Depreciation Methods Lecture No 31 Chapter 9 Contemporary

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Depreciation Methods Lecture No. 31 Chapter 9 Contemporary Engineering Economics Copyright © 2016 Contemporary

Depreciation Methods Lecture No. 31 Chapter 9 Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Book Depreciation Methods • Purpose: Used in reporting net income to stockholders/investors • Types

Book Depreciation Methods • Purpose: Used in reporting net income to stockholders/investors • Types of Depreciation Methods o Straight-line method o Declining balance method o Unit production method Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Straight-Line (SL) Method q Principle: A fixed asset as providing its service in a

Straight-Line (SL) Method q Principle: A fixed asset as providing its service in a uniform fashion over its life q Formula q Example: • I = $10, 000 • S= $2, 000 • N= 5 years o Annual depreciation Dn = (I − S) / N, and constantfor all n. o Book value Bn = I − n (D) where I = cost basis S = Salvage value N = depreciable life Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Declining Balance (DB) Method q Principle: A fixed asset as providing its service in

Declining Balance (DB) Method q Principle: A fixed asset as providing its service in a decreasing fashion q Formula q Example: o o I = $10, 000 S = $778 N = 5 years α = 0. 40 where 0 <α<2(1/N) Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Example 9. 5: DB Switching to SL q. Given: o o Depreciation Base =$10,

Example 9. 5: DB Switching to SL q. Given: o o Depreciation Base =$10, 000 Salvage Value = 0 Depreciation rate = 200% DB Depreciable life = 5 years q Without Switching q. Find: When switching to SL • SL Dep. Rate = 1/5 • α = (200%) (1/5) = 0. 40 Contemporary Engineering Economics, 6 e, GE Park 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. Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Case 1: S<BN • Switch from DB to SL after n’ Contemporary Engineering Economics,

Case 1: S<BN • Switch from DB to SL after n’ Contemporary Engineering Economics, 6 e, GE Park • Example: S = 0 Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Case 2: S>BN • No further depreciation after n” • Example: S = $2,

Case 2: S>BN • No further depreciation after n” • Example: S = $2, 000 Note: Tax law does not permit a business to depreciate assets below their salvage value. Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Units-of-Production Method q Principle: Service units will be consumed in a non-timephased fashion. •

Units-of-Production Method q Principle: Service units will be consumed in a non-timephased fashion. • Given: I = $55, 000, S = $5, 000, total service unit = 250, 000 miles, service units consumed = 30, 000 miles • Find: Dn • Solution: q Formula: I = Initial investment S = Salvage value Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Tax Depreciation q Purpose: To determine the income taxes owed for the IRS •

Tax Depreciation q Purpose: To determine the income taxes owed for the IRS • Assets placed in service prior to 1981 o Used the book depreciation methods (SL, DB, SOYD) • Assets placed in service from 1981 to 1986 o Used the ACRS (Accelerated Cost Recovery System) Table • Assets placed in service from 1986 to present o Used the MACRS (Modified ACRS) Table Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Modified Accelerated Cost Recovery Systems (MACRS) q Personal Property • Depreciation schedule based on

Modified Accelerated Cost Recovery Systems (MACRS) q Personal Property • Depreciation schedule based on the DB method switching to SL • Half-year convention • Zero salvage value q Real Property • SL Method • Mid-month convention • Zero salvage value Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

MACRS Depreciation Schedules for Personal Property with Half-Year Convention Contemporary Engineering Economics, 6 e,

MACRS Depreciation Schedules for Personal Property with Half-Year Convention Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Comparison Between DDB with Switching to SL and MACRS Method q Conventional DDB Method

Comparison Between DDB with Switching to SL and MACRS Method q Conventional DDB Method o o Cost basis: $10, 000 Salvage value: $0 Depreciable life: 5 years DB rate: 200% q MACRS Method o Property class: 5 -year o Salvage value: $0 o Half-year convention Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

MACRS for Real Property q Types o 27. 5 -year (residential) o 39 -year

MACRS for Real Property q Types o 27. 5 -year (residential) o 39 -year (commercial) q SL Method q Mid-month convention q Zero salvage value q Example: D 1 = (9. 5/12)(100%/27. 5) = 2. 8788% Placed a residential property in service in March. Find the depreciation allowance in year 1. Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Depletion • Depletion is the physical reduction of natural resources (not time-phased). • Two

Depletion • Depletion is the physical reduction of natural resources (not time-phased). • Two types of depletion o Cost depletion o Percentage depletion Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Cost Depletion q Concept: Units-ofproduction method q Cost depletion formula Contemporary Engineering Economics, 6

Cost Depletion q Concept: Units-ofproduction method q Cost depletion formula Contemporary Engineering Economics, 6 e, GE Park Example: o Cost basis = $120, 000, o Total recoverable volume = 1. 5 MBF o Amount sold this year = 0. 5 MBF o Allowed depletion this year? Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Percentage Depletion q Concept: Based on a prescribed percentage of the gross income from

Percentage Depletion q Concept: Based on a prescribed percentage of the gross income from the property during the tax year q Example 9. 11 • Given: • Solution q Basis = $30 million, q Total recoverable volume = 120, 000 ounces of gold, q Amount sold this year = 18, 000 ounces, q Gross income = $16, 425, 000, q Depletion expenses = $12, 250, 000 • Find: Maximum depletion allowance Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Calculating the Allowable Depletion Deduction for Federal Tax $2, 463, 750 $2, 088, 000

Calculating the Allowable Depletion Deduction for Federal Tax $2, 463, 750 $2, 088, 000 $4, 500, 000 Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Summary • Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the

Summary • Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the tax -deferring benefits of depreciation. • The total amount of taxes to pay remains unchangedregardless of depreciation methods adopted. It only changes the timing of the payment. Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Summary • Many firms select straight-line depreciation for book depreciation because of its relative

Summary • Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. • Given the frequently changing nature of depreciation and tax law, we must use whatever percentages, depreciable lives, and salvage values mandated at the time an asset is acquired. Contemporary Engineering Economics, 6 e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved

Depreciation and Income Taxes Asset Depreciation Book DepreciationDepreciation and Income Taxes Asset Depreciation Book Depreciation
Closing Depreciation Concept Closing Depreciation Closing Depreciation StepClosing Depreciation Concept Closing Depreciation Closing Depreciation Step
DEPRECIATION 1 DEPRECIATION CONCEPT AND DEFINITION OF DEPRECIATIONDEPRECIATION 1 DEPRECIATION CONCEPT AND DEFINITION OF DEPRECIATION
Chapter Five Appendix DEPRECIATION METHODS DEPRECIATION METHODS StraightLineChapter Five Appendix DEPRECIATION METHODS DEPRECIATION METHODS StraightLine
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Depreciation Methods Lecture No 31 Chapter 9 ContemporaryDepreciation Methods Lecture No 31 Chapter 9 Contemporary
Chapter 3 Part 2 Depreciation Depreciation loss ofChapter 3 Part 2 Depreciation Depreciation loss of
Depreciation Chapter Outline What is depreciation Why needDepreciation Chapter Outline What is depreciation Why need
Depreciation Chapter 13 Depreciation Allocating the total costDepreciation Chapter 13 Depreciation Allocating the total cost
PROFIT AND GAINSII DEPRECIATION INTRODUCTION Depreciation is aPROFIT AND GAINSII DEPRECIATION INTRODUCTION Depreciation is a
DEPRECIATION ASSET VALUATION 1 21 10 DEPRECIATION WhatDEPRECIATION ASSET VALUATION 1 21 10 DEPRECIATION What
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Depreciation Our purpose in studying depreciation is toDepreciation Our purpose in studying depreciation is to
Understanding UserDefined Depreciation Concept Understanding UserDefined Depreciation UnderstandingUnderstanding UserDefined Depreciation Concept Understanding UserDefined Depreciation Understanding
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Depreciation Definition n HKSSAP defines depreciation as theDepreciation Definition n HKSSAP defines depreciation as the
DEPRECIATION PROVISIONS AND RESERVES 1 CONCEPT OF DEPRECIATIONDEPRECIATION PROVISIONS AND RESERVES 1 CONCEPT OF DEPRECIATION