1. DEPRECIATION AND INCOME TAXES
CHAPTER 7
DEPRECIATION AND INCOME TAXES

2. DEPRECIATION
Decrease in value of physical properties with passage of time and use
Accounting concept establishing annual deduction against before-tax income
- to reflect effect of time and use on asset’s value in firm’s financial statements
- to match yearly fraction of value used by asset in production of income over asset’s economic life

3. PROPERTY IS DEPRECIABLE IF IT MUST :
be used in business or held to produce income
have a determinable useful life which is longer than one year
wear out, decay, get used up, become obsolete, or lose value from natural causes
not be inventory, stock in trade, or investment property

4. DEPRECIABLE PROPERTY TANGIBLE - can be seen or touched
personal property - includes assets such as machinery, vehicles, equipment, furniture, etc...
real property - anything erected on, growing on, or attached to land
(Since land does not have a determinable life itself, it is not depreciable)
INTANGIBLE - personal property, such as copyright, patent or franchise

5. WHEN DEPRECIATION STARTS AND STOPS
Depreciation starts when property is placed in service for use in business or for production of income
Property is considered in service when ready and available for specific use, even if not actually used yet
Depreciation stops when cost of placing it in service is removed or it is retired from service

6. DEPRECIATION METHODS Time Implemented Method
Before (SL) Straight-Line
(DB) Declining Balance
(SYD) Sum-of-the-years-digits
> 1980 > (ACRS) Accelerated Cost Recovery System Implemented by (ERTA) Economic RecoveryTax Act of
> (MACRS) Modified Accelerated Cost Recovery System Brought about by (TRA 86) TaxReform Act of 1986

7. DEPRECIATION CONCEPTS
Adjusted cost basis -- allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation and depletion deductions
Basis, or cost basis -- also called unadjusted cost -- initial cost of acquiring an asset, plus sales tax, transportation, and normal costs of making asset serviceable

8. DEPRECIATION CONCEPTS
Book Value (BV) -- Worth of depreciable property as shown on accounting records
-- Original cost basis of property, including adjustments, less allowable depletion or depreciation deductions
-- Represents amount of capital remaining invested in property and must be recovered in future through accounting
(Book Value)k=
adjusted cost basis - Skj=1 (depreciation deduction)j

9. DEPRECIATION CONCEPTS
Market Value (MV) -- Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact
-- apporximates present value of what will be received through ownership of property, including time-value of money (or profit)

10. DEPRECIATION CONCEPTS
Recovery Period -- Number of years over which basis of property is recovered through accounting process.
-- Normally the useful life for classical methods
-- Property class for General Depreciation System (GDS) under MACRS
-- Class Life for Alternative Depreciation System (ADS)
Recovery Rate -- Percentage for each year of MACRS recovery period used to calculate an annual depreciation deduction.

11. DEPRECIATION CONCEPTS
Salvage Value (SV) -- Estimated value of property at the end of useful life.
-- expected selling price of property when asset can no longer be used productively
-- net salvage value used when expenses incurred in disposing of property; cash outflows must be deducted from cash inflows for final net salvage value
-- with classical methods of depreciation, estimated salvage value is established and used
-- with MACRS, the salvage value of depreciable property is defined to be zero

12. DEPRECIATION CONCEPTS
Useful Life -- Expected (estimated) period of time property will be used in trade or business or to produce income; sometimes referred to as depreciable life.

13. DEPRECIATION CONCEPTS
The following terms are used in the classical (historical) depreciation method equations:
N = depreciable life of the asset in years
B = cost basis, including allowable adjustments
d k = annual depreciation deduction in year k (1< k <N)
d k* = cummulative depreciation through year k
BV k = book value at the end of year k
BV N = book value at the end of the depreciable (useful) life
SV N = salvage value at the end of year N
R = the ratio of depreciation in any one year to the BV at the beginning of the year

14. STRAIGHT-LINE (SL) METHOD
Simplest depreciation method
Assumes constant amount is depreciated each year over depreciable (useful) life
d k = ( B - SVN ) / N
d k* = kdk for 1 < k < N
BVk = B - d k*
This method requires an estimate of the final SV ( also the final book value at the end of year N )

15. DECLINING BALANCE (DB) METHOD
Sometimes called constant percentage method or Matheson formula
Assumed annual cost of depreciation is fixed percentage of BV at beginning of year
R is constant R = 2 / N when 200% declining balance used R = 1.5 / N when 150% declining balance used
d 1 = B ( R )
d k = B ( 1 - R ) k - 1 ( R )
d k* = B [ 1 - (1 - R ) k ]
BV k = B ( 1 - R ) k
BV N = B ( 1 - R ) N
Because declining balance method never reaches BV = 0, it’s permissible to switch from this to straight-line method so asset’s SVN will be zero or other desired value

16. UNITS-OF-PRODUCTION METHOD
Not based on the idea that decrease in value of property is a function of time
Decrease in value is mostly a function of use
Method results in cost basis (minus final SV) being allocated equally over the estimated number of units produced during useful life of asset.
Depreciation per unit of production = ( B - SVN ) / ( Estimated lifetime production in units )

17. ACCELERATED COST RECOVERY SYSTEM (ACRS)
Recognizes an asset as belonging to one of four (tangible) property classes
IRS prescribes the specific series of depreciation per property class
Rates are based on 150% Declining Balance depreciation, switching to Straight-Line

18. MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)
The principal method for computing depreciation deductions for property in engineering projects.
Applies to most tangible depreciable property placed in service after December 31, 1986
SVN is defined to be 0 ; useful life estimates are not used directly in calculating depreciation amounts
Consists of two systems for computing depreciation deductions:
1. The General Depreciation System (GDS)
2. The Alternative Depreciation System (ADS) Provides longer recovery period and uses only straight-line method of depreciation
Assets depreciated under ADS include property placed in any tax-exempt use and property used predominantly outside the U.S.

19. INFORMATION NEEDED TO CALCULATE MACRS DEPRECIATION
1. The cost basis
2. The date the property was placed in service
3. The property class and recovery period
4. The MACRS depreciation used (GDS or ADS)
5. The time convention that applies (half year)

20. GENERAL DEPRECIATION SYSTEM (GDS) BASIC INFORMATION
1. Tangible depreciable property assigned to one of six personal property classes (3, 5, 7, 10, 15 and 20-year) - Corresponds to GDS recovery period; personal depreciable property not corresponding to these periods is considered 7-yr property class.
2. Real property assigned to two real property classes -- nonresidential real property and residential rental property.
3. GDS recovery period is 39 years for nonresidential real property (31.5 years if in service before May 13, 1993) and 27.5 years for residential rental property.

21. ALTERNATIVE DEPRECIATION SYSTEM (ADS) BASIC INFORMATION
1. ADS recovery period for tangible personal property is normally the same as the class life of the property, with some exceptions ( i.e., asset class and )
2. Any tangible personal property that does not fit into one of the asset classes is depreciated using a 12-year ADS recovery period
3. ADS recovery period for nonresidential real property is 40 years

22. CALCULATING DEPRECIATION DEDUCTIONS UNDER MACRS
Depreciation Personal Approach Method Property Class
GDS , 5-, % DB method year with switch to SL when deduction greater
GDS & % DB method year with switch to SL when deduction greater
GDS residential SL over fixed GDS recovery & real rental periods
ADS personal & SL method over fixed ADS real recovery periods

23. HALF-YEAR TIME CONVENTIONS FOR MACRS DEPRECIATION CALCULATIONS
All assets placed in service during the year are treated as if use began in the middle of the year -- 1/2- year depreciation is allowed
If asset is disposed of before the full recovery period is used, only half of the normal depreciation deduction can be taken for that year

24. MACRS (GDS) PROPERTY CLASSES AND CLASS LIFE
GDS Property Class and Class Life Depreciation Method
3-year, 200% DB with 4 years or less switchover to SL
5-year, 200% DB with More than 4 years switchover to SL to less than 10 years
7-year, 200% DB with 10 years to less than switchover to SL 16
10-year, 200% DB with 16 years to less than switchover to SL 20
15-year, 150% DB with 20 years to less than switchover to SL 25
20-year, 150% DB with 25 years or more switchover to SL
27.5 year, SL N / A
39-year, SL N / A

25. MACRS DEPRECIATION
GDS OR ADS ?

26. Ascertain property class;
MACRS DEPRECIATION
GDS OR ADS ?
GDS
ADS
Ascertain property class;
Same as recovery
period for personal
Ascertain recovery
period

27. Ascertain property class; SL = --------------------------
MACRS DEPRECIATION
GDS OR ADS ?
GDS
ADS
Ascertain property class;
Same as recovery
period for personal
Ascertain recovery
period
Compute depreciation
amount;
Asset’s cost basis
SL =
Recovery period
Obtain recovery rates

28. Ascertain property class; SL = --------------------------
MACRS DEPRECIATION
GDS OR ADS ?
GDS
ADS
Ascertain property class;
Same as recovery
period for personal
Ascertain recovery
period
Compute depreciation
amount;
Asset’s cost basis
SL =
Recovery period
Obtain recovery rates
Compute depreciation
deduction in year k (dk)
by multiplying cost basis
by recovery period.
Compute depreciation
deduction in year k (dk)

29. DEPLETION
Used to indicate the decrease in the value of the resource base when natural resources are being consumed in producing products or services.
Term most commonly used in connection with mining properties, oil and gas wells, timberlands, etc...
Amounts charged as depletion cannot be used to replace sold resources

30. PAYMENTS TO RESOURCE OWNERS
Annual payments to resource owners consist of two parts:
1. Earned profit
2. Portion of owner’s capital returned, marked as depletion

31. TWO WAYS TO COMPUTE DEPLETION ALLOWANCE
1. Cost method
Applies to all types of property and is more widely used method
Depletion unit is determined by dividing adjusted cost basis by the number of units to be mined or harvested
Depletion allowance for tax year is the product of the number of units sold times the depletion unit

32. TWO WAYS TO COMPUTE DEPLETION ALLOWANCE
2. The Percentage Method
Based on percentage of year’s gross income, provided amount charged does not exceed 50% of net income (before deduction of depletion allowance)
Can be used for most types of metal mines, geothermal deposits and coal mines
Can not be used for timber and, in most cases, is not applicable to oil and gas
When percentage method applies, depletion allowance must be calculated by cost and percentage method -- the larger of the two applies

33. TYPES OF TAXES
1. Income taxes - assessed as a function of gross revenues minus allowable deductions
- levied at federal, most state, and some municipal governments
2. Property taxes - assessed as a function of owned property value;
- independent of income or profit of firm
- levied at municipal, county, and / or state level
3. Sales taxes - assessed on purchases of goods and services
- independent of gross income or profits
- relevent to engineering studies as added cost
4. Excise taxes - assessed on sale of certain nonessential goods and services
- independent of business income and profit
- cost ultimately to consumer, despite original target

34. BEFORE-TAX MARR ~
( Before Tax MARR ) [ ( 1- effective income tax rate ) ]   After Tax MARR ~ -

35. BEFORE-TAX MARR ~
( Before Tax MARR ) [ ( 1- effective income tax rate ) ]   After Tax MARR
After-tax MARR
Before-tax MARR
( 1 - effective tax rate ) ~ - ~ ~

36. BEFORE-TAX MARR ~
( Before Tax MARR ) [ ( 1- effective income tax rate ) ]   After Tax MARR
After-tax MARR
Before-tax MARR
( 1 - effective tax rate )
If the asset is nondepreciable and there are no gains or losses on disposal, tax credits, or other types of deductions involved this approximation in the equation above is exact ~ - ~ ~

37. BEFORE-TAX MARR ~
( Before Tax MARR ) [ ( 1- effective income tax rate ) ]   After Tax MARR
After-tax MARR
Before-tax MARR
( 1 - effective tax rate )
If the asset is nondepreciable and there are no gains or losses on disposal, tax credits, or other types of deductions involved this approximation in the equation above is exact
Otherwise, some degree of error is introduced, since the factors cited affect amount and timing of income tax payments ~ - ~ ~

38. CALCULATING TAXABLE INCOME - NET INCOME BEFORE TAXES ( NIBT ) -
Calculate Gross Income
Gross Profits ( revenues from sales - cost of goods sold )
+ income from dividends, interest, rent, royalties, and gains (losses) from sale or exchange of capital assets
Deduct all ordinary and necessary operating expenses to conduct business
Include interest but exclude capital investments
Deduct depreciation
taxable income = gross income - all expenses - depreciation

39. NET INCOME AFTER TAXES (NIAT)
The income after taxes have been deducted from the taxable income or Net Income Before Taxes
Net Income After Taxes = NIBT - income taxes

40. EFFECTIVE (MARGINAL) CORPORATE INCOME TAX RATE
As personal income tax rates are based on income brackets, so, too, is corporate income tax
Depending on the bracket a firm’s income falls within, the marginal federal rate can vary from 15% to a maximum of 39% (for incomes between $100,000 and $335,000)
Incomes above $18,333,333 are taxed at a flat rate of 35%
TRA 86 responsible for lowering maximum rate from 46% to 35%
Also created alternative minimum tax (AMT)

41. GAIN (LOSS) ON DISPOSAL OF A DEPRECIABLE TANGIBLE ASSET
[ GAIN (LOSS) ON DISPOSAL ] N = MVN - BVN
If gain, referred to as depreciation recapture
Tax for gain (loss) is usually the same as ordinary income gain (loss) -- effective income tax rate, t
For capital asset sold or exchanged, gain (loss) referred to as capital gain (loss)
capital assets are stocks, bonds, gold, silver, other metals, and real property

42. BEFORE-TAX ECONOMIC ANALYSIS
NIBT = ( Rk – Ek- dk )
Tk = - t ( Rk – Ek – dk )
Rk = revenues (and savings from the project: cash inflow from project during period ‘k’
Ek = cash outflows during year k for deductible expenses and interest
dk = sum of all noncash, or book costs during year ‘k’, such as depreciation and depletion
t = effective income tax rate on ordinary income (federal, state and other); assumed to remain constant during the study period
Tk= income taxes paid during year ‘k’

43. ECONOMIC VALUE ADDED (EVA)
An economic measure for estimating wealth creation potential of capital investments:
EVA = (Net Operating Profit After Taxes )k – Cost of Capital Used to Produce Profit)k
EVA = NOPATk – i . BVk-1
Where k = index for year in question (1 < k < N)
i = after-tax MARR based on firm’s cost of capital BVk-1= Beginning of year book value
N = the study (analysis) period in years

44. ECONOMIC VALUE ADDED (EVA)
NOPATK = ( 1 –t ) ( Rk – Ek –dk)
EVAk = ( 1 –t ) ( Rk – Ek –dk) – i . BVk-1
When k > 0, ATCFk = ( 1 –t ) ( Rk – Ek –dk) + dk
When k = 0, ATCF0 = BV0
ATCFk = EVAk + i . BVk + dk
dk is the sum of all noncash, or book costs during the year k, such as depreciation or depletion