King Faisal University [ ] 1 Business School Management Department Finance Pre-MBA Dr Abdeldjelil Ferhat BOUDAH 1

King Faisal University [ ] CHAPTER 4 DEPRECIATION 2 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Introduction 1- Depreciation and cash flows 2- Depreciable value of an asset 3- Depreciable life of an asset 4- Depreciation methods 5- Analyzing the firm’s cash flows. Conclusion 3 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Introduction DEPRECIATION Business firms are permitted to systematically charge a portion of the costs of fixed assets against annual revenues. This allocation of historic cost time is called DEPRECIATION. 4 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Depreciation, in other words, can be defined as the measure of the cost (or revalued amount of the economic benefits of a tangible fixed assets that have been consumed during a financial period. 5 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION The depreciation reduces the book value of the asset and is charged against income of an organization in the income statement or profit and loss account. 6 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION For tax purposes, the depreciation of business assets is regulated by law (the Internal Revenue Code). Because the objectives of financial reporting are sometimes different from those tax legislation, a firm often will use different depreciation methods for financial reporting than those required for tax purposes. 7 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Tax laws are used to accomplish economic goals such as providing incentives for business investment in certain types of assets, whereas the objectives of financial reporting are of course quite different. 8 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS), whereas financial reporting purposes, a variety of depreciation methods are available. Before discussing the methods of depreciating an asset, we must understand the relationships between depreciation and cash flows, the depreciable value of an asset, and the depreciable life of an asse t. 9 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION 1- Depreciation and cash flows cash flows from operations added back net profits after taxes. The financial manager is concerned with cash flows rather than net profits as reported on the income statement. To adjust the income statement to show cash flows from operations, all noncash charges must be added back to the firm’s net profits after taxes. 10 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Noncash charges are expenses that are deducted on the income statement but do not involve an actual outlay of cash during the period. Depreciation, amortization, and depletion allowances are examples. 11 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Because depreciation expenses are the most Noncash charges, we shall focus on their treatment. The general rule for adjusting net profit after tax by adding back all Noncash charges is expressed as follows: 12 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Cash flow from operation = net profit after tax + noncash charges 13 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION If we go back to Baker Corporation Income Statement and through table 3.1, cash flow from operation can be deduced as follows: 14 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Cash flow from operations= 280,000 $ 15 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Net profit after taxes $180, Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Plus: Depreciation expense…$ 100, Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION 2- Depreciable value of an asset Under the basic MACRS procedures the depreciable value of asset (the amount to be depreciated) is its full cost, including outlays for installation. No adjustment is required for expected salvage value. 18 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Salvage value(Scrap value) : The realizable value of an asset at the end of its useful life, when it is no longer suitable for its original use. Fixed assets, stock or waste arising from a production process can all have a salvage 19 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Example Baker Corporation acquired a new machine at a cost $38,000, with installation costs of $2,000. regardless of its expected salvage value, the depreciable value of the machine is $40,000 = (38,000 + $2,000). 20 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION 3- Depreciable life of an asset Depreciable life means time period over which an asset is depreciated. The shorter the depreciable life, the more quickly the cash flow created by the depreciation write-off will be received. 21 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION 4- Depreciation Methods A provision of depreciation can be calculated by means of a number of generally accepted techniques, including the straight-line method, declining-balance method, Units-of –Activity depreciation. 22 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION The straight-line method, The straight-line depreciation allocates a given percentage of the cost of the asset each year, thus suggesting an even spread of the cost of the asset over its useful life. 23 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION The amount of straight-line depreciation per year of life is fairly easy to calculate. Yearly depreciation = [(depreciation basis - salvage value)/ N] 24 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Where, N: Number of years that express the asset life. Salvage value: the value that may not be written off at the end of asset life. Depreciation basis: The depreciable value of an asset. See Illustration Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION The declining-balance method The declining-balance method produces a decreasing annual depreciation expense over the asset’s useful life. The periodic depreciation is based on declining book value;(cost less accumulated depreciation ) of the asset. 26 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Book value at the beginning of year × Declining balance rate = Annual Depreciation Expense Ex: $ ×40% = $5200 See Illustration Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Units-of –Activity Depreciation Under this method, useful life is expressed in terms of the total units of production or use expected from the asset, rather than as time period. See Illustration 10-12,and Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION 5- Analyzing the firm’s cash flows Figure 3.2 illustrates the firm’s cash flows. Two main observations can be noted: First, cash and marketable securities represent a reservoir of liquidity that is increased by cash inflows and decreased by cash outflows. 29 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Second, the firm’s cash flows have been divided into three categories of cash flows : (1) operating flows (2) investment flows and (3) financing flows. 30 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Classifying sources and uses of cash The statement of cash flows in effects summarizes the sources and uses of cash during a given period. Table 3.7, shows the basic sources and uses of cash. 31 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION For example, if a firm’s accounts payables increased by $ 1000 during the year, this change would be source of cash. However, if the firm’s inventory increased by $ 2500, the change would be a use of cash, meaning that an additional $ 2500 was tied up in inventory. 32 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Interpreting the statement of cash flows The statement of cash flows allows the financial manager and other interested parties to analyze the firm’s past and possibly future cash flows. 33 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION The manager should pay attention to both the major categories of cash flow and the individual items of cash inflows and outflows to assess whether any developments have been occurred that are to the contrary to company’s financial policies. (See table 3.10) 34 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION Conclusion The statement of cash flows provides the financial manager with an effective and realistic tool that shows the real disbursements and revenues may firms have to spend or to receive. 35 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] CHAPTER 4: DEPRECIATION CHAPTER 4: DEPRECIATION From financial view, the income statement is so important as a basis tool for financial analysis but not sufficient because of certain registered elements that can be used for different purposes, once as an expense and an other time as cash flow. 36 Dr Abdeldjelil Ferhat BOUDAH

King Faisal University [ ] 37 بحمد الله