ch16 brief-depreciation methods

Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6th Edition, 2005

© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved16-1

Developed By:

Dr. Don Smith, P.E.

Department of Industrial Engineering

Texas A&M University

College Station, Texas

Executive Summary Version

Chapter 16Depreciation Methods



LEARNING OBJECTIVESLEARNING OBJECTIVES1. Depreciation

terms2. Straight line3. Declining

Balance4. MACRS5. Recovery

Period6. Depletion



Sct 16.1 Depreciation TerminologySct 16.1 Depreciation Terminology Depreciation is the

reduction in value over time of an asset.

Brought on by: Wear and tear, use; Deterioration; Obsolescence.

Other definitions follow:

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.



Tax DeductionsTax Deductions Federal tax law permits

the reduction of Gross Income (GI) by a category of elements termed “deductions”.

Most deductions are real cash flows: Wages and salaries; Cost of materials; Utilities; Interest paid on debt; State and local taxes paid; etc.

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.



Depreciation AmountsDepreciation 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.

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.



Important TermsImportant Terms First Cost or Unadjusted Basis - B

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 Depreciable life of the asset in

question – often set by law Market Value - MV

Amount realized by sale on the open market

Salvage Value - S 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

Real Property Real estate and improvements,

buildings and certain structuresLand is Real Property, but by law is NOT depreciable for tax purposes



Tax DepreciationTax 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



General Book value Curves for Different General Book value Curves for Different Depreciation ModelsDepreciation Models

This diagram illustrates the decline in book values over time for the various methods of deprecation .



TheThe Half-year Half-year convention convention During a tax year, assets are

purchased and installed throughout the first year.

Under past laws, the first year of depreciation had to be prorated by the number of months remaining in the tax year.

Under current federal tax law the first year is handled using the half-year convention.

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.

This convention is utilized in this text and in most U.S.- approved tax depreciation methods.

There are also mid-quarter and mid-month conventions.



Sct 16.2 Straight Line (SL) DepreciationSct 16.2 Straight Line (SL) Depreciation The standard on which

all other depreciation models are compared

t

t

Notation:t = year (t = 1,2,...,n)D = annual depreciation chargeB = first cost or unadjusted basisS = Estimated salvage valuen = recovery periodd = depreciation rate

tD =(B-S)dB-S = n

1t t

t

BV B tD

d dn

Excel Function: =SLN(B,S,n)



Sct 16.3 Declining Balance (DB) and Double Sct 16.3 Declining Balance (DB) and Double Declining Balance (DDB) DepreciationDeclining 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.

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



DB Family of DepreciationDB Family of Depreciation

max2dn

1( )t tD d BV

1(1 )ttd d d

Max. depr. rate by law:

Depreciation for year t:

Actual depreciation rate for year t:

If BVt-1 not known, apply:1(1 )ttD dB d

Book Value amounts (two methods)

1

(1 )tt

t t t

BV B dBV BV D

Implied Salvage Value

1/

1nS

B

Implied d for S >0

(1 )nnimpS BV B d

Excel Function: =DDB(B,S,n,t,d)



DB: Implied Salvage ValueDB: 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]



Sct 16.4 Modified Accelerated Cost Sct 16.4 Modified Accelerated Cost Recovery System (MACRS)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.

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

1

t

t jj

BV B D



MACRS DetailsMACRS Details Under MACRS:

The entire basis (B) is fully depreciated (recovered) over a specified number of years (recovery periods).

A “0” salvage value is a functional part of the MACRS system – by law.

In reality, there may be a positive, “0”, or negative salvage value at some point in time.

Adjustments will have to be made at that time. (Disposal analysis)

For Personal Property the following MACRS recovery periods apply: 3- years 5-years 7-years 10-years 15-years, and 20-years

These are the Six Property Classes for Personal Property

Half-year convention applies



MACRS Personal Property Recovery RatesMACRS Personal Property Recovery RatesYear-t 3-Year 5-Year 7-Year 10-Year 15-Year 20-Year1 0.3333 0.2000 0.1429 0.1000 0.0500 0.03752 0.4445 0.3200 0.2449 0.1800 0.0950 0.07223 0.1481 0.1920 0.1749 0.1440 0.0855 0.06684 0.0741 0.1152 0.1249 0.1152 0.0770 0.06185 0.1152 0.0893 0.0922 0.0693 0.05716 0.0576 0.0892 0.0737 0.0623 0.05297 0.0893 0.0655 0.0590 0.04898 0.0446 0.0655 0.0590 0.04529 0.0656 0.0591 0.044610 0.0655 0.0590 0.044611 0.0328 0.0591 0.044612 0.0590 0.044613 0.0591 0.044614 0.0590 0.044615 0.0591 0.044616 0.0295 0.044617 0.044618 0.044619 0.044620 0.044621 0.0223

1.0000 1.0000 1.0000 1.0000 1.0000 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



Real Property ClassesReal 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.

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



Nominal Recovery PeriodsNominal 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?

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 in-service 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.



Sct 16.5 Determining The MACRS Sct 16.5 Determining The MACRS Recovery PeriodRecovery 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.

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



Personal Property – Recovery PeriodsPersonal Property – Recovery Periods 3- Year Property:

Special manufacturing and handling devices, tractors and racehorses.

5- Year Property: Computers and

peripherals, Duplicating

equipment. Automobiles, trucks,

buses, Cargo containers, Some manufacturing

equipment.

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!

The 7-year class is the ‘default’ class!



More MACRS Recovery PeriodsMore MACRS Recovery Periods 10-Year Class:

Water transportation equipment,

Petroleum refining,

Agricultural processing equipment,

Durable goods manufacturing equipment,

Ship building.

15-Year Class: Land

improvements, Landscaping, Pipelines, Nuclear power

production equipment,

Telephone distribution and switching equipment.

20-Year Class: Municipal

sewers, (developers)

Farm buildings, Telephone

switching equipment,

Power production equipment,

Water utilities equipment.



Property Class – Real PropertyProperty 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.



The Alternate Depreciation System The Alternate Depreciation System (ADS)(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 half-year convention.

Generally used by small or growing firms that do not have large taxable income now. Advantages of accelerated depreci-ation not needed

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



Sct 16.6 Depletion MethodsSct 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, Oil and gas, etc.

Cost Depletion Also called factor depletion Based upon the level of

activity or usage; Time is not involved.

Percentage Depletion Applies a constant, stated

percentage of the resource's gross income provided it does not exceed 50% of the firm’s current taxable income.

first costresource capacitycos depletion factor for year t

t

t

p

p t



DEPLETION: Cost DepletionDEPLETION: 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. 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 …

Let t denote the year pt denotes the depletion

factor for year t Then, pt is defined as:

first costresource capacitytp

Percentage depletion amount =

Percentage x gross income from property



DEPLETION: Cost Method ExampleDEPLETION: 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



DEPLETION: Important IssueDEPLETION: 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.



Percentage DepletionPercentage 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



DEPLETION: Percentage MethodDEPLETION: Percentage MethodDeposit Percentage

Sulfur, uranium, lead, nickel , zinc

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%

Note:

Due to frequent revisions of the US Federal tax code, the analyst should always refer to the latest published rates!



Depletion Law RequirementDepletion 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.



Depletion Law RequirementDepletion Law Requirement

Calculate both amounts: Cost depletion ($-Depl), and Percentage depletion (%-Depl). Then apply the following rule each year:

%Depl if %Depl $DeplAnnual Depletion =

$Depl if %Depl $Depl



Chapter SummaryChapter 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.

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.



Summary- continuedSummary- 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.

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).



Summary: DDB and MACRSSummary: 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.

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.



Summary - continuedSummary - 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.

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.



Chapter 16Chapter 16End of SetEnd of Set

ch16 brief-depreciation methods

Documents