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

2. 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
Depreciation

3. Depreciation Concept
Depreciation is viewed as a part of business expenses that reduce taxable income.
Economic Depreciation (Purchase Price – Market Value) Economic losses due to both physical deterioration and technological obsolescence)
Accounting Depreciation
Systematic allocation of the initial cost of an asset in parts over time or decline in value over time known as its depreciable life.

4. Asset 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

5. Factors to Consider in Asset Depreciation
What is the depreciable life of the asset?
What is asset’s value at the end of its useful life?
What is the cost of the asset?
What method of depreciation do we choose?

6. What Can Be Depreciated?
Assets used in business or held for production of income
Assets having a definite service (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. Depreciable property includes buildings, machinery, equipment, vehicles, and some intangible properties. If an asset has no definite service life, the asset can not be depreciated such as land.

7. Cost of a new hole-punching machine (Invoice price)
Example Cost Basis of an asset represents the total cost that is claimed as an expense over an asset's life and generally includes the followings
Cost of a new hole-punching machine (Invoice price)
$62,500
+ Freight
725
+ Installation labor
2,150
+ Site preparation
3,500
Cost of Machine (Cost basis) to use in depreciation calculation
$68,875

8. Asset Depreciation Range ADR (years)
Assets Used
Lower Limit
Midpoint Life
Upper Limit
Office furniture, fixtures, and equipment 8 10 12
Information systems (computers) 5 6 7
Airplanes
Automobiles, taxis
2.5 3
3.5
Buses 9 11
Light trucks 4
Heavy trucks (concrete ready-mixer)
Railroad cars and locomotives 15 18
Tractor units
Vessels, barges, tugs, and water transportation system
14.5
21.5
Industrial steam and electrical generation and or distribution systems
17.5 22
26.5
Manufacturer of electrical and non-electrical machinery
Manufacturer of electronic components, products, and systems
Manufacturer of motor vehicles
9.5
Telephone distribution plant 28 35 42

9. Types of Depreciation Book Depreciation Tax Depreciation
Firms report depreciation and net income to investors / stockholders (as balance sheet or income statement)
In pricing decision
Tax Depreciation
In calculating income taxes for the IRS
In engineering economics, we use depreciation in the context of tax depreciation

10. Book Depreciation Methods
Three different methods can be used to calculate the periodic depreciation allowances for financial reporting.
Types of Depreciation Methods:
Straight-Line Method
Declining Balance Method
Unit Production Method

11. Straight – Line (SL) Method
Principle
A fixed asset as an asset that provides its services in a
uniform fashion. That is, the asset provides equal amount of
service in each year of its useful life.
Formula
Annual Depreciation
Dn = (I – S) / N, and constant for all n.
Book Value
Bn = I – n (D)
where I = cost basis
S = Salvage value
N = depreciable life

12. 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

13. Declining Balance Method
Principle:
A fixed asset as providing its service in a decreasing
fashion.
Formula The fraction,  = (1/N) (multiplier)
Annual Depreciation
Book Value
where 0 < a < 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. As N increases,  decreases.

14. 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 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
$4,000 B2 D3
$2,000 D4 B3 D5
$778 B5 B4 n

15. Example 8.4 Declining Balance (DB) Switching to SL
Asset: Invoice Price $9,000
Freight
Installation
Depreciation Base $10,000
Salvage Value
Depreciation 200% DB
Depreciable life 5 years
SL Dep. Rate = 1/5
a (DDB rate) = (200%) (SL rate)
= 0.40

16. Case 1: S = 0 (a) Without switching (b) With switching to SL n
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
10,000/5 = , $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 > ,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. The rule is; if DB depreciation in any year is less than (or equal to) the depreciation amount calculated by SL, switch to and remain with the SL method for the duration of the asset’s depreciable life.

17. Adjusting to salvage value
Case 2: 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
Adjusting to salvage value 5
2,000 – 0 = 2,000
Note: Tax law does not permit us to depreciate assets below their salvage values.

18. Units-of-Production Method
Principle
The number of service units will be consumed in that period.
Formula
Annual Depreciation
Service units consumed for year
Dn =
total service units
(I - S)

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

20. Modified Accelerated Cost Recovery Systems (MACRS)
Personal Property (includes assets such as machinery, vehicles, equipment, furniture, and similar items)
Depreciation method based on DB method switching to SL
Half-year convention
Zero salvage value
Real Property [Real properties are classified into two categories:
1. residential rental property and 2. commercial building or properties]
SL Method
Mid-month convention

21. MACRS Property Classifications (IRS Publication 534)
Recovery Period
ADR Midpoint Class
Applicable 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.
27.5-year
Residential rental property
39-year
Nonresidential real property including elevators and escalators
ADR: Asset Depreciation Range

22. MACRS Table The percentages shown in the table use the half year convention, all the assets are placed in service at mid-year and will have zero salvage value.

23. Example 8.6 MACRS Depreciation
Asset cost = $10,000
Property class = 5-year recovery period
DB method = Half-year convention, zero salvage value,
200% DB switching to SL
20%
$2000
32%
$3200
Full
19.20%
$1920
Full
11.52%
$1152
Full
11.52%
$1152
Full
5.76%
$576
Half-year Convention

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

25. 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

26. Allowed depreciation expenses (not cash flow)
Capital Expenditure versus Depreciation Expenses
(7-year MACRS property) 1 2 3 4 5 6 7 8
Capital expenditure
(actual cash flow)
$28,000
1(14.29)
2 (24.49)
3 (17.49)
4 (12.49)
7 (8.93)
6 (8.92)
7 (8.93)
8 (5.76)
$1,250
$3,500
$2,500
$2,500
$2,500
$4,000
$4,900
$6,850
Allowed depreciation expenses (not cash flow)

27. Example 8.9 – Cash Flow versus Net Income
Item
Income
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

28. Net income versus net cash flow
Net cash flows = Net income + non-cash expense (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

29. U.S. Corporate Tax Rate (2005) Marginal tax rate is defined as the rate applied to the last dollar of income.
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

30. 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

31. 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
Question: Taxable income?

32. 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

33. 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%

34. 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.

35. Depreciation recapture
Depreciation recapture is taxed as ordinary income.
Gains = Salvage value – book value
= (Salvage value - cost basis)
Capital gains +
(Cost basis – book value)
Ordinary gains

36. depreciation recapture
Capital Gains and Ordinary Gains
Capital gains
Total gains
Ordinary gains or
depreciation recapture
Cost basis
Book value
Salvage value

37. Gains or Losses on Depreciable Asset
Example 8.11: A Drill press: $230,000
Project year: 3 years
MACRS: 7-year property class
Salvage value: $150,000 at the end of Year 3
14.29
24.49
17.49
12.49
8.92
Full
Half
Total Dep. = 230,000( /2) = $109,308
Book Value = 230, ,308 = $120,693
Gains = Salvage Value - Book Value = $150,000 - $120,693
= $29,308
Gains Tax (34%) = 0.34 ($29,308) = $9,965
Net Proceeds from sale = $150,000 - $9,965 = $140,035

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

39. Calculation of Gains or Losses on MACRS Property