*DepreciationOur 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?

*DepreciationThe cost of fixed assets must be recorded as expenses on a firms 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.

*DepreciationDepreciable 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!

*Depreciable AssetsBy U.S. tax law, depreciable property:Must be used in business or held for production of income.

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

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

*Cost BasisCost Basis the total cost claimed as an expense over an assets life. Includes:Actual CostSome incidental expenses:FreightSite PreparationInstallation

These are the costs reqd to put the asset into service!

*Cost BasisUsed in figuring depreciation deductions.

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

*Cost BasisIf 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.

*Depreciation MethodsWe will cover five methods:Straight Line Declining BalanceSum of Years DigitsUnits of ProductionMACRS Modified Accelerated Cost Recovery System

*NotationI = 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

*Computer PBX ExampleInitial Cost = $8,000Installation = $2,000Salvage = $1,000Useful Life = 4 yearsMACRS Property Class = 5 years

*Straight 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 nN = estimated years of useful lifen = the year currently under consideration

*Declining Balance Method = (Multiplier)

= % reduction each year

Dn = I (1)n1

Bn = I (1)n

Typical multipliers are 150% and 200%.

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

1N

*Sum of Years Digits Method SOYD = 1 + 2 + 3 + + N = N(N+1) 2

Dn = ( N n + 1 ) ( I S ) SOYD

Bn = Bn1 Dn

*Units of Production MethodDn = Service Units Consumed During Year n ( I S ) Total Service Units nBn = I Service Units Consumed During Year n ( I S ) Total Service Units

*MACRSPrior 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.

*MACRS Property Classes

Recovery Period (years)ADR Class MidpointApplicable Property3ADR 4Special tools for plastic / fabricated metal parts mfg; motor vehicles54 < ADR 10Autos, light trucks, high-tech / R&D equip., computerized phone switches710 < ADR 16Mfg equip., office furniture, fixtures1016 < ADR 20Vessels, barges, tugs, railroad cars1520 < ADR 25Waste-water plants, telephone distribution plants, other utilities2025 ADRMunicipal sewers, electric power plants27.5Residential rental property39Non-residential real property, elevators

*MACRS Depreciation Schedule* MACRS switches to straight line depreciation. Table values shown are percentages.

Class:3571015Year200% DB200% DB200% DB200% DB150% DB133.3320.0014.2910.005.00244.4532.0024.4918.009.50314.81*19.2017.4914.408.5547.4111.52*12.4911.527.70511.528.93*9.226.9367.548.927.376.2378.936.55*5.90*84.466.555.9096.565.91106.555.90113.285.91125.90135.91145.90155.91162.95

*MACRSDn = (Year n MACRS Class Table Value)( I ) nBn = ( 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 Dn value lower, and Selling year book value is Dn value higher!

Engineering EconomicsEngineering Economics*Copyright (c) 2000 - 2008, D.H. Jensen & K.D. Douglas*Copyright (c) 2000 - 2008, D.H. Jensen & K.D. Douglas