Different
Depreciation Models
This diagram illustrates
the decline in book
values over time for the
various methods of
deprecation .
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16-8
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The Half-year convention
 During a tax year, assets are
purchased and installed
throughout the first year.
 Half-year convention
assumes that assets are
placed in service or
disposed of in midyear,
regardless of when these
events actually occur
during the year.
 Under past laws, the first year
of depreciation had to be
prorated by the number of
months remaining in the tax
year.
 This convention is
utilized in this text and in
most U.S.- approved tax
depreciation methods.
 Under current federal tax law
the first year is handled using
the half-year convention.
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 There are also midquarter and mid-month
conventions.
16-9
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Sct 16.2 Straight Line (SL) Depreciation
 The standard on which
all other depreciation
models are compared
D t =(B-S)d
=
Notation:
B-S
n
BVt  B  tDt
t = year (t = 1,2,...,n)
D t = annual depreciation charge
d  dt 
B = first cost or unadjusted basis
1
n
S = Estimated salvage value
n = recovery period
d t = depreciation rate
Excel Function: =SLN(B,S,n)
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Sct 16.3 Declining Balance (DB) and Double
Declining Balance (DDB) Depreciation
 DB is an accelerated
depreciation method;
 Provides greater
depreciation amounts
in the early time
periods over straight
line.
 The method is more
complex that the SL
method.
 Requires assuming a
DB rate – normally
taken to equal 2 x SL
rate.
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 Given the DB rate,
 Dt for year t is found by
multiplying the
beginning of time
period book value by
the rate.
 The maximum DB rate
set by law is:
 dMAX = 2(1/n) or twice the
straight line rate
16-11
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DB Family of Depreciation
Max. depr. rate by law:
d max
Book Value amounts (two methods)
BVt  B(1  d )t
2

n
Depreciation for year t:
BVt  BVt 1  Dt
Implied Salvage Value
Dt  (d ) BVt 1
Actual depreciation rate for year t:
impS  BVn  B(1  d ) n
Implied d for S >0
dt  d (1  d )t 1
1/ n
S
1  
B
If BVt-1 not known, apply:
Dt  dB(1  d )t 1
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Excel Function: =DDB(B,S,n,t,d)
16-12
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DB: Implied Salvage Value
 Note, from Equations [6.4] to [16.9] there is no
mention of the salvage value S!
 DB does not directly use the estimated
salvage value.
 DB has its own implied salvage value.
 The pure DB method will never depreciate an
asset down to a “0”
 If a specific S is required, solve for “d” rate
using Eq. [16.11]
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Sct 16.4 Modified Accelerated Cost
Recovery System (MACRS)
 MACRS was derived from
the 1981 ACRS system and
went into effect in 1986.
 Defines statutory recovery
(depreciation) percentages.
 Percentages were derived
from the DB method with a
switch to SL at the optimal
time and,
 Incorporates the half-year
convention.
t
BVt  B   D j
 The MACRS approach assumes a
salvage value of “0” even though
that might not be the case!
 By current law – MACRS assumes
all assets depreciated by this
method will have a “0” salvage
value at the end of the recovery
life.
 Dt = dtB
 BVt = BV t-1 – Dt
 BVt = first cost – sum of
accumulated depreciation
j 1
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MACRS Details
 Under MACRS:
 For Personal Property
the following MACRS
recovery periods apply:
 The entire basis (B) is fully
depreciated (recovered) over
a specified number of years
(recovery periods).
 3- years
 5-years
 A “0” salvage value is a
functional part of the MACRS
system – by law.
 7-years
 10-years
 15-years, and
 In reality, there may be a
 20-years
positive, “0”, or negative
salvage value at some point
in time.
 Adjustments will have to be
made at that time. (Disposal
analysis)
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 These are the Six
16-15
Property Classes for
Personal Property
 Half-year convention
applies
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MACRS Personal Property Recovery Rates
Year-t
3-Year
5-Year
7-Year
10-Year
15-Year
20-Year
1
0.3333
0.4445
0.1481
0.0741
0.2000
0.3200
0.1920
0.1152
0.1152
0.0576
0.1429
0.2449
0.1749
0.1249
0.0893
0.0892
0.0893
0.0446
0.1000
0.1800
0.1440
0.1152
0.0922
0.0737
0.0655
0.0655
0.0656
0.0655
0.0328
0.0500
0.0950
0.0855
0.0770
0.0693
0.0623
0.0590
0.0590
0.0591
0.0590
0.0591
0.0590
0.0591
0.0590
0.0591
0.0295
0.0375
0.0722
0.0668
0.0618
0.0571
0.0529
0.0489
0.0452
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0446
0.0223
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
1.0000
1.0000
1.0000
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1.0000
1.0000
16-16
1.0000
 Current MACRS recovery
percentages for the property
classes
 Applies to Personal
Property
 Assumes a 0 salvage value
over the class life
 Has the ½ year convention
built into the tables
 There is NO Excel function
for MACRS
 Simplifies depreciation
computations but is less
flexible than classic methods
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Real Property Classes
 Real Property – buildings,
structures, residential
rental and non-residential
office-factory types:
 27.5-years for residential
rental property;
 39 years for all other
properties.
 Published percentages
prorated by months of the
year the property is placed in
service.
 Assumes a mid-month
convention.
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 Straight line method for n =
39.
 d = 1/39 = 0.02564 or
2.564% per year;
 Except in year 1 and in year
40 where technical
adjustments are made in the
percentages.
 User is referred to the IRS
published tables for real
property analysis
 Real property is prorated by
months with the mid-month
convention applied
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Nominal Recovery Periods
 3- year property is
really recovered over 4
years;
 5-year property is
really recovered over 6
years;
 And so forth for each
of the other classes.
 Why is this the case?
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 The actual recovery of a
given class life assumes a
half-year convention.
 That is, it is assumed by law
that an asset is placed inservice at the middle of the
first year.
 It does not matter when it is
actually placed in-service;
 So, only a ½ year of
recovery is permitted in the
first year.
16-18
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Sct 16.5 Determining The MACRS
Recovery Period
 For book depreciation one
should use a life the best
reflects the anticipated or
expected useful life.
 For tax depreciation one
generally wants as short as
possible recovery period to
generate more immediate
tax savings.
 For book depreciation use
whatever life best defines
the usage rate of the asset.
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 For Federal tax purposes,
the proper recovery life is
found from IRS publications
(Pub 946).
 Table 16-4 illustrated
general asset descriptions
and their respective MACRS
recovery periods permitted
by law.
 These breakdowns are
termed Property Classes.
 See Table 16-4 for general
property classes
16-19
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Personal Property – Recovery Periods
 3- Year Property:
 Special
manufacturing and
handling devices,
tractors and
racehorses.
 7 –Year Property:
 Office furniture,
 Some manufacturing
equipment,
 Railroad cars,
engines and tracks,
 Agricultural
machinery,
 Petroleum equipment
and natural gas
equipment,
 All property not in
another class!
 5- Year Property:
 Computers and
peripherals,
 Duplicating
equipment.
 Automobiles, trucks,
buses,
 Cargo containers,
 Some manufacturing
equipment.
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 The 7-year class is the
‘default’ class!
16-20
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More MACRS Recovery Periods
 10-Year Class:
 15-Year Class:
 Water




transportation
equipment,
Petroleum
refining,
Agricultural
processing
equipment,
Durable goods
manufacturing
equipment,
Ship building.
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 Land




improvements,
Landscaping,
Pipelines,
Nuclear power
production
equipment,
Telephone
distribution and
switching
equipment.
16-21
 20-Year Class:
 Municipal




sewers,
(developers)
Farm buildings,
Telephone
switching
equipment,
Power
production
equipment,
Water utilities
equipment.
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Property Class – Real Property
 27.5-Year Property: (Real Property)
 Residential rental property (homes and mobile
homes).
 39-Year Property (Real Property)
 Nonresidential real property attached to the land, but
NOT the land itself.
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16-22
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The Alternate Depreciation System
(ADS)
 The IRS offers what is
termed the Alternate
Depreciation System –
ADS.
 It is a modified form of
the MACRS system.
 Applies a straight-line
approach with the halfyear convention.
 Generally used by small
or growing firms that do
not have large taxable
income now. Advantages
of accelerated depreciation not needed
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 ADS recover periods are longer
 Assume 3-Year MACRS Property:
 For ADS, recovery period is n = 5
 1/n = 0.20 per year except in the
first year and in the last year
(effectively n= 6)
 Year 1: d1 = ½(0.20) = 0.10 or 10%
of B
 Years 2-5 = 0.20 or 20% of B
 Remaining amount – 10% - flows
over to the last year, t = 6
16-23
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Sct 16.6 Depletion Methods
 Depreciation is
applied to assets that
can be replaced.
 Depletion applies to
resources that are not
easily replaced, like:
 Timber,
 Mineral deposits,
 Cost Depletion
 Also called factor depletion
 Based upon the level of
activity or usage;
 Time is not involved.
first cost
pt 
resource capacity
pt  cos t depletion factor for year t
 Percentage Depletion
 Applies a constant, stated
 Oil and gas,
percentage of the resource's
gross income provided it
does not exceed 50% of the
firm’s current taxable income.
 etc.
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DEPLETION: Cost Depletion
 First, the cost basis of the
resource is determined – first
cost or investment cost.
 Second – one must estimate
the amount of the resource
that is available for extraction.
 Let t denote the year
 pt denotes the depletion
factor for year t
 Then, pt is defined as:
 Termed: Resource Capacity.
 It is an estimated value since it
is impossible to predict exactly
the true resource capacity!
 Then, cost depletion factor pt
for year t is calculated …
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first cost
pt 
resource capacity
 Percentage depletion amount =
Percentage x gross income from
property
16-25
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DEPLETION: Cost Method Example
 See Example 16.5
 Company buys timber rights to land for $700,000 at
time t = 0

Estimates 350 million board feet that can be
harvested.
 This is important: A realistic estimate of the resource
must be accomplished up front!
 Re-estimates can be made in the future and adjustments made.
pt = $700,000 / 350 = $2,000/mil bd. ft
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DEPLETION: Important Issue
 Major Point for depletion:
 There must be a reasonable estimate of the
amount of the resource that is being extracted.
 For firms engaged in extraction activities the
process of resource estimation is an
important activity and requires expert
analysis.
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16-27
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Percentage Depletion
 An alternative method for natural resource extraction
activities
 A constant stated percentage of the resources gross
income may be depleted each year so long as:
 The calculated depletion amount does not exceed 50% of the
firm’s taxable income
 Allowable depletions rates are published by the IRS
 Firms usually calculate depletions both ways (cost
and percentage) and select the most favorable method
Ppercenatge depletion = allowable percentage x gross income from property
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16-28
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DEPLETION: Percentage Method
Deposit
Sulfur, uranium, lead,
nickel , zinc
Percentage
22%
Gold, silver ,copper, iron
ore and geothermal
deposits
15%
Oil and gas wells (varies)
15-22%
Coal, lignite, sodium
chloride
10%
Gravel, sand, peat, stone
5%
Most other minerals
14%
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16-29
Note:
Due to frequent
revisions of the US
Federal tax code, the
analyst should always
refer to the latest
published rates!
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Depletion Law Requirement
 The depletion allowance can be determined
using either the cost or the percentage method.
 The current law requires:
 Cost depletion be used IF the percentage depletion is
smaller in any year.
 This means that one should apply both methods in the
beginning.
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16-30
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Depletion Law Requirement
 Calculate both amounts:
 Cost depletion ($-Depl), and
 Percentage depletion (%-Depl).
 Then apply the following rule each year:
%Depl if %Depl  $Depl 
Annual Depletion = 

$Depl 
$Depl if %Depl
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16-31
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Chapter Summary
 Depreciation may be
determined for internal
company records (book
depreciation) or for
income tax purposes (tax
depreciation).
 In the US, the MACRS
method is the only one
allowed for tax
depreciation.
 Depreciation does not
result in actual cash flows
directly – rather, tax
savings are the result of
depreciation.
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 Depreciation is a book
method by which the
capital investment in
tangible property is
recovered.
 The annual depreciation
amount is tax deductible,
which can result in actual
cash flow changes.
16-32
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Summary- continued
 SL method writes off
capital investment linearly
over n years. The
estimated salvage value is
always considered.
 This is the classical,
nonaccelerated
depreciation model.
 Simple to apply and is a
popular method for
computing book
depreciation.
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 DB model accelerates depreciation
compared to straight line.
 The book value is reduced each
year by a fixed percentage.
 The most used rate is twice the SL
rate, which is called double
declining balance (DDB).
16-33
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Summary: DDB and MACRS
 DB and DDB have an implied
salvage that may be lower
than the estimated salvage.
 It is not an approved tax
depreciation method in the
US.
 It is frequently used for book
depreciation purposes.
 May not target a specified
salvage value.
 MACRS applies a
modification of this method to
determine MACRS annual
recovery percentages.
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 MACRS is the only approved tax
depreciation system in US. It
automatically switches from DDB
or DB to SL depreciation.
 MACRS always depreciates to
zero; that is, it assumes S = 0.
 Recovery periods are specified by
property classes.
 Depreciation rates are tabulated.
16-34
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Summary - continued
 MACRS actual
recovery period is 1
year longer due to the
imposed half-year
convention.
 MACRS alternate
straight line
depreciation (ADS) is
an option, and is
generally used by
firms that are growing
and would be wasting
MACRS accelerated
depreciation amounts.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
 Depletion methods are used to
recover investment in the
extraction or harvesting of
natural resources.
 Two Methods:
 Cost Depletion,
 Percentage Depletion.
 Specific rules apply to both
methods.
 Normally, one would calculate
depletion allowances by both
methods then apply the IRS
rules.
16-35
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Chapter 16
End of Set
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
16-36
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved