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DepreciationDepreciationDepreciationDepreciation

Our purpose in studying depreciation is to understand its impact on taxes so that this impact can be included in our economic analysis.

What are the tax effects on the cash flow diagram?

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DepreciationDepreciationDepreciationDepreciation•The cost of fixed assets must be

recorded as expenses on a firm’s balance sheet and income statement.

•Unlike costs such as labor, maintenance, and material, the costs of fixed assets are not treated simply as expenses to be accounted for in the year that they are acquired.

• Instead, they are capitalized.

•Their costs are distributed by subtracting them as expenses from gross income – one part at a time over a number of periods.

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DepreciationDepreciationDepreciationDepreciation

•Depreciable Life – the period of time over which the asset is capitalized.

•Matching Concept – A fraction of the cost of the asset is chargeable as an expense in each of the accounting periods in which the asset provides service to the firm.

•Depreciation is NOT a real cash flow!

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Depreciable AssetsDepreciable AssetsDepreciable AssetsDepreciable Assets

By U.S. tax law, depreciable property:

1. Must be used in business or held for production of income.

2. Must have a definite service life, and that life must be longer than 1 year.

3. Must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.You can NEVER depreciate land!

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Cost BasisCost BasisCost BasisCost Basis

Cost Basis – the total cost claimed as an expense over an asset’s life. Includes:• Actual Cost• Some incidental expenses:

Freight Site Preparation Installation

These are the costs req’d to put the asset into service!

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Cost BasisCost BasisCost BasisCost Basis

• Used in figuring depreciation deductions.

• Used in calculating the gain or loss to the firm if the asset is sold or salvaged.

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Cost BasisCost BasisCost BasisCost Basis• If the asset is purchased by trading

in a similar asset, the difference between the book value and trade in allowance must be considered in determining the cost basis of the new asset.

• If the trade-in allowance exceeds the book value, the difference (unrecognized gain) needs to be subtracted from the cost basis of the new asset.

• If the book value exceeds the trade-in allowance, the difference (unrecognized loss) needs to be added to the cost basis of the new asset.

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Depreciation MethodsDepreciation MethodsDepreciation MethodsDepreciation Methods

We will cover five methods:• Straight Line • Declining Balance• Sum of Years Digits• Units of Production• MACRS – Modified

Accelerated Cost Recovery System

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NotationNotationNotationNotation

I = Cost Basis; Initial Price plus installation expenses.

S = Salvage ValueDn = Depreciation in Year nBn = Book Value in Year nN = estimated years of useful

lifen = the year currently under

consideration

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Computer PBX ExampleComputer PBX ExampleComputer PBX ExampleComputer PBX Example

Initial Cost = $8,000Installation = $2,000Salvage = $1,000Useful Life = 4 yearsMACRS Property Class = 5

years

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Straight Line MethodStraight Line MethodStraight Line MethodStraight Line MethodDn = ( I – S )

N

Bn = I – Dn (n)Where:I = Cost Basis; Initial Price plus

installation expenses.S = Salvage ValueDn = Depreciation in Year nBn = Book Value remaining in Year n

N = estimated years of useful lifen = the year currently under

consideration

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Declining Balance Declining Balance MethodMethod

Declining Balance Declining Balance MethodMethod = (Multiplier)

= % reduction each year

Dn = I (1–)n–1

Bn = I (1–)n

Typical multipliers are 150% and 200%.

200% is also called Double Declining Balance (DDB).

1

N

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Sum of Years Digits Sum of Years Digits MethodMethod

Sum of Years Digits Sum of Years Digits MethodMethod

SOYD = 1 + 2 + 3 + … + N

= N(N+1) 2

Dn = ( N – n + 1 ) ( I – S ) SOYD

Bn = Bn–1 – Dn

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Units of Production Units of Production MethodMethod

Units of Production Units of Production MethodMethod

Dn = Service Units Consumed During Year n ( I – S ) Total Service Units

n

Bn = I – Service Units Consumed During Year n ( I – S )

Total Service Units

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MACRSMACRSMACRSMACRS

• Prior to 1981, taxpayers could choose among several methods when depreciating assets for tax purposes.

• With the Economic Recovery Act of 1981, ACRS was required and MACRS was instituted in 1986.

• MACRS is a simpler, more rapid depreciation method.

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MACRS Property MACRS Property ClassesClasses

MACRS Property MACRS Property ClassesClassesRecovery

Period (years)

ADR Class Midpoint Applicable Property

3 ADR ≤ 4Special tools for plastic / fabricated

metal parts mfg; motor vehicles

5 4 < ADR ≤ 10Autos, light trucks, high-tech / R&D

equip., computerized phone switches

7 10 < ADR ≤ 16 Mfg equip., office furniture, fixtures

10 16 < ADR ≤ 20 Vessels, barges, tugs, railroad cars

15 20 < ADR ≤ 25Waste-water plants, telephone distribution plants, other utilities

20 25 ≤ ADR Municipal sewers, electric power plants

27.5 Residential rental property

39 Non-residential real property, elevators

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MACRS Depreciation MACRS Depreciation ScheduleSchedule

MACRS Depreciation MACRS Depreciation ScheduleScheduleClass: 3 5 7 10 15

Year 200% DB 200% DB 200% DB 200% DB 150% DB

1 33.33 20.00 14.29 10.00 5.00

2 44.45 32.00 24.49 18.00 9.50

3 14.81* 19.20 17.49 14.40 8.55

4 7.41 11.52* 12.49 11.52 7.70

5 11.52 8.93* 9.22 6.93

6 7.54 8.92 7.37 6.23

7 8.93 6.55* 5.90*

8 4.46 6.55 5.90

9 6.56 5.91

10 6.55 5.90

11 3.28 5.91

12 5.90

13 5.91

14 5.90

15 5.91

16 2.95

* MACRS switches to straight line depreciation.

Table values shown are percentages.

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MACRSMACRSMACRSMACRS

Dn = (Year n MACRS Class Table Value)( I )

n

Bn = ( I )[1 – ( Year n MACRS Class Table Values )] j=1

NOTE: If selling an asset BEFORE the final year of depreciation:• Selling year depreciation is ½ Dn value lower, and …• Selling year book value is ½ Dn value higher!