1. Chapter 8 Accounting for Depreciation and Income Taxes

2. Chapter 8 Accounting for Depreciation and Income Taxes
Asset Depreciation
Book Depreciation
Tax Depreciation
How to Determine “Accounting Profit”
Corporate Taxes

3. 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 1 2 3 4 5
$15,000
10,000
8,000
6,000
5,000
4,000
$5,000
2,000
1,000

4. Accounting (Asset) Depreciation
The costs of assets are capitalized, i.e. their costs are distributed by subtracting them as expenses from gross income-one part at a time over a number of periods.

5. Why Do We Consider Depreciation?
Business Expense: Depreciation is viewed as a part of business expenses that reduce taxable income.
Gross Income -Expenses:
(Cost of goods sold)
(Depreciation)
(Operating expenses)
Taxable Income
- Income taxes
Net income (profit)

6. Depreciation Concept Economic Depreciation
Purchase Price – Market Value
(Economic losses due to both physical deterioration and technological obsolescence)
Accounting Depreciation (Asset Depreciation)
A systematic allocation of the cost basis over a period of time.

7. 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 asset’s value in
portions over its
depreciable life—often
used in engineering
economic analysis
Tax
depreciation

8. Factors to Consider in Asset Depreciation
Depreciable life (how long?)
Salvage value (disposal value)
Cost basis (depreciation basis)
Method of depreciation (how?)

9. 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.
Examples:
Depreciable property: buildings, machinery, equipment, vehicles
Non-depreciable property: inventories, land

10. Cost Basis
Cost basis of an asset represents the total cost that is claimed as an expense.
Cost basis generally includes the actual cost of an asset and all incidental expenses such as freight, site preparation and installation.
Cost of a 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

11. Asset Depreciation Ranges (ADRs)

12. Types of Depreciation Book Depreciation Tax Depreciation
In reporting net income to investors/stockholders
In pricing decision
Tax Depreciation
In calculating income taxes
In engineering economics, we use depreciation in the context of tax depreciation

13. Types of Accounting Depreciation and Their Primary Purposes

14. 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 = 1,…, N.
Book Value
Bn = I – n (D)
where
I = cost basis
S = Salvage value
N = depreciable life

15. 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
$4,000
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 B2 B3 D5 B4
$2,000 B5 n

16. Declining Balance Method (most widely used)
Principle:
A fixed asset as providing its service in a
decreasing fashion ( e.g. Assumes efficiency of the asset declines with age)
Formula
The fraction
Book Value
Annual Depreciation
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. This means that the depreciation rate will be 200% of the Straight-Line rate.

17. 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 n 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 D3 B2
$2,000 D4 D5 B3
$778 B4 B5 n

18. S = $2,000 Note: Tax law does not permit us to depreciate assets below
their salvage values .
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
2,000 – 0 = 2,000

19. Example 8.4 DB Switching to SL
We try to reduce an asset’s book value to its salvage value as quickly as possible. So, at any year, when SL leads to a greater depreciation than DB, switching to SL results in a more rapid reduction in book value. This can take place at any year.
Asset: Invoice Price $9,000
Freight
Installation
Depreciation Base $10,000
Salvage Value
Depreciation 200% DB
Depreciable life 5 years
SL Rate = 1/5
a (DDB rate) = (200%) (SL rate)
= 0.40

20. S = 0 (a) Without switching (b) With switching to SL
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) =
1,296(0.4) =
$6,000
3,600
2,160
1,296
778 n
Book
Depreciation Value 1 2 3 4 5
4, $6,000
6,000/4 = 1,500 < 2, ,600
3,600/3 = 1,200 < 1, ,160
2,160/2 = 1,080 > ,080
1,080/1 = 1,080 >
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.

21. Units-of-Production Method
Principle
Service units will be consumed in a non time-phased fashion
Formula
Annual Depreciation

22. Example 8.5
Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles
Solution: Depreciation expense for this year:

23. Types of Accounting Depreciation and Their Primary Purposes

24. Tax Depreciation
Purpose: Used to compute income taxes for the IRS (Internal Revenue Service)
Assets placed in service prior to 1981
Use book depreciation methods (SL, DB, Sum of Years Digits Method)
Assets placed in service from 1981 to 1986
Use ACRS (Accelerated Cost Recovery System) Table
Assets placed in service after 1986
Use MACRS (Modified ACRS) Table

25. Modified Accelerated Cost Recovery Systems (MACRS)
Personal Property
Depreciation method based on DB method switching to SL
Half-year convention (all assets are placed in service in mid-year)
Zero salvage value
Real Property (residential rental property, commercial building or properties)
SL Method
Mid-month convention

26. MACRS Property Classifications
Recovery Period
Asset Depr. Range Midpoint Class
Applicable Property
Personal 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
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.
Real Property
27.5-year
Residential rental property
39-year
Nonresidential real property including elevators and escalators
ADR: Asset Depreciation Range

27. MACRS Depreciation Schedules for Personal Property with Half-Year Convention

28. Example 8.6 MACRS Depreciation: Personal Property

29. Year (n) 1 2 3 4 5 6
Calculation in %
(0.5)(0.40)(100%) 20%
(0.4)(100%-20%) 32%
SL = (1/4.5)(80%) %
(0.4)(100%-32%-20%) %
SL = (1/3.5)(48%) %
(0.4)(100%-71.20%) Switch to SL 11.52%
SL = (1/2.5)(29.80%) %
SL = (1/1.5)(17.28%) %
SL = (0.5)(11.52%) %
MACRS (%)
DDB
DDB
DDB SL SL

30. Conventional DB Switching to SL
4,000 2,400 1,440 1,080 1,080
MACRS with half-year convention
2,000 3,200 1,920 1,152 1,

31. MACRS for Real Property
Types of Real Property
27.5-year (Residential)
39-year (Commercial)
Underlying assumptions
SL Method
Zero salvage value
Mid-month convention
Example: Placed a residential property in service in March.
Find the depreciation allowance in year 1.
D1 = (9.5/12)(100%/27.5)
= 2.879%
9.5 months
Jan
Dec

32. Depreciation Allowances for a 10-year Ownership of the Property
Year (n)
Calculation
Allowed Depreciation (%) 1
(9.5/12)(100%/27.5)
2.8788% 2
100%/27.5
3.6364% 3 4 5 6 7 8 9 10
(11.5/12)(100%/27.5)
3.4848%
Assume that the property will be sold in December of the10th year.

33. Land cannot be depreciated.
May 1, 2000: Pay $100,000 for a residential rental property ($80,000 for building+$20,000 for land) October 1, 2003: Sell the property for $130,000
Land cannot be depreciated.
Year (n)
Calculation Dn
Recovery percentages 1
(7.5/12)(80,000-0)/27.5
$1,818
2.273% 2
(80,000-0)/27.5
$2,909
3.636% 3 4
(9.5/12)(80,000-0)/27.5
$2,303
2.879%

34. Gross Income (revenues) Expenses Cost of goods sold
How to determine “Accounting Profit” (= Net Income) Taxable Income and Income Taxes
Item
Gross Income (revenues)
Expenses
Cost of goods sold
(labor, material, inventory, supplies)
Depreciation
Interest Expenses
Operating expenses
(renting buildings, insurance coverage)
Taxable income
Income taxes (=tax rate × taxable income)
Net income

35. 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
Taxes (40%)
8,000
Net income
$12,000

36. Capital Expenditure versus Depreciation Expenses
Not Cash Expenses

37. Cash Flow vs. Net Income
Net income: Net income is an accounting means of
measuring a firm’s profitability based
on the matching concept. Costs become
expenses as they are matched against
revenue. The actual timing of cash inflows
and outflows are ignored.
Cash flow: Considering the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So,
cash flows are more relevant data to use in
project evaluation.
Net income important for accounting purposes, cash flow for project evaluation. But once we know net income, we can deduce cash flow.

38. Example 8.9 – Cash Flow versus Net Income
Item
Income
Statement
Cash Flow
Gross income (revenue
$50,000
Expenses
Cost of goods sold
Depreciation
Operating expenses
20,000
4,000
6,000
-20,000
-6,000
Taxable income
Taxes (40%)
8,000
-8,000
Net income
$12,000
Net cash flow
$16,000

39. Net income versus net cash flow
Net cash flows = Net income + non-cash expense (i.e. depreciation)
$50,000
Net income
Net
cash flow
$12,000
$40,000
Depreciation
$4,000
Income taxes
$8,000
$30,000
Gross
revenue
$6,000
Operating expenses
$20,000
$10,000
$20,000
Cost of goods sold $0

40. Corporate Taxes

41. Taxable Income and Income Taxes
Item
Gross Income (revenues)
Expenses
Cost of goods sold
Depreciation
Operating expenses
Taxable income
Income taxes
Net income

42. U.S. Corporate Tax Rate (2005)
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
$18,333,334 and Up
Tax rate
15%
25%
34%
39%
35%
38%
Tax computation
$ (D)
$7, (D)
$13, (D)
$22, (D)
$113, (D)
$3,400, (D)
$5,150, (D)
$6,416, (D)
(D) denotes the taxable income in excess of the lower bound of each tax bracket

43. Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000
Marginal Tax Rate
Amount of Taxes
Cumulative Taxes
First $50,000
15%
$7,500
Next $25,000
25%
6,250
13,750
34%
8,500
22,250
Next $235,000
39%
91,650
113,900
Next $9,665,000
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 OR
$5,150, (D) = 5,150, (16,000,000-15,000,000) = 5,530,000

44. 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
Find taxable income, income taxes, average and marginal
tax rates.

45. 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 15% $7,500
25% $6,250
34% $8,500
39% $90,480
Total taxes $112,730

46. 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%

47. 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.

48. Disposal of a MACRS Property and Its Effect on Depreciation Allowances

49. + (Cost basis – book value)
Depreciation recapture
When a depreciable asset is sold for an amount different from its book value, gain or loss occurs.
Depreciation recapture (the gain) is taxed as ordinary income.
Gains = Salvage value – book value
= (Salvage value - cost basis)
Capital gains
+ (Cost basis – book value)
Ordinary gains

50. Taxable Gains (or Losses)
Case 1: Salvage value < Cost basis:
gains (losses) = salvage value – book value
Case 2: Salvage value > Cost basis:
ordinary gains (depreciation recapture)
gains = salvage value – book value
= (salvage value - cost basis)
+ (cost basis – book value)
ordinary gains
capital gains
Depreciation recapture is taxed as ordinary income.

51. Determining Ordinary Gains and Capital Gains

52. Gains or Losses on Depreciable Asset
Example 8.11: A Drill press: $230,000 (Cost basis)
Sold: at the end of 3 years
MACRS: 7-year property class
Salvage value: $150,000 at the end of Year 3 < 230,000
Assume a gains tax of 34%.
14.29
24.49
17.49
12.49
8.92
Full
Half
Total Dep. = 230,000( /2) = $109,308
Book Value = 230, ,308 = $120,692
Gains = Salvage Value - Book Value = $150,000 - $120,692
= $29,308
Gains Tax (34%) = 0.34 ($29,308) = $9,965
Net Proceeds from sale = $150,000 - $9,965 = $140,035

53. Calculation of Gains or Losses on MACRS Property

54. 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.

55. 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:
(a) cost basis, (b) salvage value, (c) depreciable life , and (4) depreciation method.

56. 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 unchanged regardless of depreciation methods adopted. It only changes the timing of the payment.
Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation.

57. 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.

58. 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

59. 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.

60. Explicit consideration of taxes is a necessary aspect of any complete economic study of an investment project.
Once we understand that depreciation has a significant influence on the income and cash position of a firm, we will be able to appreciate fully the importance of utilizing depreciation as a means to maximize the value both of engineering projects and of the organization as a whole.

61. For corporations, the U. S
For corporations, the U.S. tax system has the following characteristics:
1. Tax rates are progressive: The more you
earn, the more you pay.
2. Tax rates increase in stair-step fashion:
four brackets for corporations and two
additional surtax brackets, giving a total
of six brackets.
3. Allowable exemptions and deductions
may reduce the overall tax assessment.

62. Marginal tax rate is the rate applied to the last dollar of income earned;
Average (effective) tax rate is the ratio of income tax paid to net income; and
Incremental tax rate is the average rate applied to the incremental income generated by a new investment project.
Capital gains are currently taxed as ordinary income, and the maximum rate is capped at 35%.
Capital losses are deducted from capital gains; net remaining losses may be carried backward and forward for consideration in years other than the current tax year.