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Book Depreciation - Home Pages of All Faculty at KFUPM

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Chapter 8
Depreciation and Income Taxes
пЃ®
Asset Depreciation
пЃ±
Book Depreciation
пЃ±
Tax Depreciation
пЃ±
How to Determine
“Accounting Profit”
пЃ±
Corporate Taxes
Depreciation
Definition: Loss of value for a fixed asset
Example: You purchased a car worth $15,000 at
the beginning of year 2000.
End of
Year
$15,000
10,000
8,000
6,000
5,000
4,000
Loss of
Value
$5,000
2,000
2,000
1,000
1,000
p
Depreciation
0
1
2
3
4
5
Market
Value
Depreciation Concept
Depreciation is viewed as a part of business expenses that
reduce taxable income.
Economic Depreciation (Purchase Price – Market Value)
Economic losses due to both physical deterioration
and technological obsolescence)
Accounting Depreciation
Systematic allocation of the initial cost of an asset
in parts over time or decline in value over time known
as its depreciable life.
Asset Depreciation
Economic depreciation
the gradual decrease in
utility in an asset with
use and time
Physical
depreciation
Functional
depreciation
Depreciation
Accounting depreciation
The systematic allocation
of an asset’s value in
portions over its
depreciable life—often
used in engineering
economic analysis
Book
depreciation
Tax
depreciation
Factors to Consider in Asset Depreciation
пЃ± What is the depreciable life of the asset?
 What is asset’s value at the end of its useful life?
пЃ± What is the cost of the asset?
пЃ± What method of depreciation do we choose?
What Can Be Depreciated?
пѓј Assets used in business or held for production of income
пѓј Assets having a definite service (useful) life and a life
longer than one year
пѓј Assets that must wear out, become obsolete or lose value
A qualifying asset for depreciation must satisfy all of the three conditions
above. Depreciable property includes buildings, machinery, equipment,
vehicles, and some intangible properties. If an asset has no definite service
life, the asset can not be depreciated such as land.
Example 8.1
Cost Basis
of an asset represents the total cost that is claimed as an expense over an asset's
life and generally includes the followings
Cost of a new hole-punching machine
(Invoice price)
+ Freight
$62,500
725
+ Installation labor
2,150
+ Site preparation
3,500
Cost of Machine (Cost basis) to use in
depreciation calculation
$68,875
Asset Depreciation Range ADR (years)
Assets Used
Lower Limit
Midpoint Life
Upper Limit
Office furniture, fixtures, and equipment
8
10
12
Information systems (computers)
5
6
7
Airplanes
5
6
7
2.5
3
3.5
Buses
7
9
11
Light trucks
3
4
5
Heavy trucks (concrete ready-mixer)
5
6
7
12
15
18
5
6
7
Vessels, barges, tugs, and water transportation system
14.5
18
21.5
Industrial steam and electrical generation and or
distribution systems
17.5
22
26.5
Manufacturer of electrical and non-electrical machinery
8
10
12
Manufacturer of electronic components, products, and
systems
5
6
7
Manufacturer of motor vehicles
9.5
12
14.5
Telephone distribution plant
28
35
42
Automobiles, taxis
Railroad cars and locomotives
Tractor units
Types of Depreciation
пЃ®
Book Depreciation
пЃ±
пЃ±
пЃ®
Firms report depreciation and net income to investors /
stockholders (as balance sheet or income statement)
In pricing decision
Tax Depreciation
пЃ±
пЃ±
In calculating income taxes for the IRS
In engineering economics, we use depreciation in the
context of tax depreciation
Book Depreciation Methods
пЃ®
Three different methods can be used to calculate
the periodic depreciation allowances for financial
reporting.
пЃ®
Types of Depreciation Methods:
пЃ±
пЃ±
пЃ±
Straight-Line Method
Declining Balance Method
Unit Production Method
Straight – Line (SL) Method
Principle
A fixed asset as an asset that provides its services in a
uniform fashion. That is, the asset provides equal amount of
service in each year of its useful life.
Formula
• Annual Depreciation
Dn = (I – S) / N, and constant for all n.
• Book Value
Bn = I – n (D)
where I = cost basis
S = Salvage value
N = depreciable life
Example 8.2 – Straight-Line Method
Annual Depreciation
$10,000
$8,000
D2
$6,000
$4,000
D3
B1
D4
B2
B3
D5
B4
$2,000
Total depreciation at end of life
D1
Book Value
I = $10,000
N = 5 Years
S = $2,000
D = (I - S)/N
n
B5
0
1
2
3
4
5
n
1
2
3
4
5
Dn
1,600
1,600
1,600
1,600
1,600
Bn
8,400
6,800
5,200
3,600
2,000
Declining Balance Method
Principle:
A fixed asset as providing its service in a decreasing
fashion.
Formula
The fraction, пЃЎ = (1/N) (multiplier)
• Annual Depreciation
D n пЂЅ пЃЎ B n пЂ­1 пЂЅ пЃЎ (1 пЂ­ пЃЎ ) n пЂ­1
• Book Value
B пЂЅ (1 пЂ­ пЃЎ )
n
where 0 < пЃЎ < 2(1/N)
Note: if пЃЎ is chosen to be the upper bound, пЃЎ = 2(1/N), we call it a 200% DB or
double declining balance method. As N increases, пЃЎ decreases.
Example 8.3 – Declining Balance
Method
Annual Depreciation
Book Value
I = $ 1 0 ,0 0 0
$10,000
Total depreciation at end of life
D1
$8,000
$6,000
D2
$4,000
B1
B2
D3
$2,000
B3
1
2
3
B4
4
D5
B5
5
5 ye a rs
S = $778
D n = пЃЎ Bn пЂ­1
= пЃЎ I (1 - пЃЎ пЂ©
B n пЂЅ I (1 пЂ­ пЃЎ )
n
0
1
2
3
4
5
D4
$778
0
N =
n
Dn
$4,000
2,400
1,440
864
518
n
Bn
$10,000
6,000
3,600
2,160
1,296
778
n пЂ­1
Example 8.4
Declining Balance (DB) Switching to SL
Asset: Invoice Price
Freight
Installation
Depreciation Base
Salvage Value
Depreciation
Depreciable life
$9,000
500
500
$10,000
0
200% DB
5 years
• SL Dep. Rate = 1/5
•  (DDB rate) = (200%) (SL rate)
= 0.40
Case 1: S = 0
(a) Without switching
n
Depreciation
1
2
3
4
5
10,000(0.4) = 4,000
6,000(0.4) = 2,400
3,600(0.4) = 1,440
2,160(0.4) = 864
1,296(0.4) = 518
(b) With switching to SL
Book
Value
$6,000
3,600
2,160
1,296
778
n
1
2
3
4
5
Depreciation
10,000/5 =
4,000
6,000/4 = 1,500 < 2,400
3,600/3 = 1,200 < 1,440
2,160/2 = 1,080 > 864
1,080/1 = 1,080 > 518
Book
Value
$6,000
3,600
2,160
1,080
0
Note: Without switching, we have not depreciated the entire cost of the asset and thus have
not taken full advantage of depreciation’s tax deferring benefits. The rule is; if DB
depreciation in any year is less than (or equal to) the depreciation amount calculated by SL,
switch to and remain with the SL method for the duration of the asset’s depreciable life.
Case 2: S = $2,000
End of
Year
Depreciation
Book Value
1
0.4($10,000) = $4,000
$10,000 - $4,000 = $6,000
2
0.4(6,000) = 2,400
6,000 – 2,400 = 3,600
3
0.4(3,600) = 1,440
3,600 –1,440 = 2,160
4
0.4(2,160) = 864 > 160
2,160 – 160 = 2,000
Adjusting to salvage value
5
0
2,000 – 0 = 2,000
Note: Tax law does not permit us to depreciate assets below their salvage values.
Units-of-Production Method
Principle
The number of service units will be consumed in
that period.
Formula
Annual Depreciation
Service units consumed for year
Dn
(I - S)
=
total service units
Example 8.5
пЃ®
Given: I = $55,000, S = $5,000, Total service units = 250,000
miles, usage for this year = 30,000 miles
пЃ®
Solution:
D ep пЂЅ
30, 000
($ 5 5, 0 0 0 пЂ­ $ 5, 0 0 0 )
250, 000
пѓ¦ 3 пѓ¶
пЂЅ пѓ§
пѓ· ($ 5 0 , 0 0 0 )
пѓЁ 25 пѓё
пЂЅ $6, 000
Modified Accelerated Cost Recovery Systems
(MACRS)
Personal Property
(includes assets such as machinery, vehicles,
equipment, furniture, and similar items)
пЃ±
пЃ±
пЃ±
Depreciation method based on DB method switching to SL
Half-year convention
Zero salvage value
Real Property [Real properties are classified into two categories:
1. residential rental property and 2. commercial building or properties]
пЃ±
пЃ±
пЃ±
SL Method
Mid-month convention
Zero salvage value
MACRS Property Classifications (IRS Publication 534)
Recovery Period
ADR Midpoint Class
3-year
ADR п‚Ј 4
Applicable Property
Special tools for manufacture of plastic
products, fabricated metal products, and
motor vehicles.
5-year
7-year
10-year
15-year
4 пЂј ADR п‚Ј 10
Automobiles, light trucks, high-tech
equipment, equipment used for R&D,
computerized telephone switching systems
10 пЂј ADR п‚Ј 16
Manufacturing equipment, office furniture,
fixtures
16 пЂј ADR п‚Ј 20
20 пЂј ADR п‚Ј 25
20-year
25 п‚Ј ADR
Vessels, barges, tugs, railroad cars
Waste-water plants, telephone- distribution
plants, or similar utility property.
Municipal sewers, electrical power plant.
27.5-year
Residential rental property
39-year
Nonresidential real property including
elevators and escalators
ADR: Asset Depreciation Range
MACRS Table The percentages shown in the table use the half year
convention, all the assets are placed in service at mid-year and will have zero salvage value.
Example 8.6
MACRS Depreciation
Asset cost = $10,000
Property class = 5-year recovery period
DB method = Half-year convention, zero salvage value,
200% DB switching to SL
20%
32%
19.20% 11.52% 11.52% 5.76%
$2000 $3200 $1920 $1152 $1152
Full Full
Full
1
2
3
4
Half-year Convention
$576
Full
5
6
Taxable Income and Income Taxes
Item
Gross Income
Expenses
Cost of goods sold (revenues)
Depreciation
Operating expenses
Taxable income
Income taxes
Net income
Example 8.8 - Net Income Calculation
Item
Amount
Gross income (revenue)
$50,000
Expenses
Cost of goods sold
Depreciation
Operating expenses
20,000
4,000
6,000
Taxable income
20,000
Taxes (40%)
Net income
8,000
$12,000
Capital Expenditure versus Depreciation Expenses
(7-year MACRS property)
0
$28,000
0
1
2
3
4
5
6
7
8
Capital expenditure
(actual cash flow)
1(14.29) 2 (24.49) 3 (17.49) 4 (12.49) 7 (8.93) 6 (8.92) 7 (8.93) 8 (5.76)
$1,250
$4,000
$4,900
$6,850
$3,500 $2,500
$2,500 $2,500
Allowed depreciation expenses (not cash flow)
Example 8.9 – Cash Flow versus Net Income
Item
Income
Cash Flow
Gross income (revenue
$50,000
$50,000
Expenses
Cost of goods sold
Depreciation
Operating expenses
20,000
4,000
6,000
-20,000
Taxable income
20,000
Taxes (40%)
Net income
Net cash flow
8,000
-6,000
-8,000
$12,000
$16,000
Net income versus net cash flow
Net cash flows = Net income + non-cash expense (depreciation)
$50,000
$40,000
$30,000
$20,000
$10,000
$0
Net
cash flow
Net income
$12,000
Depreciation
$4,000
Income taxes
$8,000
Operating expenses
Cost of goods sold
$6,000
$20,000
Gross
revenue
U.S. Corporate Tax Rate (2005)
Marginal tax rate is defined as the rate applied to the last dollar of income.
Taxable income
Tax rate
0-$50,000
15%
$50,001-$75,000
25%
$75,001-$100,000
34%
$100,001-$335,000
39%
$335,001-$10,000,000
34%
$10,000,001-$15,000,000 35%
$15,000,001-$18,333,333 38%
$18,333,334 and Up
35%
Tax computation
$0 + 0.15(DпЂ©
$7,500 + 0.25 (DпЂ©
$13,750 + 0.34(DпЂ©
$22,250 + 0.39 (DпЂ©
$113,900 + 0.34 (DпЂ©
$3,400,000 + 0.35 (DпЂ©
$5,150,000 + 0.38 (DпЂ©
$6,416,666 + 0.35 (DпЂ©
(DпЂ© denotes the taxable income in excess of the lower bound of
each tax bracket
Marginal and Effective (Average) Tax Rate for a
Taxable Income of $16,000,000
Taxable income
Marginal
Tax Rate
Amount of
Taxes
Cumulative
Taxes
First $50,000
15%
$7,500
$7,500
Next $25,000
25%
6,250
13,750
Next $25,000
34%
8,500
22,250
Next $235,000
39%
91,650
113,900
Next $9,665,000
34%
3,286,100
3,400,000
Next $5,000,000
35%
1,750,000
5,150,000
Remaining
$1,000,000
38%
380,000
$5,530,000
A v erage ta x rate =
$ 5 ,5 3 0 ,0 0 0
$ 1 6, 0 0 0 , 0 0 0
пЂЅ 3 4 .5 6 %
Example 8.10 - Corporate Income Taxes
Facts:
Capital expenditure
(allowed depreciation)
Gross Sales revenue
Expenses:
Cost of goods sold
Depreciation
Leasing warehouse
Question: Taxable income?
$290,000
$58,000
$1,250,000
$840,000
$58,000
$20,000
Taxable income:
Gross income
- Expenses:
(cost of goods sold)
(depreciation)
(leasing expense)
Taxable income
• Income taxes:
First $50,000 @ 15%
$25,000 @ 25%
$25,000 @ 34%
$232,000 @ 39%
Total taxes
$1,250,000
$840,000
$58,000
$20,000
$332,000
$7,500
$6,250
$8,500
$90,480
$112,730
Average tax rate:
Total taxes =
$112,730
Taxable income = $332,000
A verage tax rate =
$112,730
$332,000
пЂЅ 33.95%
Marginal tax rate:
Tax rate that is applied to the last dollar
earned
39%
Disposal of Depreciable Asset
If a MACRS asset is disposed of during the
recovery period,
пѓ�Personal property: the half-year convention
is applied to depreciation amount for the
year of disposal.
пѓ�Real property: the mid-month convention is
applied to the month of disposal.
Depreciation recapture
Depreciation recapture is taxed as ordinary income.
Gains = Salvage value – book value
= (Salvage value - cost basis)
Capital gains
+
(Cost basis – book value)
Ordinary gains
Capital Gains and Ordinary Gains
Capital gains
Total gains
Ordinary gains
or
depreciation recapture
Cost basis
Book value
Salvage value
Gains or Losses on Depreciable Asset
Example 8.11: A Drill press: $230,000
Project year: 3 years
MACRS:
7-year property class
Salvage value: $150,000 at the end of Year 3
Full
Full
Half
8.92
8.92
14.29 24.49 17.49 12.49
8.92
Total Dep. = 230,000(0.1429 + 0.2449 + 0.1749/2) = $109,308
Book Value = 230,000 -109,308 = $120,693
Gains = Salvage Value - Book Value = $150,000 - $120,693
= $29,308
Gains Tax (34%) = 0.34 ($29,308) = $9,965
Net Proceeds from sale = $150,000 - $9,965 = $140,035
Disposal of a MACRS Property and Its
Effect on Depreciation Allowances
Calculation of Gains or Losses on MACRS Property
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