1 DepreciationDepreciation Our purpose in studying depreciation is to understand its impact on taxes so that this impact can be included in our economic analysis. What are the tax effects on the cash flow diagram?

2 DepreciationDepreciation The cost of fixed assets must be recorded as expenses on a firm’s balance sheet and income statement. Unlike costs such as labor, maintenance, and material, the costs of fixed assets are not treated simply as expenses to be accounted for in the year that they are acquired. Instead, they are capitalized. Their costs are distributed by subtracting them as expenses from gross income – one part at a time over a number of periods.

3 DepreciationDepreciation Depreciable Life – the period of time over which the asset is capitalized. Matching Concept – A fraction of the cost of the asset is chargeable as an expense in each of the accounting periods in which the asset provides service to the firm. Depreciation is NOT a real cash flow!

4 Depreciable Assets By U.S. tax law, depreciable property: 1. Must be used in business or held for production of income. 2. Must have a definite service life, and that life must be longer than 1 year. 3. Must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes. You can NEVER depreciate land!

5 Cost Basis Cost Basis – the total cost claimed as an expense over an asset’s life. Includes: Actual Cost Some incidental expenses:  Freight  Site Preparation  Installation These are the costs req’d to put the asset into service!

6 Cost Basis Used in figuring depreciation deductions. Used in calculating the gain or loss to the firm if the asset is sold or salvaged.

7 Cost Basis If the asset is purchased by trading in a similar asset, the difference between the book value and trade in allowance must be considered in determining the cost basis of the new asset. If the trade-in allowance exceeds the book value, the difference (unrecognized gain) needs to be subtracted from the cost basis of the new asset. If the book value exceeds the trade-in allowance, the difference (unrecognized loss) needs to be added to the cost basis of the new asset.

8 Depreciation Methods We will cover five methods: Straight Line Declining Balance Sum of Years Digits Units of Production MACRS – Modified Accelerated Cost Recovery System

9 NotationNotation I = Cost Basis; Initial Price plus installation expenses. S = Salvage Value D n = Depreciation in Year n B n = Book Value in Year n N = estimated years of useful life n = the year currently under consideration

10 Computer PBX Example Initial Cost = $8,000 Installation = $2,000 Salvage = $1,000 Useful Life = 4 years MACRS Property Class = 5 years

11 Straight Line Method D n = ( I – S ) N B n = I – D n (n) Where: I = Cost Basis; Initial Price plus installation expenses. S = Salvage Value D n = Depreciation in Year n B n = Book Value remaining in Year n N = estimated years of useful life n = the year currently under consideration

12 Declining Balance Method  = (Multiplier) = % reduction each year D n =  I (1–  ) n–1 B n = I (1–  ) n Typical multipliers are 150% and 200%. 200% is also called Double Declining Balance (DDB). 1N1N

13 Sum of Years Digits Method SOYD = … + N = N(N+1) 2 D n = ( N – n + 1 ) ( I – S ) SOYD B n = B n–1 – D n

14 Units of Production Method D n = Service Units Consumed During Year n ( I – S ) Total Service Units n B n = I –  Service Units Consumed During Year n ( I – S ) Total Service Units

15 MACRSMACRS Prior to 1981, taxpayers could choose among several methods when depreciating assets for tax purposes. With the Economic Recovery Act of 1981, ACRS was required and MACRS was instituted in MACRS is a simpler, more rapid depreciation method.

16 MACRS Property Classes Recovery Period (years) ADR Class MidpointApplicable Property 3ADR ≤ 4 Special tools for plastic / fabricated metal parts mfg; motor vehicles 54 < ADR ≤ 10 Autos, light trucks, high-tech / R&D equip., computerized phone switches 710 < ADR ≤ 16Mfg equip., office furniture, fixtures 1016 < ADR ≤ 20Vessels, barges, tugs, railroad cars 1520 < ADR ≤ 25 Waste-water plants, telephone distribution plants, other utilities 2025 ≤ ADRMunicipal sewers, electric power plants 27.5Residential rental property 39Non-residential real property, elevators

17 MACRS Depreciation Schedule Class: Year200% DB 150% DB * * * *5.90* * MACRS switches to straight line depreciation. Table values shown are percentages.

18 MACRSMACRS D n = ( Year n MACRS Class Table Value )( I ) n B n = ( I ) [ 1 – (  Year n MACRS Class Table Values ) ] j=1 NOTE: If selling an asset BEFORE the final year of depreciation: Selling year depreciation is ½ D n value lower, and … Selling year book value is ½ D n value higher!