The Most Taxing Questions or We Depreciate You ©2004 Dr. B. C. Paul

Conventions on Spreading Cost  We already met Depreciation with Earnest and Crader Mining  Method was called “Straight Line”  Starts with a “Cost Basis” what the asset originally cost  Trucks cost $700,000 and lasted 7 years  Calculation is  $700,000/7 = $100,000  Cost Basis/ Life = Annual Depreciation

Plot Thickens  Some assets may have a salvage value at discard  Straight Line is actually  (Cost Basis – Salvage)/ Life = Depreciation  Example before treated the salvage value as 0  This assumption is common for tax calculations

Problem of Real Behavior  Auto illustration  Typical new car in $24,000 range  Drops in value about $4,000 when drives off lot  Drops in value rapidly at first (at age 5 or 6 it may be only worth $4,000 or $5,000)  Loss of market value slows down  At 10 years may be worth $2,500

The Gap Problem  Most people buy cars on credit  Auto pay-off may be linear with simple interest  Will be slow at first with compound interest loan  Market value of car is dropping faster than your debt  What happens if you get hit by a semi pulling off car lot and have a vehicle worth $20,000, but you owe $24,000  Insurance pays you what vehicle is worth and leaves you holding bag with the loan  Gaps of $10,000 are not uncommon (insurance often uses low value estimates on wholesale used car market while you bought the car retail)

Solutions  Some insurance offers replacement cost for first few years  But only if accident is your fault and covered under comprehensive  If other guys fault his insurance still try low wholesale market value  Gap Insurance  Difference between market and loan

Back to Depreciation  Gap problem can occur for tax purposes if government forces you to spread out cost in a manner that does not reflect loss of value  Need for method that depreciates fast at first and then slows down  Two methods commonly meet requirement  Sum of Years Digits  Declining Balance

Sum of Years Digits  (Basis – Salvage) * Factor  Factor = (N – t + 1)/(SOYD)  N= number years depreciable life  t = the current year for example depreciation in year three would have t = 3  SOYD = Sum of Years Digits  If life is 5 years then  SOYD = = 15  There is a formula to save you undignified counting  N * (N+1)/2 = SOYD

Application  If Earnest Depreciated his truck by SOYD  Basis = $700,000 (assume no salvage)  Factor 1 =(7 – 1 + 1)/ ((7/2)*(7+1)) = 0.25  Depreciation Year 1 = $700,000*0.25= $175,000  Year 2 6/28*$700,000 = $150,000  Year 3 5/28*$700,000 = $125,000  Year 4 4/28*$700,000 = $100,000  Year 5 3/28*$700,000 = $75,000  Year 6 2/28*$700,000 = $50,000  Year 7 1/28*$700,000 = $25,000

Declining Balance Methods  Need one more term – Book Value  Book Value = (Cost Basis – Salvage – Depreciation Taken to Date)  Annual Depreciation = Book Value * Dbalance factor  Dbalance factor = (% rate)/(100*N) where N is the life of the item  Percentage rate is any ratio of initial depreciation to straight line that is desired  Ie the system has infinite adaptations  In practice 150% and 200% are historical conventions

Lets Do Earnest’s Truck with 150% Declining Balance  Book Value 1 = $700,000  Dbalance factor 1 = 150/(100*7) =  Depreciation Year 1 = $150,000  Note that Dbalance factor will not change like with SOYD, but Book Value will  Year 2  *($700,000 – 150,000) = $117,857

Continuing  Year *(700,000 – )=$92,602  Year *(700,000 – 360,459) = $72,759  Year *(700,000 – 433,218) = $57,168  Year *(700,000 – 490,386) = $44,917  Year *(700,000 – 535,303) = $35,292  Year *(700,000 – 570,595) = $27,730  Year *(700,000 – 598,324) = $21,788  Wait a Cotton Picken Minute Here - The truck was dead at 7 years – how long does this depreciation go on  Answer – Till you are dead too (forever)

Houston- We have a problem  Declining balance methods start out fine, but going on forever makes no sense  Solution – Do a straight line calculation in parallel with the declining balance calculation and switch when straight line is more

Implementation  Year 1 SL = Book Value/ Remaining Life  $700,000/ 7 = $100,000  Declining Balance says $150,000  $150,000 > $100,000 – select declining balance  Year 2 SL = $550,000/ 6 = $91,667  Declining Balance says $117,857  $117,857 > $91,667 – select declining balance  Year 3 SL = $432,143/ 5 = $86,439  Declining Balance says $92,602  $92,602 > $86,439 – select declining balance

Implementation Continued  Year 4 SL $339,541/4 = $84,885  Declining Balance says $72,759  $84,885 > $72,759 - switch to SL for rest of depreciation  Thus  Year 5 is $84,885  Year 6 is $84,885  Year 7 is $84,885  Depreciation is done

Things to Note  Depreciation is funny money  Money really moves like the cash flow  Why do people use funny money?  Accountants realized long ago that reporting profits and losses based on when big purchases occurred put earning all over the map – didn’t reflect how businesses asset position had changed  Depreciation allowed accounted earnings and losses to show how the companies performance changed its asset position  Why don’t we use them on cash flows  We are valuing the earnings and investment of a project not trying to put a value on the company every year  We do things different because what we are trying to do is different

The Funny Money Problem  Everyone understands why we need to depreciate long lived assets  Getting people to agree on how to do it is another matter  We have shown you 3 ways – and haven’t yet talked about how we know how long the asset will last  Everyone and his dog has a different way of calculating profits  SEC says how to do it for business reporting  Enron, MCI, Tyco, and Arthur – Anderson do it any way that looks good  Feds say how to do it for their taxes  States say how to do it for theirs  Idea that companies have 5 sets of books is not unusual

How do the Feds Do it?  1971 U.S. Treasury Dept collected data on equipment lives – plotted the midpoint of the distribution and called it the Asset Depreciation Range (ADR)  This created standard lives for Property  Reagan Revolution  Economy in stagflation / World poised for Nuclear annihilation with cold war

Reagan’s Solution  Grow the economy out of stagnation and bury the Soviets with military spending  Key pin was stimulating investment and activity  He stimulated investment with tax credits and an accelerated depreciation system  He used artificially short depreciation lives  Called Modified Accelerated Cost Recovery System (MACRS)

Understanding MACRS  Have to Divide Up Depreciable Property  Tangible Property (can touch and feel it)  We’ll deal with intangible later  Tangible Property  Real – land buildings, things upon or attached to land  Personal Property – things like equipment and furniture are not really attached

Divide Personal Property into Life Classes  Three Year – Food and Bev handling equipment, tools for producing metal or plastic goods and autos, anything with an ADR life of 4 or under  Five Year – Autos for business (not yours), trucks, aircraft, research equipment, computers, oil drilling equipment, anything with an ADR less than 10 years (and more than 4)  Seven Year – Office furniture, fixtures, rugs, equipment, anything with ADR less than 16 years  Ten Year – Oil Refining Equipment, barges and ships, anything with ADR less than 20 years  Fifteen Year – Telephone Distribution Lines, Sewerage Plants, anything with an ADR less than 25 years  Twenty Year – Municipal sewers, personal property with an ADR of more than 25 years

The Real Property Classes  Commercial non-residential property (including hotels and motels)  Do 39 year straight-line  Residential rental property (your landlord)  Do 27.5 year straight-line  Did You Say 27.5 Years?!!

Time Line Conventions  With cash flows remember we accumulated events and put them at one point in time  Commonly we put all money events for a compounding period at the end of the period  Government also uses a convention about where to put expenses for depreciation purposes  Use the “Mid Year Convention” – ie the years purchases are treated as occurring exactly at the middle of the year  Thus on 3 year property you get half a year in year 1, full years in 2 and 3, and a half in year 4  There are also some rules that allow some property (usually 7 year and under to be set by Mid-Quarter Convention)

The Problem of Unwieldy Math  3, 5, 7, and 10 year property is depreciated by 200% declining balance converting to straight line  15, and 20 year property is 150% declining balance converting to straight line  Real Property is Straight Line  Try that with Mid-Year and Mid-Quarter Conventions

The IRS Solution  IRS considered a $100 investment for each type of property using mid-year, and 4 mid-quarter conventions where applicable  Calculated depreciation each year  This just happens to be the % depreciation allowable each year  They then publish the numbers in a table and spare you the need to understand how they got them

Example  Consider depreciation on a new carpet put in an office building  Carpeting cost $10,000  Its 7 year Property  The table says  Year %*$10,000 = $1,429  Year %*$10,000 = $2,449  Year %*$10,000 = $1,749  Year %*$10,000 = $1,249  Year %*$10,000 = $893  Year %*$10,000 = $893  Year %*$10,000 = $893  Year %*$10,000 = $446