1. Copyright Oxford University Press 2009
Chapter 11 Depreciation
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2. 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
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3. 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
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4. 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)
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5. 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,…
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6. 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,…
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7. 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
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8. 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.
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9. 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.
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10. 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
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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
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
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12. 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)
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13. 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
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14. 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
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15. 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
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16. 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
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17. 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.
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18. 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
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19. Applying MACRS-GDS Depreciation
(11-5)
where
dt = Depreciation charge in year t
B = Cost basis
rt = Appropriate MACRS percentage rate
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20. 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
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21. 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
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22. 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
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23. 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
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24. 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
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25. 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.
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26. 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
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27. 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%
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28. 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%)
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29. 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
$2,000,000 1
1.819%
($ )(1.819%)
$36,380
1,963,620 2
2.564%
( )(2.564%)
51,280
1,912,340 3
( )(2.564 %)
1,861,060 4
1,809,780 5
1,758,500 6
(7.5/12)( )(2.564 %)
32,100
1,726,400
273,600
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30. Example 11-8 Comparison of Depreciation MethodsSL
SOYD
MACRS
DDB
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31. 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.
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32. Depreciation and Asset Disposal
$4000
Capital
Gain
$2000
Depreciation
Recapture
$5000
Depreciation
Recapture
$3000
Loss
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33. 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
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34. Example 11-10 Depreciation and Asset Disposal1)
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 – = (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 – = (Recaptured Depreciation)
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35. 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 = (Loss)
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36. 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
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37. 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
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38. 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
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39. 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%
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40. 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
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41. Example 11-13 Percentage Depletion
Gross income = $250,000
Mining expenses = $210,000
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42. 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.
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