Depreciation and Income Taxes Asset Depreciation Book Depreciation

Depreciation and Income Taxes Asset Depreciation Book Depreciation Tax Depreciation How to Determine “Accounting Profit” 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 1, 000 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 Depreciation Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation

What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite service (useful) life and a life longer than one year 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.

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

Types of Depreciation Book Depreciation Firms report depreciation and net income to investors / stockholders (as balance sheet or income statement) In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation

Book Depreciation Methods Three different methods can be used to calculate the periodic depreciation allowances for financial reporting. Types of Depreciation Methods: 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 D 2 $6, 000 $4, 000 D 3 B 1 D 4 B 2 B 3 D 5 B 4 $2, 000 Total depreciation at end of life D 1 Book Value I = $10, 000 N = 5 Years S = $2, 000 D = (I - S)/N n B 5 0 1 2 3 4 5 n 1 2 3 4 5 Dn 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, = (1/N) (multiplier) • Annual Depreciation • Book Value where 0 < < 2(1/N)

Example 8. 3 – Declining Balance Method Annual Depreciation Book Value $10, 000 Total depreciation at end of life D 1 $8, 000 $6, 000 D 2 $4, 000 B 1 B 2 D 3 $2, 000 B 3 $778 0 1 2 3 D 4 B 4 4 D 5 B 5 5 n n 0 1 2 3 4 5 Dn $4, 000 2, 400 1, 440 864 518 Bn $10, 000 6, 000 3, 600 2, 160 1, 296 778

Example 8. 4 Declining Balance (DB) Switching to SL Asset: Invoice Price Freight Installation Depreciation Base Salvage Value Depreciation Depreciable life $9, 000 500 $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 1 2 3 4 5 Depreciation 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 Given: I = $55, 000, S = $5, 000, Total service units = 250, 000 miles, usage for this year = 30, 000 miles Solution:

Modified Accelerated Cost Recovery Systems (MACRS) Personal Property (includes assets such as machinery, vehicles, equipment, furniture, and similar items) 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] SL Method Mid-month convention Zero salvage value

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% 5. 76% $2000 $3200 $1920 $1152 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 $6, 850 $4, 900 $3, 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 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 34% $10, 001 -$15, 000 35% $15, 000, 001 -$18, 333 38% $18, 333, 334 and Up 35% Tax computation $0 + 0. 15( $7, 500 + 0. 25 ( $13, 750 + 0. 34( $22, 250 + 0. 39 $113, 900 + 0. 34 $3, 400, 000 + 0. 35 $5, 150, 000 + 0. 38 $6, 416, 666 + 0. 35 ( 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 Taxable income Marginal Tax Rate Amount of Taxes Cumulative Taxes First $50, 000 15% $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 35% 1, 750, 000 5, 150, 000 Remaining $1, 000 38% 380, 000 $5, 530, 000

Example 8. 10 - Corporate Income Taxes Facts: Capital expenditure (allowed depreciation) $290, 000 $58, 000 Gross Sales revenue Expenses: Cost of goods sold Depreciation Leasing warehouse $1, 250, 000 $840, 000 $58, 000 $20, 000 Question: Taxable income?

Taxable income: Gross income $1, 250, 000 - Expenses: (cost of goods sold) $840, 000 (depreciation) $58, 000 (leasing expense) $20, 000 Taxable income $332, 000 • Income taxes: First $50, 000 @ 15% $7, 500 $25, 000 @ 25% $6, 250 $25, 000 @ 34% $8, 500 $232, 000 @ 39% $90, 480 Total taxes $112, 730

Average tax rate: Total taxes = $112, 730 Taxable income = $332, 000 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, Personal property: the half-year convention is applied to depreciation amount for the year of disposal. Real property: the mid-month convention is applied to the month of disposal.

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 Half 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