1. DEPRECIATION AND INCOME TAXES CHAPTER 9

2. Asset Depreciation
Book Depreciation
Tax Depreciation
Corporate Taxes

3. WHAT IS DEPRECIATION?
Definition: Loss of value for a fixed asset between two periods
Example: Market values of a vehicle over 5 years
End of Year
Market
Value
Loss of
2009
$20,000
2010
$14,000
$6,000
2011
$10,000
$4,000
2012
$7,000
$3,000
2013
$5,000
$2,000
2014
$1,000
D e p r e c i a t i o n

4. Depreciation Concept
is a term used in accounting, economics, and finance to spread the cost of an asset over the period of several years.
is the reduction in the value of an asset due to usage, passage of time, and technological outdating or other factors.
Economic Depreciation (Purchase Price – Market Value)
Economic losses due to both physical deterioration and technological obsolescence.
Accounting Depreciation
Systematic allocation (distribution) of the initial cost of an asset in parts over a time or decline in value over time and sometimes referred to more generally as asset depreciation.

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

6. Assets must be used in business or held for production of income.
What Can Be Depreciated? Depreciable property has the following characteristics
Assets must be used in business or held for production of income.
Assets must have a definite service (useful) life which must be longer than one year.
Assets must wear out, become obsolete or loses value from natural causes.
A qualifying asset for depreciation must satisfy all of the three conditions above.

7. Cost of a new stamping machine (Invoice price)
Example 9.1 on Cost Basis
Cost Basis of an asset represents the total cost that is claimed as an expense over an asset's life and generally includes the actual cost of an asset and all accompanying expenses, such as freight, site preparation, and installation.
Cost of a new stamping machine (Invoice price)
$22,700
Freight
525
Installation labor
1,350
Site preparation
2,125
Cost of Machine (Cost basis)
$26,700

8. Useful Life and Salvage Value:
The following questions must be answered when determining an asset's depreciable life. i.e., the number of years over which the asset is to be depreciated.
Q1) How long will an asset be useful to the company?
Q2) What do statutes (law) and accounting rules mandate in determining an asset's depreciable life?
Determining the service life of an asset is often very difficult.
The uncertainty of these estimates often led to disputes between taxpayers and the Internal Revenue Service (IRS).
The IRS publishes guidelines on lives for categories of assets known as Asset Depreciation Ranges or ADRs.
These guidelines specify a range of lives for classes of assets, based on historical data allowing taxpayers to choose a depreciable life within the specified range for a given asset.

9. 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
17.5 22
26.5
Manufacturer of electrical and non-electrical machinery
Manufacturer of electronic components, products,
Manufacturer of motor vehicles
9.5
Telephone distribution plant 28 35 42

10. Types of Depreciation Book Depreciation [financial report]
Firms report depreciation and net income to investors / stockholders (such as in balance sheet or income statement)
Actual loss of value in asset is generally reflected
Tax Depreciation [Internal Revenue Service]
In calculating income taxes for the IRS
In engineering economics, we use depreciation in the context of tax depreciation
Tax depreciation method allows firms to benefit from the tax advantages of depreciating assets, (will not pay high income tax).
Tax depreciation methods generally permit a higher depreciation in earlier years than do book depreciation methods.
Firms generally pay lower taxes in the initial years of an investment project.

11. 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

12. Straight – Line (SL) Method
Principle of this method
It considers 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 (years).
Book Value after Depreciation Charge
Bn = I – n (Dn) where I = cost basis
S = Salvage value
N = depreciable life

13. n n Dn Bn I = $10,000 N = 5 Years S = $2,000 D = (I – S)/N
Example Straight – Line Method Consider the following data on an automobile, compute the annual depreciation allowances and resulting book values using the straight-line method.
I = $10,000
N = 5 Years
S = $2,000
D = (I – S)/N
Find: Dn and Bn
n Dn Bn
$10,000
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 n

15. Declining Balance Method ( D B M )
Principle:
A fixed asset as providing its service in a decreasing fashion over time. DBM calculating depreciation allocates a fixed fraction  and it is obtained from S L depreciation rate (1/N) as a basis:  = (1/N) x (multiplier). N and multiplier are given.
Most commonly used multipliers in the USA are 1.5 DB or 2.0 DB
Annual Depreciation
Book Value
Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance (DDB) method.
where 0 <  <
2(1/N)

16. Declining Balance (DB) Depreciation
Example 9.3
Declining Balance (DB) Depreciation
Asset: Invoice Price ……………… $9,000
Freight ……………………
Installation …………………
Depreciation Base ………………… $10,000
Salvage Value ,000
Depreciation 200% DDB (Double) multiplier=2
Depreciable life 5 years
SL Dep. Rate = 1/5=0.2
a (DDB rate) = (200%) (SL rate) = 0.40

17. S = $2,000 End of Year Depreciation Book Value Bn 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) = $160
2,160 – 160 = 2,000
Adjusting to salvage value 5
Total = $8,000
2,000 – 0 = 2,000
Note: Tax law does not permit to depreciate assets below their salvage values.

19. Declining Balance (DB) Depreciation
Example 9.4
Declining Balance (DB) Depreciation
Asset: Invoice Price ……………… $9,000
Freight ………………………
Installation …………………
Depreciation Base ………………… $10,000
Salvage Value
Depreciation 200% DDB
Depreciable life 5 years
SL Dep. Rate = 1/5
a (DDB rate) = (200%) (SL rate) = 0.40

20. Example 9.4 Declining Balance (DB) with conversion to
Straight Line Depreciation (Bn > S)
Suppose the asset given in example 9.3 has a zero salvage value instead of $2,000
(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 = 2,000 < 4, $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 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. The Switch can be in any of the n years.

22. Declining Balance (DB) with conversion to
Straight Line Depreciation (Bn > S)
Straight line depreciation in year n:
Consider I=15000, S=1000, N=7, using DDB with conversion to straight line method

23. Units – of – Production Method No
Units – of – Production Method No. of units or operating hours are different from year to year
Principle
The number of service units consumed in that period.
Formula
Annual Depreciation
Service units consumed for year
Dn =
total service units
x ( I – S )

24. Example 9.5 Units – of – Production Depreciation
A truck for hauling coal has an estimated net cost of $55,000 and is expected to give service for 250,000 miles, resulting in $5,000 a salvage value. Compute the allowed depreciation amount for the truck usage of 30,000 miles
Find: Depreciation amount this year
Solution:

25. History of Tax Depreciation Methods
Purpose: compute income taxes for the IRS
Assets placed in service prior to 1981
Use book depreciation methods (SL, DB)
Assets placed in service from 1981 to 1986
Use ACRS (Accelerated Cost Recovery System) Table
Assets placed in service after 1986
Use MACRS (Modified ACRS) Table

26. Modified Accelerated Cost Recovery Systems (MACRS)
Personal Property: (movable property, includes assets such as machinery, vehicles, equipment, furniture, and similar items)
Depreciation method based on DB method switching to SL
Half-year convention (assumes all assets are placed in service at midyear)
Half year is allowed for the first year.
Half year is taken in the year following the end
Zero salvage value
Real Property: (includes houses and land) are classified into two categories:
residential rental property and
commercial building or properties
SL Method; Mid-month convention; Zero salvage value

27. MACRS Property Classifications (ADR = Asset Depreciation Range)
Recovery Period
ADR
Midpoint Class
Applicable Property
Personal 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.
Real Property
27.5-year
Residential rental property
39-year
Nonresidential real property including elevators and escalators

28. M A C R S Depreciation TABLE for Personal Property with Half-Year Conversion from Internal Revenue Service (IRS)

29. Example MACRS Depreciation
Asset cost = $10,000
Property class = 5 year MACRS
Depreciation method = Half – year convention, zero salvage value, % 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

34. How to Determine “Accounting Profit”
Item
Gross Income
Expenses
Cost of goods sold
Depreciation
Interest expenses
Operating expenses
Taxable income
Income taxes
Net income (Accounting Profit)

35. Example Net Income within a year
A company buys a numerically control (NC) machines for $28,000 (year Zero) and uses it for five years, after which time it is scrapped. The allowed depreciation deduction during the first year is $4,000, as the equipment falls into the seven year MACRS property category. (The first year depreciation rate is 14.29%) The cost of goods produced by this NC machine should include a charge for the depreciation of the machine. Suppose the company estimates the following revenues and expenses, including the depreciation for the first operating year.
Gross income = $50,000
Cost of goods sold = $20,000
Depreciation on NC machine = $4,000
Operating expenses = $6,000
If the company pays taxes at the rate of 40% on its taxable income, what is the net income from the project during the first year?

36. Example of Net Income within a year
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

37. 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)
5 (8.93)
6 (8.92)
7 (8.93)
8 (4.46)
$1,250
$3,500
$2,500
$2,500
$2,500
$4,000
$4,900
$6,850
Allowed depreciation expenses (not cash flow)

38. Cash Flow from Operation versus Net Income
Example
Cash Flow from Operation 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 from operation
$16,000

39. Net income versus net cash flow

40. U.S. Corporate Tax Schedule 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

41. 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

42. Example 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?

43. 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:
Taxable income
Marginal Tax Rate
Amount of Taxes
Cumulative
Taxes
First $50,000
15%
$7,500
$25,000
25%
6,250
13,750
34%
8,500
22,250
$232,000
39%
90,480
112,730

44. 39% 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%

45. Gain Taxes on Asset Disposals
When a depreciable asset used in business is sold for an amount that differs from its book value, the gains or losses have an important effect on income taxes.
To calculate a gain or loss, we first need to determine the book value of the depreciable asset at the time of disposal.
For a MACRS property, the year of disposal is charged one-half of that year's annual depreciation amount, should the disposal occur during the recovery period.
For example, let's consider a five-year MACRS property with a cost basis of $100,000.

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

48. + (cost basis – book value)
Taxable Gains (or Losses) are defined as the differences between the salvage value and the book value.
Case 1: Salvage value < Cost basis:
gains (losses) = salvage value – book value
Case 2: Salvage value > Cost basis:
ordinary gains (depreciation recapture)
gains = salvage value – book value
= (salvage value – cost basis)
+ (cost basis – book value)
capital gains
ordinary gains

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

50. Example 9.9 Gains or Losses on Depreciable Asset
A Drill press: $230,000
Project year: 3 years
MACRS: 7-year property class
Salvage value: $150,000 at the end of Year 3
Total Dep. = 230,000( /2) = $109,308
Book Value = 230, ,308 = $120,692
Ordinary Gains = Salvage Value - Book Value = $150,000 - $120,692 = $29,308
Gains Tax (34%) = 0.34 ($29,308) = $9,965
Net Proceeds from sale = $150,000 - $9,965 = $140,035

51. Calculation of Gains or Losses on – Cases 2 - 4

52. Case 2: S = $120,692 Case 3: S = $100,000 Total Dep. = 230,000(0
Case 2: S = $120,692 Case 3: S = $100,000 Total Dep. = 230,000( /2) = $109,308 Book Value = 230,000 – 109,308 = $120,692 Ordinary Gains = Salvage Value – Book Value = $100,000 - $120,692 = -$20,692 Gains Tax or Tax credit (34%) = 0.34 (-$20,692) = - $7,035 Net Proceeds from sale = $100,000 – (-$7,035) = $107,035.28

53. Case 4: S = $250,000 Total Dep. = 230,000(0. 1429 + 0. 2449 + 0
Case 4: S = $250,000 Total Dep. = 230,000( /2) = $109,308 Book Value = 230, ,308 = $120,692 Capital gains = Salvage Value – Cost Basis= $250,000 - $230,000=$20,000 Ordinary Gains = Cost Basis– Book Value = $230,000 - $120,692 = $109,308 Total Gains = Salvage Value – Book Value = $250,000 - $120,692 = $129,308 Gains Tax (34%) = 0.34 ($129,308) = $43,965 Net Proceeds from sale = $250,000 – $43,965 = $206,035

54. PRACTICE PROBLEMS
9; ; 17; 39; 40

55. 9.9) Consider the following data on an asset:
Compute the annual depreciation allowances and resulting book values, using the Double Declining Balance method and then switching to the SL method
Cost of the asset, I
$120,000
Useful life, N
7 years
Salvage value, S $0

56. Cost of the asset, I $120,000 Useful life, N 7 years Salvage value, S$0
SOLUTION 9.9)
DDB method With switching n
Dn =2/N =
SL method Dn =1/N Bn
$120,000 1
$34,284
7 / $17, $ 85,716 2
$24,489.10
6 / $14, $ 61,227 3
$17,492.6
5 / $12, $ 43,735 4
$12,495.1
4/ $10, $ 31,240 5
$8, shift }}}}}}
3 /$10, $ 20,827 6
2 /$10, $10,413.5 7
1 /$10, $0

57. 9.12) Consider the following data on an asset:
Compute the annual depreciation allowances and resulting book values, by using DDB method and then switching to the SL method to reach with zero salvage value
Cost of the asset, I
$38,000
Useful life, N
6 years
Salvage value, S $0

58. SOLUTION 9.12) With switching n Cost of the asset, I $38,000
Useful life, N
6 years
Salvage value, S $0
With switching n
DDB method Dn =
SL method Dn = 1 / Bn
$38,000 1
$12,667
6 / $6, $25,333 2
$8,444.40
5 / $5, $16,889.60 3
$5,629.47
4 / $4, $11,260.13 4
$3,753.34
3 / $3, shift to SL $7,506.73 5
2 / $3, $3,753.40 6
1 / $3, $0

59. 9.17)
New York Limousine Service owns 10 limos and uses the units of production method in computing depreciations on its limos. Each limo costing $32,000 is expected to be driven 200,000 miles and is expected to have a salvage value of $3,000. Limo # 1 was driven 24,000 miles in year 1 and 28,000 miles in year 2. Determine the depreciation for each year and the book value at the end of year 2.

60. The book value of Limo # 1 at the end of year 2:
SOLUTION
The book value of Limo # 1 at the end of year 2:

61. a) year 3 with a salvage value of $20,000;
9.39
Consider a five year MACRS asset that was purchased for $76,000. Compute the gain or loss amounts if the asset were disposed of in:
a) year 3 with a salvage value of $20,000;
b) year 5 with a salvage value of $10,000;
c) year 6 with salvage value of $5,000.

62. Disposed of in year 3:
Disposed of in year 5:
Disposed of in year 6:

63. 9.40)
An electrical appliance company purchased an industrial robot costing $320,000 in year 0. The industrial robot, to be used for welding operations, is classified as a seven year MACRS recovery property. If the robot is to be sold after five years, compute the amounts of gains (losses) for the following three salvage values, assuming that both capital gains and ordinary incomes are taxed at 35%;
a) $15, b) $125, c) $200,000

64. 9.40) SOLUTION
If sold at $15,000:
If sold at $125,460:
If sold at $200,000: