Chapter 8 Accounting for Depreciation and Income Taxes

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

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

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.

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)

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.

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

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

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

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

Asset Depreciation Ranges (ADRs)

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

Types of Accounting Depreciation and Their Primary Purposes

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

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 1 2 3 4 5 n

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.

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 1 2 3 4 5 n

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

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 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years SL Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40

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) = 864 1,296(0.4) = 518 $6,000 3,600 2,160 1,296 778 n Book Depreciation Value 1 2 3 4 5 4,000 $6,000 6,000/4 = 1,500 < 2,400 3,600 3,600/3 = 1,200 < 1,440 2,160 2,160/2 = 1,080 > 864 1,080 1,080/1 = 1,080 > 518 0 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.

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

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:

Types of Accounting Depreciation and Their Primary Purposes

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

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

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

MACRS Depreciation Schedules for Personal Property with Half-Year Convention

Example 8.6 MACRS Depreciation: Personal Property

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%) 17.78% (0.4)(100%-32%-20%) 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 (%) DDB DDB DDB SL SL

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 1,152 576

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

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.

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%

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

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

Capital Expenditure versus Depreciation Expenses Not Cash Expenses

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.

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

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

Corporate Taxes

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

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 $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

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 $5,150,000 + 0.38 (D) = 5,150,000 + 0.38 (16,000,000-15,000,000) = 5,530,000

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.

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 @ 15% $7,500 $25,000 @ 25% $6,250 $25,000 @ 34% $8,500 $232,000 @ 39% $90,480 Total taxes $112,730

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%

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.

Disposal of a MACRS Property and Its Effect on Depreciation Allowances

+ (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

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.

Determining Ordinary Gains and Capital Gains

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(0.1429 + 0.2449 + 0.1749/2) = $109,308 Book Value = 230,000 -109,308 = $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

Calculation of Gains or Losses on MACRS Property

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.

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.

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.

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.

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

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.

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.

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.

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.