(c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation

(c) 2001 Contemporary Engineering Economics

1

Chapter 10Depreciation

• Asset Depreciation• Factors Inherent to

Asset Depreciation• Book Depreciation• Tax Depreciation• Depletion• Repairs or

Improvements to Depreciable Assets


2

Depreciation• Definition: Loss of value for a fixed asset• Example: You purchased a car worth $15,000 at the beginning of year 2000.

Dep

reciation

End of Year

Market

Value

Loss of

Value

0

1

2

3

4

5

$15,00010,0008,0006,0005,0004,000

$5,0002,0002,0001,0001,000p


3

Why Do We Need to Consider Depreciation?

Gross Income -Expenses:(Cost of goods sold)(Depreciation)(operating expenses)

Taxable Income

- Income taxes

Net income (profit)

Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income.


4

Depreciation Concept

• Economic Depreciation

Purchase Price – Market Value(Economic loss due to both physical deterioration and technological obsolescence)

• Accounting DepreciationA systematic allocation of cost basis over a period of time.


5

Asset Depreciation

Depreciation

Economic depreciationthe gradual decrease inutility in an asset with

use and time

Accounting depreciationThe systematic allocation

of an asset’s value inportions over its

depreciable life—oftenused in engineeringeconomic analysis

Physicaldepreciation

Functionaldepreciation

Book depreciation

Taxdepreciation


6

Factors to Consider in Asset Depreciation

• Depreciable life (how long?)

• Salvage value (disposal value)

• Cost basis (depreciation basis)

• Method of depreciation (how?)


7

What Can Be Depreciated?

• Assets used in business or held for production of income

• Assets having a definite 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. Can you depreciate land?


8

Cost Basis

Cost of new hole-punching machine (Invoice price) $62,500

+ Freight 725

+ Installation labor 2,150

+ Site preparation 3,500

Cost basis to use in depreciation calculation

$68,875


9

Cost Basis with Trade-In Allowance

Old hole-punching machine (book value) $4,000

Less: Trade-in allowance 5,000

Unrecognized gains $1,000

Cost of new hole-punching machine $62,500

Less: Unrecognized gains (1,000)

Freight 725

Installation labor 2,150

Site preparation 3,500

Cost of machine (cost basis) $67,875


10

Asset Depreciation Range (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 nonelectrical 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


11

Types of Depreciation

• Book Depreciation– In reporting net income to investors/stockholders– In pricing decision

• Tax Depreciation– In calculating income taxes for the IRS– In engineering economics, we use depreciation in

the context of tax depreciation


12

Book Depreciation Methods

• Purpose: Used to report net income to stockholders/investors

• Types of Depreciation Methods:– Straight-Line Method– Declining Balance Method– Sum of the Years’ Digits Method– Unit Production Method


13

Straight – Line (SL) Method

• Principle A fixed asset as providing its service in a uniform fashion over its 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 valueN = depreciable life


14

Example 10.3 – Straight-Line Method

n Dn Bn1 1,600 8,4002 1,600 6,8003 1,600 5,2004 1,600 3,6005 1,600 2,000

I = $10,000N = 5 YearsS = $2,000D = (I - S)/N

D1

D2

D3

D4

D5

B1

B2

B3

B4B5

$10,000

$8,000

$6,000

$4,000

$2,000

00 1 2 3 4 5

Total depreciation at end of

life

n

Annual Depreciation

Book Value


15

Declining Balance Method• Principle: A fixed asset as providing its service in a decreasing fashion• Formula

• Annual Depreciation

• Book Value

1 nn BD 1)1( n

nB )1( where 0 << 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.


16

Example 10.4 – Declining Balance Method

n012345

Dn

$4,0002,4001,440

864518

Bn$10,000

6,0003,6002,1601,296

778

I

N

S

D B

I

B I

n n

n

nn

= $10,

= years

= $778

=

= ( -

000

5

1

1

1

1

( )

D1

D2

D3

D4D5

B1

B2

B3

B4 B50 0 1 2 3 4 5


life

n

$10,000

$8,000

$6,000

$4,000

$2,000

Annual Depreciation

Book Value


17

Example 10.5 DB Switching to SL

• SL Dep. Rate = 1/5• (DDB rate) = (200%) (SL rate)

= 0.40

Asset: Invoice Price $9,000Freight 500Installation 500

Depreciation Base $10,000Salvage Value 0Depreciation 200% DBDepreciable life 5 years


18

n Depreciation

Book

Value

12345

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

$6,0003,6002,1601,296

778

n

Book

Depreciation Value

12345

4,000 $6,0006,000/4 = 1,500 < 2,400 3,6003,600/3 = 1,200 < 1,440 2,1602,160/2 = 1,080 > 864 1,0801,080/1 = 1,080 > 518 0

(a) Without switching (b) With switching to SL

Note: Without switching, we have not depreciated the entirecost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits.

Case 1: S = 0


19

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

5 0 2,000 – 0 = 2,000

Note: Tax law does not permit us to depreciate assets belowtheir salvage values.


20

Sum-of-Years’ Digits (SOYD) Method

• PrincipleDepreciation concept similar to DB but with decreasing depreciation rate.

Charges a larger fraction of the cost as an expense of the early years than of the later years.


•Book ValueSOYDnNSIDn /)1)((

n

j jn DIB1

where SOYD=N(N+1)/2


21

Example 10.7 – Sum-of-years’ digits method

D1

D2

D3

D4

D5

B1

B2

B3

B4 B5

$10,000

$8,000

$6,000

$4,000

$2,000

00 1 2 3 4 5


life

Annual Depreciation

Book Value

I = $10,000N = 5 yearsS = $2,000SOYD = 15

n12345

Dn(5/15)(8,000)=$2,667(4/15)(8,000)=$2,133(3/15)(8,000)=$1,600(2/15)(8,000)=$1,067(1/15)(8,000)=$533

Bn$7,3335,2003,6002,5332,000

n


22

Units-of-Production Method

• PrincipleService units will be consumed in a non

time-phased fashion


Dn = Service units consumed for yeartotal service units

(I - S)


23

Tax Depreciation• Purpose: Used to compute income taxes for the IRS

•Assets placed in service prior to 1981

Use book depreciation methods (SL, BD, SOYD)

•Assets placed in service from 1981 to 1986

Use ACRS Table

•Assets placed in service after 1986

Use MACRS Table


24

Modified Accelerated Cost Recovery Systems (MACRS)

• Personal Property• Depreciation method based on DB method

switching to SL• Half-year convention• Zero salvage value

• Real Property• SL Method• Mid-month convention• Zero salvage value


25

MACRS Property ClassificationsRecovery Period ADR Midpoint Class Applicable Property

3-year Special tools for manufacture of plastic products, fabricated metal products, and motor

vehicles. (ADR =Asset Depreciation Range)

5-year Automobiles, light trucks, high-tech equipment, equipment used for R&D, 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 4

4 10 ADR

10 16 ADR

16 20 ADR

20 25 ADR

25 ADR


26

MACRS Table


27

MACRS Rate CalculationExample 10.9

Asset cost = $10,000Property class = 5-yearDB method = Half-year convention, zero salvage value, 200% DB switching to SL

20%

$2000

32%

$3200

Full

19.20%

$1920

Full

11.52%

$1152

Full

11.52%

$1152

Full

5.76%

$576

1 2 3 4 5 6

Half-year Convention


28

Year (n)

12

3

4

56

Calculation in %

(0.5)(0.40)(100%) 20%(0.4)(100%-20%) 32%

SL = (1/4.5)(80%) 17.78%

(0.4)(100%-52%) 19.20%

SL = (1/3.5)(48%) 13.71%

(0.4)(100%-71.20%) Switch to SL 11.52%SL = (1/2.5)(29.80%) 11.52%

SL = (1/1.5)(17.28%) 11.52%SL = (0.5)(11.52%) 5.76%

MACRS (%)

DDBDDB

DDB

SL

SL


29

Conventional DB Switching to SL

MACRS with half-year convention

2,000 3,200 1,920 1,152 1,152 576

4,000 2,400 1,440 1,080 1,080


30

MACRS for Real Property

• 27.5-year (Residential)• 39-year (Commercial)

• SL Method• Zero salvage value• Mid-month convention

•Example: placed an asset (residential property) in March

D1 = (9.5/12)(100%/27.5) = 2.879%


31

Percentage Depletion vs. Cost Depletion

Gross income from sale of 45,000 ounces

$16,425,000

Depletion percentage

Computed percentage depletion

$2,463,750

15%

Gross income from sale of 45,000 ounces

$16,425,000

Less mining expenses 12,250,000

Taxable income from mine 4,175,000

Deduction limitation

Maximum depletion deduction $2,088,000

50%

Cost depletion= ($30,000,000/300,000)(45,000)= $4,500,000

Allowable deduction= $2,088,000

Select cost depletionwith $4,500,000

Percentage Depletion

(Example 10.12)


32

Calculating the Allowable Depletion Deduction


33

Percentage Depletion Allowances for Mineral Properties

Deposits Percentage

Oil and gas wells (only for certain domestic and gas production) 15

Sulfur and uranium, and, if from deposits in the United States, asbestos, lead, zinc, nickel, mica, and certain other ores and minerals

22

Gold, silver, copper, iron ore, and oil shale, if from deposits in the United States

15

Coal, lignite, and sodium chloride 10

Clay and shale to be used in making sewer pipe or bricks 7.5

Clay (used for roofing tile), gravel, sand, and stone 5

Most other minerals; includes carbon dioxide produced from a well and metallic ores.

14


34

Repairs and Improvements

Principle: Any repairsor improvements extendsthe life of the asset, thedepreciation amount alsoneeds to be adjusted.Book Depreciation: Changethe current book value andspread the value over the extended life.Tax Depreciation: Treat therepairs or improvements asseparate MACRS properties.


35

Summary

• The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service.

• The cost charged to operations during a particular year is called depreciation.

• From an engineering economics point of view, our primary concern is with accounting depreciation; The systematic allocation of an asset’s value over its depreciable life.


36

• Accounting depreciation can be broken into two categories:1. Book depreciation—the method of depreciation used for financial reports and pricing products;2. Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation.

• The four components of information required to calculate depreciation are:1. The cost basis of the asset,2. The salvage value of the asset,3. The depreciable life of the asset, and4. The method of its depreciation.


37

•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.

•Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation.


38

• Depletion is a cost allocation method used particularly for natural resources. Cost depletion is based on the units-of-production method of depreciation. Percentage depletion is based on a prescribed percentage of the gross income of a property during a tax year.

• 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.


39

Component of

Depreciation

Book Depreciation Tax depreciation (MACRS)

Cost basis Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc.

Same as for book depreciation

Salvage value

Estimated at the outset of depreciation analysis. If the final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations.

Salvage value is zero for all depreciable assets


40

Component of

Depreciation

Book Depreciation Tax depreciation (MACRS)

Depreciable life

Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs)

Eight recovery periods– 3,5,7,10,15,20,27.5,or 39 years– have been established; all depreciable assets fall into one of these eight categories.

Method of depreciation

Firms may select from the following:

•Straight-line

•Accelerated methods (declining balance, double declining balance, and sum-of- years’ digits)

•Units-of-proportion

Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straight-line methods. The SOYD method is rarely used in the U.S. except for some cost analysis in engineering valuation.

(c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation

depreciation definition

depreciation calculation

time accounting depreciation

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(c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation

Text of (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors...