Text of Chapter 8 Depreciation and Income Taxes Asset Depreciation Book Depreciation Tax Depreciation How...
Chapter 8 Depreciation and Income
Taxes Asset Depreciation
How to Determine “Accounting Profit”
DepreciationDefinition: Loss of value for a fixed asset
Example: You purchased a car worth $15,000 at the beginning of year 2000.
End of Year
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 DepreciationSystematic allocation of the initial cost of an
asset in parts over time or decline in value over time
known as its depreciable life.
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
Factors to Consider in Asset Depreciation
What is the depreciable life of the asset?
What is asset’s value at the end of its useful life?
What is the cost of the asset?
What method of depreciation do we choose?
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.
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
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
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) MethodPrinciple 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 ValueBn = I – n (D)
where I = cost basisS = Salvage valueN = depreciable life
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 1: S = 0
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.
PrincipleThe number of service units will be consumed in that period.
Service units consumed for year
total service units
(I - S)
Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles
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 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 R&D, computerized telephone switching systems