Chapter 8 Depreciation and Income Taxes

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Chapter 8 Depreciation and Income Taxes

• Asset Depreciation
• Book Depreciation
• Tax Depreciation
• How to Determine Accounting Profit
• Corporate Taxes

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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 Market Value Loss of Value
0 1 2 3 4 5 15,000 10,000 8,000 6,000 5,000 4,000 5,000 2,000 2,000 1,000 1,000
Depreciation
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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.

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Asset Depreciation
Physical depreciation
Economic depreciation the gradual decrease
in utility in an asset with use and time
Functional depreciation
Depreciation
Book depreciation
Accounting depreciation The systematic
allocation of an assets value in portions over
its depreciable lifeoften used in
engineering economic analysis
Tax depreciation
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Factors to Consider in Asset Depreciation

• What is the depreciable life of the asset?
• What is assets value at the end of its useful
  life?
• What is the cost of the asset?
• What method of depreciation do we choose?

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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.

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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) 62,500
Freight 725
Installation labor 2,150
Site preparation 3,500
Cost of Machine (Cost basis) to use in depreciation calculation 68,875
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Asset Depreciation Range ADR (years) Asset Depreciation Range ADR (years) 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
Automobiles, taxis 2.5 3 3.5
Buses 7 9 11
Light trucks 3 4 5
Heavy trucks (concrete ready-mixer) 5 6 7
Railroad cars and locomotives 12 15 18
Tractor units 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
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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

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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

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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

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Example 8.2 Straight-Line Method
Annual Depreciation
10,000
Book Value
D1
Total depreciation at end of life
I 10,000 N 5 Years S 2,000 D (I - S)/N
8,000
D2
6,000
D3
B1
D4
n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200
4 1,600 3,600 5 1,600 2,000
4,000
B2
D5
B3
B4
2,000
B5
0
1 2 3 4
5
n

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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 lt a lt 2(1/N)
Note if ? is chosen to be the upper bound, ?
2(1/N), we call it a 200 DB or double declining
balance method. As N increases, ? decreases.
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Example 8.3 Declining Balance
Method
Annual Depreciation
Book Value
10,000
Total depreciation at end of life
D1
8,000
6,000
D2
B1
4,000
B2
D3
2,000
D4
B3
778
B5
0
B4
1 2 3
4 5
n
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Example 8.4 Declining Balance (DB) Switching to
SL
Asset Invoice Price 9,000 Freight
500 Installation 500 Depreciation
Base 10,000 Salvage Value
0 Depreciation 200 DB Depreciable life 5 years

• SL Dep. Rate 1/5
• a (DDB rate) (200) (SL rate)
• 0.40

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Case 1 S 0
(a) Without switching
(b) With switching to SL
n Depreciation Book Value
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 6,000 3,600 2,160 1,296 778
n Book Depreciation Value
1 2 3 4 5 10,000/5 4,000 6,000 6,000/4 1,500 lt 2,400 3,600 3,600/3 1,200 lt 1,440 2,160 2,160/2 1,080 gt 864 1,080 1,080/1 1,080 gt 518 0
Note Without switching, we have not depreciated
the entire cost of the asset and thus have not
taken full advantage of depreciations 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 assets depreciable life.
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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 gt 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.
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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 total service units
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Example 8.5

• Given I 55,000, S 5,000, Total service
  units 250,000 miles, usage for this year
  30,000 miles
• Solution

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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

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MACRS Property Classifications (IRS Publication
534)
Recovery Period ADR Midpoint Class Applicable Property
3-year Special tools for manufacture of plastic products, fabricated metal products, and motor vehicles.
5-year Automobiles, light trucks, high-tech equipment, equipment used for RD, computerized telephone switching systems
7-year Manufacturing equipment, office furniture, fixtures
10-year Vessels, barges, tugs, railroad cars
15-year Waste-water plants, telephone- distribution plants, or similar utility property.
20-year Municipal sewers, electrical power plant.
27.5-year Residential rental property
39-year Nonresidential real property including elevators and escalators
ADR Asset Depreciation Range
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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.
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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 2000
11.52 1152 Full
32 3200 Full
19.20 1920 Full
11.52 1152 Full
5.76 576
1 2 3 4 5 6
Half-year Convention
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Taxable Income and Income Taxes
Item
Gross Income Expenses Cost of goods sold
(revenues) Depreciation Operating
expenses Taxable income Income taxes Net income
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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) 8,000
Net income 12,000
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Capital Expenditure versus Depreciation Expenses
(7-year MACRS property)
1
2
3
4
5
6
7
8
0
Capital expenditure (actual cash flow)
28,000
0
8 (5.76)
7 (8.93)
6 (8.92)
7 (8.93)
3 (17.49)
4 (12.49)
1(14.29)
2 (24.49)
1,250
2,500
2,500
3,500
2,500
4,000
4,900
6,850
Allowed depreciation expenses (not cash flow)
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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 -6,000
Taxable income 20,000
Taxes (40) 8,000 -8,000
Net income 12,000
Net cash flow 16,000
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Net income versus net cash flow
Net cash flows Net income non-cash expense
(depreciation)
50,000
Net income
12,000
Net cash flow
40,000
4,000
Depreciation
Income taxes
8,000
30,000
Gross revenue
6,000
Operating expenses
20,000
10,000
20,000
Cost of goods sold
0
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U.S. Corporate Tax Rate (2005)Marginal tax rate
is defined as the rate applied to the last
dollar of income.
Taxable income 0-50,000 50,001-75,000 75,001-
100,000 100,001-335,000 335,001-10,000,000 10
,000,001-15,000,000 15,000,001-18,333,333 18,3
33,334 and Up
Tax rate 15 25 34 39 34 35 38 35
Tax computation 0 0.15(D) 7,500 0.25
(D) 13,750 0.34(D) 22,250 0.39 (D) 113,900
0.34 (D) 3,400,000 0.35 (D) 5,150,000
0.38 (D) 6,416,666 0.35 (D)
(D) denotes the taxable income in excess of the
lower bound of each tax bracket
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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
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Example 8.10 - Corporate Income Taxes
Facts Capital expenditure 290,000 (allowed
depreciation) 58,000 Gross Sales revenue
1,250,000 Expenses Cost of
goods sold 840,000 Depreciation
58,000 Leasing warehouse 20,000 Question
Taxable income?
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• 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 _at_ 15 7,500
• 25,000 _at_ 25 6,250
• 25,000 _at_ 34 8,500
• 232,000 _at_ 39 90,480
• Total taxes 112,730

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• 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

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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.

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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
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Capital Gains and Ordinary Gains
Capital gains
Total gains
Ordinary gains or depreciation recapture
Book value
Salvage value
Cost basis
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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
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
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Disposal of a MACRS Property and Its Effect on
Depreciation Allowances
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Calculation of Gains or Losses on MACRS Property