Copyright Oxford University Press 2009 Chapter 11 Depreciation Copyright Oxford University Press 2009

Copyright Oxford University Press 2009 Chapter Outline Basic Aspects of Depreciation Historical Depreciation Methods Modified Accelerated Cost Recovery System (MACRS) Depreciation and Asset Disposal Unit-of-Production Depreciation Depletion Spreadsheets and Depreciation Copyright Oxford University Press 2009

Copyright Oxford University Press 2009 Learning Objectives Understand the concepts of depreciation, deterioration, and obsolescence Use historical and MACRS to calculate annual depreciation charge and book value over the asset’s life Account for capital gains/losses, ordinary losses, and depreciation recapture due to the disposal of a depreciated asset Use unit-of-production and depletion depreciation methods in economic analysis Use spreadsheets to calculate depreciation Copyright Oxford University Press 2009

Basic Aspects of Depreciation Decline in market value of an asset due to deterioration or obsolescence Decline in value of an asset to its owner Systematic allocation of an asset’s cost over its useful or depreciable life (accountant’s definition) Copyright Oxford University Press 2009

Depreciation and Expenses Part of regular business operations “Consumed” over short period of time Sometimes recurring Do not lose value gradually over time Subtracted from business revenues as they occur Reduce income taxes as they can be written off when they occur Examples: labor, utilities, materials, insurance,… Copyright Oxford University Press 2009

Depreciation and Expenses Business costs due to capital assets are not fully written off when they occur Capital assets lose value gradually over time Capital cost must be written off or depreciated over its depreciable life or recovery period Reduce the taxable income, and thus reduce income taxes as they were written off It is a non-cash cost Examples: building, plants, machines,… Copyright Oxford University Press 2009

Basic Requirements for Depreciation A property is depreciable If: The property must be used for business purposes to produce income. The property must have a useful life that can be determined, and the useful life must be longer than one year. The property must be an asset that decays, gets used up, wears out, becomes obsolete, or loses value to the owner from natural causes. Only the owner of property may claim depreciation expenses Copyright Oxford University Press 2009

Copyright Oxford University Press 2009 Types of Property Tangible property: can be seen, touched, and felt. Real property: land, buildings, and things growing on, built upon, constructed on, or attached to the land Personal property: equipment, furnishings, vehicles, office machinery, and anything that is tangible excluding real property Intangible property: has value but cannot be directly seen or touched, examples include patents, copyrights, and trademarks, trade names, and franchises. Copyright Oxford University Press 2009

Property and Depreciation Almost all tangible property can be depreciated except land, factory inventory, containers considered as inventory, and leased property. Tangible property used in both business and personal activities can be depreciated, but only in proportion to the use for business purposes. Intangible property can generally be depreciated. Copyright Oxford University Press 2009

Depreciation Calculation Fundamentals (11-1) B Book Value Total Depreciation Charges BVt = Book value at the end of time t Cost basis = B = Dollar amount being depreciated including the asset’s purchase price and any other costs necessary to make the asset “ready to use” Dj = Depreciation deduction in year j  Dj = Accumulated depreciation charges from time 1 to j Curve values depend On depreciation method S Salvage value Depreciable Life Copyright Oxford University Press 2009

Copyright Oxford University Press 2009 Depreciation Methods Pre-1981 historical methods: Straight-line (SL) Sum-of-the-years’-digits (SOYD) Declining balance (DB) required estimates of useful life and salvage value 1981-1986 method: Accelerated Cost Recovery System (ACRS) Property class lives were created Salvage value was ignored Shorter recovery periods were used 1986-present: Modified Accelerated Cost Recovery System (MACRS) Number of property classes was expanded Half-year convention for the first and final years Copyright Oxford University Press 2009

Historical Depreciation Methods Straight-line (SL) (11-2) where dt = Depreciation charge in year t B = Cost of the asset made ready for use S = Estimated salvage value after depreciable life N = Number of years in depreciable life SOYD = Sum of years’ digits = N(N+1)/2 Sum-of-the-years’-digits (SOYD) (11-3) Double declining balance (DDB) (11-4) Copyright Oxford University Press 2009

Example 11-2 SL Depreciation Cost of the asset, B $900 Depreciable life, in years, N 5 Salvage value, S $70 166 Year dt ådt BV 900 1 166 734 2 332 568 3 498 402 4 664 236 5 830 70 166 166 166 166 Salvage value Copyright Oxford University Press 2009

Example 11-3 SOYD Depreciation Cost of the asset, B $900 Depreciable life, in years, N 5 Salvage value, S $70 Year dt ådt BV $900.00 1 $276.67 623.33 2 221.33 498.00 402.00 3 166.00 664.00 236.00 4 110.67 774.67 125.33 5 55.33 830.00 70.00 277 221 166 111 Salvage value 55 Copyright Oxford University Press 2009

Example 11-4 DDB Depreciation Cost of the asset, B $900 Depreciable life, in years, N 5 Salvage value, S $70 360 Year dt ådt BV 900.00 1 360.00 540.00 2 216.00 576.00 324.00 3 129.60 705.60 194.40 4 77.76 783.36 116.64 5 46.66 830.02 69.98 216 130 78 Salvage value 47 Copyright Oxford University Press 2009

Advantages of Modified Accelerated Cost Recovery System “Property class lives” are less than the “actual useful lives” Definition of MACRS classes of depreciable property is based on the guideline of the asset depreciable range (ADR) With ADR, each class of property has a lower limit, a midpoint, and a upper limit of useful life The ADR midpoint lives were somewhat shorter than the actual average useful lives MACRS property class lives are shorter than the ADR midpoint lives Salvage value was assumed to be 0 Tables of annual percentages simplify computations Copyright Oxford University Press 2009

Modified Accelerated Cost Recovery System (MACRS) General Depreciation System (GDS) Based on declining balance with switch to straight-line depreciation Alternative Depreciation System (ADS) ADS provides a longer recovery period and uses straight-line depreciation ADS must be used for Tangible property used primarily outside the United States Property that is tax exempt or financed by tax-exempt bonds Farming property placed in service when uniform capitalization rules are not applied ADS may be elected for an asset, it is not possible to switch back to the GDS. Copyright Oxford University Press 2009

Procedures in Applying MACRS-GDS Depreciation Determine if a property is eligible for depreciation Determine the asset’s cost basis (B) Cost to obtain and place the asset in service fit for use For real property, the basis may include certain fees and charges, such as legal and recording fees, abstract fees, survey charges, transfer taxes, title insurance, … Determine the property class and recovery period Use property class given in problem Match asset name with MACRS-GDS property classes definition (Table 11-2) Use IRS publication, such as Table 11-1 Use ADR class life to determine property class Copyright Oxford University Press 2009

Applying MACRS-GDS Depreciation (11-5) where dt = Depreciation charge in year t B = Cost basis rt = Appropriate MACRS percentage rate Copyright Oxford University Press 2009

Table 11-1 Example Class Lives and MACRS Property Classes IRS Asset Class Asset Description Class Life (years) ADR MACRS Property Class (years) GDS ADS 00.11 Office furniture, fixtures, and equipment 10 7 00.12 Information Systems: computer/peripheral 6 5 00.22 Automobiles, taxis 3 00.241 Light general-purpose trucks 4 00.25 Railroad cars and locomotives 15 00.40 Industrial steam and electric distribution 22 01.11 Cotton gin assets 12 01.21 Cattle, breeding or dairy 13.00 Offshore drilling assets 7.5 13.30 Petroleum refining assets 16 15.00 Construction assets Copyright Oxford University Press 2009

Table 11-1 Example Class Lives and MACRS Property Classes IRS Asset Class Asset Description Class Life (years) ADR MACRS Property Class (years) GDS ADS 21.10 Manufacture of grain and grain mill products 17 10 22.2 Manufacture of yarn, thread, and woven fabric 11 7 24.10 Cutting of timber 6 5 32.20 Manufacture of cement 20 15 37.11 Manufacture of motor vehicles 12 48.11 Telephone Communications assets and buildings 24 48.2 Radio and television broadcasting equipment 49.12 Electric utility nuclear production plant 49.13 Electric utility steam production plant 28 49.23 Natural gas production plant 14 50.00 Municipal wastewater treatment plant 80.00 Theme and amusement park assets 12.5 Copyright Oxford University Press 2009

Table 11-2 MACRS GDS Property Classes 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 Automobiles and trucks (The depreciation for automobiles is limited to $2960 the first tax year, $4700 the second year, $2850 the third year, and 1675 per year in subsequent years.) Aircraft (of non-air-transport companies) Equipment used in research and experimentation 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 10 years or more and less than 16 years Copyright Oxford University Press 2009

Table 11-2 MACRS GDS Property Classes Personal Property (all property except real estate) 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 Residential rental property (does not include hotels and motels) 39 Years Nonresidential real property Copyright Oxford University Press 2009

Table 11-3 MACRS GDS Percentage Rate Recovery Year 3-Year Class 5-Year 7-Year 10-Year Class 15-Year Class 20-Year Class 1 33.33 20.00 14.29 10.00 5.00 3.750 2 44.45 32.00 24.49 18.00 9.50 7.219 3 14.81* 19.20 17.49 14.40 8.55 6.677 4 7.41 11.52* 12.49 11.52 7.70 6.177 5 8.93* 9.22 6.93 5.713 6 5.76 8.92 7.37 6.23 5.285 7 8.93 6.55* 5.90* 4.888 8 4.46 6.55 5.90 4.522 9 6.56 5.91 4.462* 10 4.461 11 3.28 4.462 12-15 16 2.95 17-20 21 2.231 Copyright Oxford University Press 2009

Calculation of MACRS GDS Percentages The 3-, 5-, 7-, and 10-year classes use 200% and the 15- and 20-year classes use 150% declining balance depreciation. All classes convert to straight-line depreciation in the optimal year, shown with the asterisk (*). A half-year of depreciation is allowed in the first and last recovery years. Salvage value are assumed to be zero for all assets. Copyright Oxford University Press 2009

Table 11-4 MACRS GDS Percentage Rate Residential Rental Property Recovery Year Month Placed in Service 1 2 3 4 5 6 7 8 9 10 11 12 3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152 2-27 3.636 28 29 Nonresidential Real Property Recovery Year Month Placed in Service 1 2 3 4 5 6 7 8 9 10 11 12 2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107 2-39 2.564 40 Copyright Oxford University Press 2009

Example 11-5 Calculation of MACRS GDS Percentages The 5-year class uses 200% declining balance depreciation with conversion to straight-line depreciation. B=100%, S=0, half-year for the 1st and last of recovery period Year DDB Calculation SL Calculation MACRS Rates Book Value 100.00% 1 (½)(2/5)(100%)=20.00% (½)(100%/5)=10.00% 20.00% 80.00% 2 (2/5)(80.00%)=32.00% (80.00%/4.5)=17.78% 32.00% 48.00% 3 (2/5)(48.00%)=19.20% (48.00%/3.5)=13.71% 19.20% 28.80% 4 (2/5)(28.80%)=11.52% (28.80%/2.5)=11.52% 11.52% 17.28% 5 5.76% 6 (½)11.52%=5.76% 0.00% Copyright Oxford University Press 2009

Example 11-6 Calculation of MACRS GDS Depreciation 7-year property class, B=$150000, S=$30000 Year MACRS % MACRS Calculation MACRS Depreciation, dt Book Value $150,000 1 14.29% ($150000)(14.29%) $21,435 128,565 2 24.49% (150000)(24.49%) 36,735 91,830 3 17.49% (150000)(17.49%) 26,235 65,595 4 12.49% (150000)(12.49%) 18,735 46,860 5 8.93% (150000)(8.93%) 13,395 33,465 6 8.92% (150000)(8.92%) 13,380 20,085 7 6,690 8 4.46% (150000)(4.46%) Copyright Oxford University Press 2009

Example 11-7 Calculation of MACRS GDS Depreciation 39-year property class, B=$2,000,000, purchased in April, disposed 5 years later in August Year MACRS % MACRS Calculation MACRS Depreciation, dt Book Value $2,000,000 1 1.819% ($2000000)(1.819%) $36,380 1,963,620 2 2.564% (2000000)(2.564%) 51,280 1,912,340 3 (2000000)(2.564 %) 1,861,060 4 1,809,780 5 1,758,500 6 (7.5/12)(2000000)(2.564 %) 32,100 1,726,400 273,600 Copyright Oxford University Press 2009

Example 11-8 Comparison of Depreciation Methods SL SOYD MACRS DDB Copyright Oxford University Press 2009

Depreciation and Asset Disposal When a depreciable asset is disposed of, and the market value is different than the book value, the difference must be treated as: Depreciation recapture (ordinary gains): Depreciation recapture occurs when an asset is sold for more than its current book value, but less than the original cost basis. Losses: A loss occurs when an asset is sold for less than its current book value. Capital gains: Capital gain occur when an asset is sold for more than its original cost basis. Capital gains may be taxed at lower rate than ordinary gains. Copyright Oxford University Press 2009

Depreciation and Asset Disposal $4000 Capital Gain $2000 Depreciation Recapture $5000 Depreciation Recapture $3000 Loss Copyright Oxford University Press 2009

Example 11-9 Depreciation and Asset Disposal 3-year property class, B=$10000 Year MACRS % MACRS Depreciation, dt Book Value Market Value $10,000 1 33.33% $3,333 6,667 2 44.45% 4,445 2,222 3 14.81% 1,481 741 4 7.41% 5 X If market value = $7000, the recaptured depreciation = $7000 b) If market value = $0, no recaptured depreciation or loss c) If market value = -$2000, there is a loss of $2000 Copyright Oxford University Press 2009

Example 11-10 Depreciation and Asset Disposal 1) Year MACRS % MACRS Depreciation, dt Book Value Market Value $10,000 1 33.33% $3,333 6,667 2 44.45% (1/2)4,445=2,222.5 4,444.5 $2500 Market Value – Book Value = $2500 – 4444.5 = - 1944.5 (Loss) 2) Year MACRS % MACRS Depreciation, dt Book Value Market Value $10,000 1 33.33% $3,333 6,667 2 44.45% 4,445 2,222 3 14.81% (1/2)1,481=740.5 1,481.5 $2500 Market Value – Book Value = $2500 – 1481.5 = 1018.5 (Recaptured Depreciation) Copyright Oxford University Press 2009

Example 11-10 Depreciation and Asset Disposal 3) B=10,000, S=5000, N=5 Year SL Depreciation, dt Book Value Market Value $10,000 1 $1000 9,000 2 1000 8,000 3 7,000 $4000 Market Value – Book Value = $4000 – 7000 = -3000 (Loss) Copyright Oxford University Press 2009

Unit-of-Production Depreciation Useful when the recovery of depreciation on an asset is more closely related to use than time Not considered an acceptable method for general use (11-6) where dt = Depreciation charge in year t B = Cost basis S = Estimated salvage value after depreciable life Productiont = Production for year t Production = Total lifetime production for asset Copyright Oxford University Press 2009

Example 11-11 Unit-of-Production Depreciation 5-year depreciable life, B=$900, S=$70 Year Annual Production UOP Depreciation Calculation UOP Depreciation, dt Book Value $900 1 4,000 (4,000/40,000)(830) $83 817 2 8,000 (8,000/40,000)(830) 166 651 3 16,000 (16,000/40,000)(830) 332 319 4 153 5 83 70 40,000 Copyright Oxford University Press 2009

Copyright Oxford University Press 2009 Depletion Depletion is the exhaustion of natural resources as a result of their removal. Except for standing timber and most oil and gas wells, depletion allowance is the larger of the two methods. Cost Depletion: Similar to the unit-of-production depreciation method Permissible for standing timber and most oil and gas wells Cost of land must be excluded from the property cost Percentage Depletion: Depletion allowance is a certain percentage of the property’s gross income during the year Cannot exceed 50% of the property’s taxable income computed without the depletion deduction Copyright Oxford University Press 2009

Table 11-6 Percentage Depletion Allowance Type of Deposits Rate Sulfur, uranium, and, if from deposits in the United States, asbestos, lead ore, zinc ore, nickel ore, and mica 22% Gold, silver, copper, iron ore, and certain oil shale, if from deposits in the United States 15% Borax, granite, limestone, marble, mollusk shells, potash, slate, soapstone, and carbon dioxide produced from a well 14% Coal, lignite, and sodium chloride 10% Clay and shale used or sold for use in making sewer pipe or bricks or used or sold for use as sintered or burned lightweight aggregates 7½% Clay used or sold for making drainage and roofing tile, flower pots, and kindred products, and gravel, sand, and stone (other than stone used or sold for use by a mine owner or operator as dimension or ornamental stone) 5% Copyright Oxford University Press 2009

Example 11-12 Cost Depletion Cost of property (timber) = $35,000 Cost of land = $5000 (included in the cost of property) Estimated timber production = 1.5 million board-feet First year’s production = 100,000 board-feet Copyright Oxford University Press 2009

Example 11-13 Percentage Depletion Gross income = $250,000 Mining expenses = $210,000 Copyright Oxford University Press 2009

Spreadsheet and Depreciation Excel Functions Purpose SLN(cost, salvage, life) Returns the straight-line depreciation of an asset for one period. DDB(cost, salvage, life, period, [factor]) Returns the depreciation of an asset for a specified period using the double-declining balance method or some other method specified. SYD(cost, salvage, life, period) Returns the sum-of-years' digits depreciation of an asset for a specified period. VDB(cost, salvage, life, start_period, end_period, [factor], [no_switch]) Returns the depreciation of an asset for any period specified, including partial periods, using the double-declining balance method or some other method specified. VDB stands for variable declining balance. Copyright Oxford University Press 2009