1. 1 DEALING WITH ASSETS Fixed assets appear in the Balance Sheet Fixed assets appear in the Balance Sheet Cost to the organization is the total cost of acquisition Cost to the organization is the total cost of acquisition Purchase price Purchase price Cost of installation Cost of installation Cost of transportation to organization Cost of transportation to organization Assets decrease in value as time progresses, Assets decrease in value as time progresses, i.e. Assets depreciate with time i.e. Assets depreciate with time Possible exceptions - land, property, collectable items Possible exceptions - land, property, collectable items Classifications of depreciation: Classifications of depreciation: Physical Physical Functional Functional

2. 2 PHYSICAL DEPRECIATION Depreciation resulting from physical impairment of the asset Depreciation resulting from physical impairment of the asset Example: corrosion of tubes in a heat exchanger Example: corrosion of tubes in a heat exchanger This type of depreciation results in the lowering of the ability of a physical asset to perform its intended purpose This type of depreciation results in the lowering of the ability of a physical asset to perform its intended purpose Primary causes: Primary causes: Deterioration due to action of the elements including the corrosion of pipes, rotting of timber, chemical decomposition, bacterial action. Deterioration is substantially independent of use. Deterioration due to action of the elements including the corrosion of pipes, rotting of timber, chemical decomposition, bacterial action. Deterioration is substantially independent of use. Wear and tear from use that subjects the asset to abrasion, shock, vibration, impact, etc. These forces primarily result from use and result in a loss of value over time. Wear and tear from use that subjects the asset to abrasion, shock, vibration, impact, etc. These forces primarily result from use and result in a loss of value over time.

3. 3 FUNCTIONAL DEPRECIATION Depreciation resulting from changes in the demand for the services it is designed to provide Depreciation resulting from changes in the demand for the services it is designed to provide Demand change can result from it being a more profitable tool for the manufacture of a part, the more efficient achievement of a task or provision of a specific service. Can also result when the asset is used in excess of its designed capacity Demand change can result from it being a more profitable tool for the manufacture of a part, the more efficient achievement of a task or provision of a specific service. Can also result when the asset is used in excess of its designed capacity Primary causes: Primary causes: Obsolescence of another asset Obsolescence of another asset Inadequacy or inability to meet demand placed upon the asset due to revised product demand Inadequacy or inability to meet demand placed upon the asset due to revised product demand Examples of functional obsolescence include steam trains, sailing ship (other than for pleasure), horse drawn carriages Examples of functional obsolescence include steam trains, sailing ship (other than for pleasure), horse drawn carriages

4. 4 SUMMARY Depreciation: Depreciation: “... the measure of the wearing out, consumption or other reduction in the useful economic life of a fixed asset whether arising from use, passage of time or obsolescence through technology or market changes” “... the measure of the wearing out, consumption or other reduction in the useful economic life of a fixed asset whether arising from use, passage of time or obsolescence through technology or market changes” Fact based: Fact based: Original total cost of acquisition of the asset Original total cost of acquisition of the asset Ownership strategy – expected life Ownership strategy – expected life

5. 5 ACCOUNTING FOR DEPRECIATION Asset Purchase Cost 1st Year of use in production 1st Year of use in production 1st Year of use in production Some of the life of the asset is ‘used’ each year of use. This amount is a charge to the operation for the year Value of the asset to the organization Initial value End 1st year End 2nd year End 3rd year Annual charge Annual charge

6. 6 DEPRECIATION Depreciation is the annual amount by which an asset is reduced in ‘book value’ within the organisation Depreciation is the annual amount by which an asset is reduced in ‘book value’ within the organisation This annual depreciation is also the annual amount charged to the profit and loss statement in recognition of the use of the asset for the purposes of producing something This annual depreciation is also the annual amount charged to the profit and loss statement in recognition of the use of the asset for the purposes of producing something Note the notion of a balance here we need this to ensure the balance sheet balances! ‘Book Value’ is the acquisition cost of an asset less its accumulated depreciation charges. ‘Book Value’ is the acquisition cost of an asset less its accumulated depreciation charges. How do we decide the annual charge?

7. 7 DEPRECIATION METHODS Traditional methods Traditional methods Linear depreciation - ‘Straight Line’ depreciation Linear depreciation - ‘Straight Line’ depreciation Accelerated depreciation - Reducing/Declining Balance Accelerated depreciation - Reducing/Declining Balance Modern methods Modern methods Accelerated Cost Recovery System (ACRS) Accelerated Cost Recovery System (ACRS) Modified Accelerated Cost Recovery System (MACRS) Modified Accelerated Cost Recovery System (MACRS)

8. 8 STRAIGHT LINE DEPRECIATION Characterized by a constant annual depreciation amount Characterized by a constant annual depreciation amount Where: Where: A = annual charge A = annual charge C = total acquisition cost C = total acquisition cost n = useful life of the asset in years n = useful life of the asset in years Simple method, requires definition of ‘n’ Simple method, requires definition of ‘n’

9. 9 STRAIGHT LINE - EXAMPLE A high specification compressor is purchased for 100,000 m.u. A high specification compressor is purchased for 100,000 m.u. It is expected to have a usable life of 5 years after which it will have a residual value of 10,000 m.u. It is expected to have a usable life of 5 years after which it will have a residual value of 10,000 m.u. The compressor is used to make balloons. Each balloon costs 1.00 m.u. and sells for 2 m.u. The compressor is used to make balloons. Each balloon costs 1.00 m.u. and sells for 2 m.u. 25,000 balloons are sold each year 25,000 balloons are sold each year 1. Calculate the annual depreciation charge 2. Show how the asset book value changes over time 3. Show how the depreciation charge affects reported profit

10. 10 STRAIGHT LINE - SOLUTION C = 100,000 C = 100,000 R = 10,000A = 18,000 m.u. R = 10,000A = 18,000 m.u. n = 5 n = 5Year12345 Annual charge to Profit and Loss 18,00 0 Net Book Value 82,00 0 64,00 0 46,00 0 28,00 0 10,00 0 Sales revenue Cost of sales Gross profit Depreciation Reported profit 50,00 0 25,00 0 18,00 0 7,000 7,000 50,00 0 25,00 0 18,00 0 7,000 7,000 50,00 0 25,00 0 18,00 0 7,000 7,000 50,00 0 25,00 0 18,00 0 7,000 7,000 50,00 0 25,00 0 18,00 0 7,000 7,000

11. 11 REDUCING BALANCE METHOD Characterized by a constant annual percentage reduction in asset value Characterized by a constant annual percentage reduction in asset value Where: Where: r = depreciation rate r = depreciation rate C = total acquisition cost C = total acquisition cost R = residual value of the asset R = residual value of the asset n = useful life of the asset in years n = useful life of the asset in years

12. 12 REDUCING BALANCE - EXAMPLE A high specification compressor is purchased for 100,000 m.u. A high specification compressor is purchased for 100,000 m.u. It is expected to have a usable life of 5 years after which it will have a residual value of 10,000 m.u. It is expected to have a usable life of 5 years after which it will have a residual value of 10,000 m.u. The compressor is used to make balloons. Each balloon costs 1.00 m.u. and sells for 2 m.u. The compressor is used to make balloons. Each balloon costs 1.00 m.u. and sells for 2 m.u. 25,000 balloons are sold each year 25,000 balloons are sold each year 1. Calculate the annual depreciation charge 2. Show how the asset book value changes over time 3. Show how the depreciation charge affects reported profit

13. 13 REDUCING BALANCE - SOLUTION C = 100,000 C = 100,000 R = 10,000r = 36.9% R = 10,000r = 36.9% n = 5 n = 5 Year12345 Annual charge to Profit and Loss 36,90 0 23,30 0 14,69 0 9,2705,800 Net Book Value 63,10 0 39,80 0 25,10 0 15,80 0 10,00 0 Sales revenue Cost of sales Gross profit Depreciation Reported profit 50,00 0 25,00 0 36,90 0 11,90 0 50,00 0 25,00 0 23,30 0 1,700 1,700 50,00 0 25,00 0 14,69 0 10,31 0 50,00 0 25,00 0 9,270 9,270 15,73 0 50,00 0 25,00 0 5,800 5,800 19,16 0

14. 14 WHAT IS THE LIFE OF AN ASSET? Experience Experience General policy General policy ‘Standardized’ systems ‘Standardized’ systems IRS Class Life Asset Depreciation Range (CLADR) Asset Description Lower Limit ADR Life Upper Limit Automobiles, taxis Agricultural equipment Hydraulic parts Manufacturing Rubber products Rubber products Electrical equipment Electrical equipment Ferrous metals Ferrous metals Furniture Furniture5840119.514.586105014121810712601714.521.512 Complete CLADR tables in Revenue Procedure 83-35 (IRS)

15. 15 ACCELERATED COST RECOVERY SYSTEM (ACRS) 1. Ascribed assets to proper class 2. Assign prescribed depreciation rates 3. Apply declining-balance depreciation (which switches to straight line depreciation (see table)  The method assumes no residual asset value at the end of its service life.  The method assumes the asset is acquired during the first year, hence 50% of the first years depreciation is charged.  Upon salvage and difference between salvage value and Book Value determines the tax liability.

16. 16 ACCELERATED COST RECOVERY SYSTEM (ACRS) All assets fall into one of four classes of property: All assets fall into one of four classes of property: 3-year property includes cars and light vehicles, machinery and equipment used in research and experimentation and all equipment having an CLADR of 4 years or less. 3-year property includes cars and light vehicles, machinery and equipment used in research and experimentation and all equipment having an CLADR of 4 years or less. 5-year property includes all personal property not included in any other class, most production equipment and public utility property with 5 < CLADR < 18 years. 5-year property includes all personal property not included in any other class, most production equipment and public utility property with 5 < CLADR < 18 years. 10-year property includes public utility property with 10-year property includes public utility property with 18 < CLADR < 25 years and depreciable buildings and structural components with CLADR < 12.5 years. 18 < CLADR < 25 years and depreciable buildings and structural components with CLADR < 12.5 years. 15-year property includes depreciable buildings with CLADR > 12.5 years and public utility property with CLADR > 25 years. 15-year property includes depreciable buildings with CLADR > 12.5 years and public utility property with CLADR > 25 years.

17. 17 ACCELERATED COST RECOVERY SYSTEM (ACRS) Recovery year 3-year property 5-year property 10-year property 15-year property 1251585 238221410 33721129 421108 521107 6107 796 896 996 1096 116 126 136 146 156

18. 18 ACRS - EXAMPLE An asset classified as a 5-year property is acquired for a total cost of 5,000 m.u. An asset classified as a 5-year property is acquired for a total cost of 5,000 m.u. The estimated salvage value is 1,000 m.u. at any time after acquisition The estimated salvage value is 1,000 m.u. at any time after acquisition What depreciation charge is made each year? What is the impact of salvage?

19. 19 ACRS - EXAMPLE End of year, t Depreciation charges during year t Book value at end of year t 05,000 1 0.15 * 5,000 = 750 4,250 2 0.22 * 5000 = 1,100 3,150 3 0.21 * 5000 = 1,050 2,100 4 1,050 5 0 Acquisition cost = 5,000, life = 5 years

20. 20 ACRS - EXAMPLE End of year, t Depreciation charges during year t Book value at end of year t 05,000 1 0.15 * 5,000 = 750 4,250 2 0.22 * 5000 = 1,100 3,150 3 0.21 * 5000 = 1,050 2,100 4 1,050 5 0 Acquisition cost = 5,000, life = 5 years, Salvage value = 1,000 If asset sold before fully depreciated no depreciation can be charged in the year of salvage. Consider salvage in year 3

21. 21 ACRS - EXAMPLE End of year, t Depreciation charges during year t Book value at end of year t 05,000 1 0.15 * 5,000 = 750 4,250 2 0.22 * 5000 = 1,100 3,150 3 Asset sold during this year 4 5 Acquisition cost = 5,000, life = 5 years, Salvage value = 1,000 Consider salvage in year 3 Book value at time of disposal = 3,150. Salvage value = 1,000. Write-off to Profit and Loss Account = 3,150 - 1,000 = 2,150 m.u.

22. 22 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Introduced into the U.S. in 1986 through the Tax Reform Act Introduced into the U.S. in 1986 through the Tax Reform Act Still used Still used Similar to ACRS but Similar to ACRS but Increased number of property classes Increased number of property classes Revised depreciation rates Revised depreciation rates Some realignment of class definitions Some realignment of class definitions No distinction between new and used property No distinction between new and used property Salvage value is still ignored Salvage value is still ignored 50% depreciation in first year + 50% in final year + 1 50% depreciation in first year + 50% in final year + 1 Quick look at the classes and depreciation rates

23. 23 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Personal Property Personal Property All business property, other than structural components, contained in or attached to buildings or real property is tangible personal property. Examples include machinery, vehicles used for business & equipment. All business property, other than structural components, contained in or attached to buildings or real property is tangible personal property. Examples include machinery, vehicles used for business & equipment. Copyrights and patents are considered to be intangible personal property Copyrights and patents are considered to be intangible personal property Real Property Real Property Property that is permanently part of the land. Property that is permanently part of the land. Buildings and their structural components Buildings and their structural components Air conditioning systems, plumbing & wiring Air conditioning systems, plumbing & wiring

24. 24 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Personal Property classes Personal Property classes 3-year property - special material handling devices and special tools for manufacturing. ADR < 4 years 3-year property - special material handling devices and special tools for manufacturing. ADR < 4 years 5-year property - autombiles, light and heavy trucks, computers, copiers, semiconductor manufacturing equipment, equipment used in research. 4 < ADR < 10 years 5-year property - autombiles, light and heavy trucks, computers, copiers, semiconductor manufacturing equipment, equipment used in research. 4 < ADR < 10 years 7-year property - property not assigned to another class, office furniture, fixtures, single-purpose agricultural structures. 10 < ADR < 16 years 7-year property - property not assigned to another class, office furniture, fixtures, single-purpose agricultural structures. 10 < ADR < 16 years 10-year property - assets used in petroleum refining, manufacture of castings, forging, manufacture of tobacco products and some food products. 16 < ADR < 20 years 10-year property - assets used in petroleum refining, manufacture of castings, forging, manufacture of tobacco products and some food products. 16 < ADR < 20 years

25. 25 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Personal Property classes Personal Property classes 15-year property - telephone distribution equipment, municipal water and sewerage treatment plants. 20 < ADR < 25 years 15-year property - telephone distribution equipment, municipal water and sewerage treatment plants. 20 < ADR < 25 years 20-year property - vessels, barges and tugs and municipal sewers. 25 years < ADR 20-year property - vessels, barges and tugs and municipal sewers. 25 years < ADR Real Property classes Real Property classes Residential property - includes apartment buildings and rental houses. [Straight line depreciation 27.5 years with half-year convention 1 ] Residential property - includes apartment buildings and rental houses. [Straight line depreciation 27.5 years with half-year convention 1 ] Nonresidential property - office buildings, warehouses, manufacturing facilities, refineries, mills, parking facilities, fences and roads. [Straight line depreciation 31.5 years with half-year convention 1 ] Nonresidential property - office buildings, warehouses, manufacturing facilities, refineries, mills, parking facilities, fences and roads. [Straight line depreciation 31.5 years with half-year convention 1 ] 1 Half-year’s depreciation in year of purchase & year of disposal 1 Half-year’s depreciation in year of purchase & year of disposal

26. 26 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Recovery year 3-year property 5-year property 7-year property 10-year property 15-year property 20-year property 133.3320.0014.2910.005.003.75 244.4432.0024.4918.009.507.22 314.8119.2017.4914.408.556.68 47.4111.5212.4911.527.706.18 511.528.929.226.935.71 65.768.927.376.235.28 78.926.555.904.89 84.466.555.904.52 96.555.904.46 106.555.904.46 113.285.904.46 125.904.46

27. 27 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) Recovery year 3-year property 5-year property 7-year property 10-year property 15-year property 20-year property 135.904.46 145.904.46 155.904.46 162.954.46 174.46 184.46 194.46 204.46 212.23