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Chapter 17Chapter 17

DepreciationDepreciation

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

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• Explain the concept and causes of depreciation

• Prepare a depreciation schedule and calculate partial-year depreciation

Depreciation#17#17Learning Unit ObjectivesConcepts of Depreciation and the Straight-Line Method

LU17.1LU17.1

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• Explain how use affects the units-of-production method

• Prepare a depreciation schedule

Depreciation#17#17Learning Unit ObjectivesUnits-of-Production MethodLU17.2LU17.2

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• Explain how to use the fraction in the sum-of-the-years’-digits method

• Prepare a depreciation schedule

Depreciation#17#17Learning Unit ObjectivesSum-of-the-Years’-Digits MethodLU17.3LU17.3

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• Explain the importance of residual value in the depreciation schedule

• Prepare a depreciation schedule

Depreciation#17#17Learning Unit ObjectivesDeclining-Balance MethodLU17.4LU17.4

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• Explain the goals of ACRS and MACRS and their limitations

• Calculate depreciation using the MACRS guidelines

Depreciation#17#17Learning Unit ObjectivesModified Accelerated Cost Recovery System (MACRS) with Introduction to ACRS

LU17.5LU17.5

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Estimated Useful Life - Number of years or time periods for which the company can be use the asset

Depreciation - An estimate of the use or deterioration of an asset

Asset Cost - Amount paid for an asset including freight charges

Concept of Depreciation

Accumulated Depreciation - The total amount of the asset’s depreciation taken to date

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Residual Value (Salvage Value) - Expected cash value at the end of an assets useful life.

Concept of Depreciation

Book Value - The unused amount of the asset cost that may be depreciated in

future accounting periods

Book Value = Asset cost - Accumulated Book value

Book value cannot be less than residual value

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Causes of Depreciation

Product Obsolescence Physical Deterioration

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Straight-Line Method

Distributes the same amount of expense to each period of time

Depreciation expense = Cost - Residual value each year Estimated useful life in years

Sam’s delivery company buys a new truck to make deliveries. The truck cost $20,000, the estimated useful life is 5 years. After 5 years

the residual value is $1,000. Calculate depreciation expense and complete a depreciation schedule.

$20,000 - $1,000 = $3,800 5

100% = 100% = 20%# of yrs. 5

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Depreciation Schedule

Book value at endDepreciation Accumulated of year (Cost -

End of Cost of expense for depreciation Accumulatedyear equipment year at end of year depreciation)

1 $20,000 $3,800 $ 3,800 $16,200

2 $20,000 $3,800 $ 7,600 $12,400

3 $20,000 $3,800 $11,400 $ 8,600

4 $20,000 $3,800 $15,200 $ 4,800

5 $20,000 $3,800 $19,000 $ 1,000

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Depreciation for Partial Years

Assume Sam’s Delivery bought the truck August 10th. What would be depreciation for t he first year?

Depreciation expense = Cost - Residual value each year Estimated useful life in years

$20,000 - $1,000 = $3,800 x 5 = $1583.33 5 12

15thRule

Aug, Sept., Oct., Nov., & Dec.

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Units-of-Production MethodDepreciation determined by how much the company uses the asset

Depreciation expense = Cost - Residual value per unit Total estimated units produced

Sam’s delivery company buys a new truck to make deliveries. The truck cost $20,000, the estimated useful life is 100,000 miles. After 5

years the residual value is $1,000. Calculate depreciation expense and complete a depreciation schedule.

Depreciation = Unit x Units amount depreciation produced

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Depreciation Schedule

Depreciation Accumulated Book valueEnd of Cost of Units expense for depreciation at endyear equipment prod. year at end of year of year

1 $20,000 20,000 $3,800 $ 3,800 $16,200

2 $20,000 15,000 $2,850 $ 6,650 $13,350

3 $20,000 25,000 $4,750 $11,400 $ 8,600

4 $20,000 22,000 $4,180 $15,580 $ 4,420

5 $20,000 18,000 $3,420 $19,000 $ 1,000

$20,000 - $1,000 = $.19 per unit 100,000

15,000 x $.19

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Sum-of-the-Years’ Digits Method

Accelerated depreciation method which computes more depreciation expense in the early years of the asset’s life

Depreciation = (Cost - Residual value) x Remaining life expense Sum-of-the-Years’ Digits

Sam’s delivery company buys a new truck to make deliveries. The truck cost $20,000, the estimated useful life is 5 years. After 5 years

the residual value is $1,000. Calculate depreciation expense and complete a depreciation schedule.

Sum of the asset’s service life

5+4+3+2+1=15 or N(N+1) = 5(5+1) = 30 = 152 2 2

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Depreciation Schedule

Depreciation Accumulated Book value End of Cost - Fraction expense for depreciation at end year Res. Value for year year at end of year of year

1 $19,000 5/15 $6,333.33 $6,333.33 $13,666.67

2 $19,000 4/15 $5,066.67 $11,400 $8,600

3 $19,000 3/15 $3,800 $15,200 $4,800

4 $19,000 2/15 $2,533.33 $17,733.33 $2,266.67

5 $19,000 1/15 $1,266.67 $19,000 $1,000

$19,000 x 4

15$20,000 - $1,000 = $19,000

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Rate = 100% x 2 = 40% 5 years

Sam’s delivery company buys a new truck to make deliveries. The truck cost $20,000, the estimated useful life is 5 years. After 5 years

the residual value is $1,000. Calculate depreciation expense and complete a depreciation schedule.

Depreciation expense = Book value of equip. x Depreciation each year at beginning of year rate

Accelerated method which computes more depreciation expense in the early years of the asset’s life. Uses up to twice the straight-line rate

Declining-Balance Method

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Depreciation Schedule

Accumulated Book value at Depreciation Accumulated Book valueEnd of Cost of depreciation beginning expense for depreciation at endyear Truck at beg. of year of year year at end of year of year

1 $20,000 0 $20,000 $8,000 $ 8,000 $12,000

2 $20,000 $ 8,000 $12,000 $4,800 $12,800 $7,200

3 $20,000 $12,800 $ 7,200 $2,880 $15,680 $4,320

4 $20,000 $15,680 $ 4,320 $1,728 $17,408 $2,592

5 $20,000 $17,408 $ 2,592 $1,036.80 $18,444.80 $1,555.20*

$12,000 x .40

Rate = 100% x 2 = 40% 5 years

*Since we do not reach the residual value of $1,000 another $555.20 could have been taken as depreciation expense to bring it to the estimated residual value of $1,000

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Modified Accelerated Cost Recovery System (MACRS) with Introduction to (ACRS)

Federal tax laws state how depreciation must be taken for income tax purposes

Provides users with tables giving the useful lives of various assets and the depreciation rates

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Key points of MACRS

1. It calculates depreciation for tax purposes.

2. It ignores residual value.

3. Depreciation if the first year (for personal property) is based on the assumption that the asset was purchased halfway through the year. (A new law adds a midquarter convention for all personal property if more than 40% is placed in service during the last 3 months of the taxable year.)

4. Classes 3,5,7, and 10 use a 200% declining-balance method for a period of years before switching to straight-line depreciation. You do not have to determine the year in which to switch since Table 17.6 builds this into the calculation.

5. Classes 15 and 20 use a 150% declining-balance method before switching to straight-line depreciation.

6. Classes 27.5 and 31.5 use straight-line depreciation.

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Table 17.5 - Modified Accelerated Cost Recovery System (MACRS)

Class recovery

Period (life) Asset types

3-year Racehorses more than 2 years old or any horse other than a racehorse that is more than 12 years old at the time place into service special tools of certain industries.

5-year Automobiles (not luxury) taxis; light general purpose trucks; semiconductor manufacturing equipment computer-based telephone central-office switching equipment qualified technological equipment; property used in connection with research and experimentation.

7-year Railroad track single-purpose agricultural (pigpens), or horticultural; structures; fixtures; equipment; furniture.

10-year New law doesn’t add any specific property under this class.

15-year Municipal wastewater treatment plants; telephone distribution plants and comparable equipment used for two-way exchange of voice and data communications.

20-year Municipal sewers.

27.5-year Only residential property.

31.5-year Only nonresidential real property.

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Table 17.6 - Annual Recovery for MACRS

Recovery 3-year class 5-year class 7-year class 10-year class 15-year class 20-year classyear (200% D.B.) (200% D.B.) (200% D.B.) (200% D.B.) (150% D.B.) (150% D.B.)

1 33.00 20.00 14.28 10.00 5.00 3.752 45.00 32.00 24.49 18.00 9.50 7.223 15.00 19.20 17.49 14.40 8.55 6.684 7.00 11.52 12.49 11.52 7.69 6.185 11.52 8.93 9.22 6.93 5.716 5.76 8.93 7.37 6.23 5.287 8.93 6.55 5.90 4.898 4.46 6.55 5.90 4.529 6.55 5.90 4.46

10 6.55 5.90 4.4611 3.29 5.90 4.4612 5.90 4.4613 5.90 4.4614 5.90 4.4615 5.90 4.4616 3.00 4.46

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Depreciation Schedule

Depreciation Accumulated Book valueEnd of Cost of expense for depreciation at endyear equipment year at end of year of year

1 $20,000 $4,000 $4,000 $16,000

($20,000 x .20)

2 $20,000 $6,400 $10,400 $9,600

($20,000 x .32)

3 $20,000 $3,840 $14,240 $5,760

4 $20,000 $2,304 $16,544 $3,456

5 $20,000 $2,304 $18,848 $1,152

6 $20,000 $1,152 $20,000 $ 0