CONSIDERATION OF DEPRECIATION AND INCOME TAXES

DEPRECIATION DEPRECIATION METHODS DEPRECIATION AND INCOME TAXES ECONOMIC VALUE ADDED (EVA)

What is Depreciation? Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner.

Process of cost allocation, not asset valuation.

Which Assets are Depreciated? Plant assets are tangible resources that are used in the operations of a business and are not intended for sale to customers. They are also called property, plant, and equipment; plant and equipment; or fixed assets.

Plant assets are subdivided into four classes: 1. Land such as a building site 2. Land improvements such as driveways, parking lots… 3. Buildings such as stores, offices, factories and warehouses. 4. Equipment such as office furniture, factory machine, delivery equipment…

Depreciation applies to three classes of plant assets: Land improvements, Buildings, Depreciable Equipment Assets Land is not a depreciable asset.

Causes of Depreciation Physical deterioration Functional obsolescence Economic obsolescence

Deterioration Deterioration is the decay and disintegration which takes place in structures with the passage of time. Deterioration operates to terminate the physical life of a building

Physical Deterioration Physical deterioration as a cause of depreciation is the result of wear and tear with usage and deterioration with age among others. wear and tear rust, rot and decay

Obsolescence Obsolescence refers to those changes in usefulness of structures in certain neighborhoods which cause them to become less desirable or less useful. Obsolescence operates to terminate the economic life of a building.

Functional Obsolescence Functional Obsolescence is loss in value of a property resulting from changes in tastes, preferences, technical innovations, or market standards. new technology inadequacy

Economic Obsolescence Economic obsolescence is a loss of value as a result of impairment in utility and desirability caused by factors outside the property’s boundaries. External or Locational obsolescence.

Measuring Depreciation Cost Estimated Useful Life Estimated Salvage Value (residual value or scrap value)

COST Cost will include all expenditures incurred by the business to bring the asset to its required location and to make it ready for use.

COST The acquisition cost of land improvements, buildings, and equipment includes all costs of acquisition and preparation for use Sales tax Transportation Installation Repair cost prior to use

ESTIMATED USEFUL LIFE Estimated useful life is the length of the service period expected from the asset. years, units of output, miles, or another measure.

Changing the Useful Life of a Depreciable Asset Estimating the useful life of each plant asset poses an accounting challenge. Generally accepted accounting principles require the business to report the nature, reason, and effect of the accounting change on net income.

Willamette Industries, Inc. 1998 Due to technologic advances 1999 $89 million, $146million or or $0.80 a share $1,32 a share 65 percent improvement in earnings per share!

ESTIMATED SALVAGE VALUE Estimated salvage value - also called scrap value or residual value - is the expected cash value of an asset at the end of its useful life.

Factors in Measuring Depreciation Cost Useful Life Salvage Value

METHODS & USAGE OF DEPRECIATION There are three types of methods used in depreciation.These are: Straight-Line (SL) Declining-Balance (DB) Units-of-Production (UOP)

METHODS & USAGE OF DEPRECIATION STRAIGHT-LINE METHOD: The simplest and most often used technique, in which the company estimates the salvage value of the asset, after the length of time over which it will be used to generate revenues (useful life), and will recognize a portion of that original cost in equal increments over that amount of time.

METHODS & USAGE OF DEPRECIATION Imagine a truck bought on 01.01.2001 at an amount $41,000 and a usefuful life of 5 years or 100,000 miles can be driven.And also salvage value of the truck is $1,000. Data Item Amount Cost Of Truck...................................................................................................$41000 Less:Salvage Value.........................................................................................($1,000) Depreciable Cost.............................................................................................$40,000 Estimeted Useful Life: Years.........................................................................................................5 Years Units Of Production........................................................................100,000 Miles

METHODS & USAGE OF DEPRECIATION Straight-Line Depreciation: (Cost-Salvage Value)/Useful Life,In Years =($41,000-$1,000)/5= $8,000 per year Depreciation For The Year Date Asset Cost Depreciation Rate Depreciable Cost Depreciation Expense Accumulated Depreciation Book Value 01.01.2001 $41,000 12.31.2001 0.20* x $40,000 $8,000 $33,000 12.31.2002 0.20 x $16,000 $25,000 12.31.2003 $24,000 $17,000 12.31.2004 $32,000 $9,000 12.31.2005 $1,000 *1/5 year=0.20 per year

METHODS & USAGE OF DEPRECIATION DECLINING-BALANCE METHOD:Declaning-balance method also known as reducing-balance method , is a type of accelerated depreciation because it recognizes a higher depreciation cost earlier in an asset's lifetime. Also there’s an accerelated method for declining-balance method that is called double-declining-balance(DDB). In DDB the asset’s decreasing book value is multiplied by a constant percentage that is 2 times bigger than DB.

METHODS & USAGE OF DEPRECIATION Declining-Balance

METHODS & USAGE OF DEPRECIATION

METHODS & USAGE OF DEPRECIATION Let’s have a look at how these depreceiation amounts are calculated: Fistly we compute the depreciation rate per year.A 5-year asset has a straight-line rate of 1/5, or 20% per year.A 10-year asset also has 1/10, or 10% and so on.In double-declining balance method,we multiply the depreciation rate by 2. DDB Rate = [1/(useful life of the asset,in year)] x 2 Then we’re going to find every year’s the depreciation amount: DDB For The 1st Year: $41,000 x 0.40 = $16,400 DDB For The 2nd Year: ($41,000-16,400) x 0.40 = $9,840 DDB For The 3rd Year: ($41,000-$16,400-$9,840) x 0.40 = $5,904 DDB For The 4th Year: ($41,000-$16,400-$9,840-$5,904) x 0.40 = $3,542 DDB For The 5th Year: ($41,000-$16,400-$9,840-$5,904-$3,542) - $1,000 =$4,314 (Final Depreciation Year)

METHODS & USAGE OF DEPRECIATION Double-Declining Balance

Units Of Production Method (UOP) The UOP method determines depreciation expense based on the amount the asset is used. In the UOP, a fixed amount of depreciation goes with unit of output produced by the asset.

Units Of Production Method (UOP) The length of life of an asset is expressed in a form of productive capacity. Units of usage can be expressed in quantitiy of goods produced, hours used, miles driven, for instance

Units Of Production Method (UOP) The depreciation expense of a period is determined by mutliplying usage by a fixed UOP rate of usage.

Units Of Production Method (UOP)

Units Of Production Method (UOP) Our truck has an useful life of 100,000 miles.And assume that this truck is likely to be driven 20,000 miles the first year 30,000 the second,25,000 the third,15,000 the fourth, and 10,000 during the fifth.The amount of UOP depreciation each period varies with the number of units the asset produces.

Units Of Production Method (UOP) UOP Depreciation Per Unit Of Output: (Cost-Residual Value)/Useful Life In Units Of Production= ($41,000-$1,000)/100,000 miles =$0,40 per mile

Comparing Depreciation Methods Straight-Line Method:

Comparing Depreciation Methods Declining Balance Method

Comparing Depreciation Methods Double-Declining Balance Method

Comparing Depreciation Methods Units of Production Method

Comparing Depreciation Methods Many businesses use the straight line method in their financial statements and accelerated methods in their income tax returns. Accelerated methods result in higher depreciation expenses, thus a lower reported income.

Comparing Depreciation Methods Most publicy owned companies want to appear as profitable as possibleas thier competitors. Therefore, majority of these companies straight-line method.

Comparing Depreciation Methods For income tax purposes, finance experts usually want to report the lowest income to pay the lowest tax amount. Accelerated depreciation methods can reduce taxable income and so the tax payments decrease.

Double-Declining Balance YEARS Depreciation Methods Straight-Line Declining-Balance Double-Declining Balance Units-Of-Production Dep. Exp. 1st $8,000 $8,200 $16,400 2nd $6,560 $9,840 $12,000 3rd $5,248 $5,904 $10,000 4th $4,198.4 $3,542 $6,000 5th $15,793.6 $4,314 $4,000

Conclusion Accounting principles and income tax laws both permit companies to use different depreciation methods in their financial statements and their income tax returns. Therefore, many companies use straight-line method in their financial statements and accelerated methods in their income tax returns.

DEPRECIATION AND INCOME TAXES Systemmatic allocation of the cost of a capital asset over a period of time for financial reporting purposes,tax purposes os both. A noncash expense and thus does not affect cash from operations. A tax deductable expense

DEPRECIATION AND INCOME TAXES The higher the depreciation the lower income and the lower tax payment.

Depreciation Methods Straight-Line Method Declining Balance Method (DB) Units-of-Production Method (UOP) Accelerated Cost Recovery Method (ACRS) Modified Accelerated Cost Recovery Method (MACRS)

ACRS Prior to the Accelerated Cost Recovery System (ACRS) most capital purchases were depreciated using a straight line technique, that allowed for the depreciation of the asset over its useful life.ACRS was unique in three ways: property class lives were established, calculations were based on an estimated salvage value of zero, and shorter recovery periods were used to calculate annual depreciation. This resulted in an accelerated write off of capital costs (in comparison to that available using straight line depreciation) and was the source of the name. Depreciation under ACRS = 2 x Straight Line Depreciation

MACRS Used only for income tax purposes Cost of asset ,including any other capitalized expenditures such as shipping and installation. The asset’s depreciable basis is not reduced by the estimated salvage value of the asset.

MACRS GDS Property Classes Table   Property Class Personal Property (all property except real-estate) 3-year property Special handling devices for food and beverage manufacture. Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehicles Property with ADR class life of 4 years or less 5-year property Information Systems; Computers / Peripherals Aircraft (of non-air-transport companies) Computers Petroleum drilling equipment Property with ADR class life of more than 4 years and less than 10 years 7-year property All other property not assigned to another class Office furniture, fixtures, and equipment Property with ADR class life of more than 10 years and less than 16 years 10-year property Assets used in petroleum refining and certain food products Vessels and water transportation equipment Property with ADR class life of 16 years or more and less than 20 years 15-year property Telephone distribution plants Municipal sewage treatment plants Property with ADR class life of 20 years or more and less than 25 years 20-year property Municipal sewers Property with ADR class life of 25 years or more Real Property (real estate) 27.5-year property Residential rental property (does not include hotels and motels) 39-year property Non-residential real property

Class Identified by Asset Life (Years) Depreciation Method 3 DDB 5 10 20 150% DB 27,5 SL 39

Economic Value Added (EVA)

What is Economic Value Added (EVA)? EVA is a value-based financial performance measure reflecting the absolute amount of shareholder value created or destroyed during each year.

What is Economic Value Added (EVA)? (cont.) It is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital.

What is EVA?(cont.) A value-based financial performance measure A useful tool for choosing the most promising financial investments An effective protection against shareholder value destruction A tool suitable to control operations

Stern Stewart & Company Owns a registered trademark for EVA™ The proprietary component of what Stern Stewart & Co. does is the adjustments. The amortization of goodwill or capitalization of brand advertising and other similar adjustments are the translations that occur to Economic Profit to make it EVA.

EVA Basic Premise Managers are obliged to create value for their investors Investors invest money in a company because they expect returns There is a minimum level of profitability expected from investors, called capital charge Capital charge is the average equity return on equity markets; investors can achieve this return easily with diversified, long-term equity market investment

EVA Basic Premise (cont.) Thus creating less return than the capital charge is economically not acceptable (especially from shareholders perspective) Investors can also take their money away from the firm since they have other investment alternatives

EVA Simplified Calculation EVA = OPBT - TAX - (TCE x COC) = NOPAT - (TCE x COC) OPBT: Operating Profit Before Tax TAX: Federal , state, county tax NPAT = Net Operating Profit Before Tax TCE: Total Capital Employed COC: Cost of Capital !!!! positive EVA indicates that this company creates value

EVA Simplified Calculation Example Assume that you have a firm with IA = 100 In each year 1-5, assume that ROCA = 15% DI = 10 (Investments are at beginning of each year) WACCA = 10% ROCNew Projects = 15% WACC = 10% Assume that all of these projects will have infinite lives. After year 5, assume that Investments will grow at 5% a year forever ROC on projects will be equal to the cost of capital (10%)

Firm Value using EVA Approach Capital Invested in Assets in Place = $ 100 EVA from Assets in Place = (0.15 - 0.10) (100) / 0.10 = $ 50 + PV of EVA from New Investments in Year 1 = [(0.15 - 0.10)(10)/0.10] = $ 5 + PV of EVA from New Investments in Year 2 = [(0.15 - 0.10)(10)/0.10]/1.12 = $ 4.55 + PV of EVA from New Investments in Year 3 = [(0.15 - 0.10)(10)/0.10]/1.13 = $ 4.13 + PV of EVA from New Investments in Year 4 = [(0.15 - 0.10)(10)/0.10]/1.14 = $ 3.76 + PV of EVA from New Investments in Year 5 = [(0.15 - 0.10)(10)/0.10]/1.15 = $ 3.42 Value of Firm = $ 170.86

EVA Implementation Stern Stewart & Co., the trademark owner of EVA, supports approximately 250 large companies around the world. EVA implementation results are highly correlated with stock prices. This measure can be maximized. Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital. EVA is an estimator for company’s true economic value creation A good basis for management compensation systems to motivate managers to create shareholder value.

EVA in Comparison with Other Economic Measurements Economic Value Added is a tool more useful than rate of return (ROI) in controlling and steering day-to-day operations. EVA has not steering failures like ROI and EPS (maximizing these measures might lead to not optimal outcome; not max. shareholder value). EVA is a concept practically the same as Economic Profit (EP), Residual Income (RI) and Economic Value Management (EVM)

Why is EVA also useful for small companies (even with less than 100 employees) ? Traditional performance measures used by small companies are unable to describe the company´s true business results EVA calculation is simple The EVA concept is easy to understand and use EVA helps to understand the concept of profitability even by persons not familiar with finance and accounting Managers can make the EVA concept transparent to all employees in a short time

Why is EVA also useful for small companies?(cont.) EVA reflects company’s performance in dollars Positive EVA indicates value creation Negative EVA indicates value destruction Series of negative EVA is a signal that restructuring in a company may be needed

Why is EVA also useful for small companies?(cont.) EVA helps to convert a small company’s strategy into objectives tangible for all employees EVA is a useful tool for allocation of a small company’s scarce capital resources The EVA concept integrated in decisions making process improves its business performance because managers having deeper knowledge about capital and capital cost

What is Needed to Calculate Company’s Economic Value Added (EVA)? Only following the information is needed for a calculation of a company’s EVA: Company’s Income Statement Company’s Balance Sheet

EVA Implementation by a Small Company EVA calculation is just a starting point Permanent EVA improvement has to be the main management objective EVA has to be calculated periodically (at least every three months) Changes in EVA have to be analyzed EVA development is the basis for a company’s financial and business policy

How can the Management in a Small Company Improve EVA? Try to improve returns with no or with only minimal capital investments Invest new capital only in projects, equipment, machines able to cover capital cost while avoiding investments with low returns Identify where capital employment can be reduced Identify where the returns are below the capital cost; divest those investments when improvements in returns are not feasible

EVA Deficiency To transform traditional income statements into EVA ones, up to 164 adjustments need to be made Recommends inexpensive debts in order to reduce Cost of Capital (COC); a very questionable strategy for small businesses A passive accounting tool: measures past performance Because the business environment for small companies changes extremely quickly, a frequently financial evaluation is essential

Conclusion appropriate management tool for small business easy-to-calculate periodical EVA calculation and analysis can be done with minimal effort starting point for improvement in financial and business policy scarce capital resources of a small company can be more efficiently allocated result in a better business performance, because of better understanding the objectives

Conclusion (cont.) Since EVA helps the organization to realize that capital is a costly resource the most immediate effect of EVA implementation is in most cases dramatic improvement in capital efficiency (improved capital turnover) Compared to conventional measures, EVA is an epochal measure since it can be maximized: it is the better the bigger EVA is.

Conclusion (cont.) EVA helps enormously the management and employees to see what should be real objective of the company, since it makes clear to all what profitability really is