Chapter 7

Depreciation and Income Taxes

 Asset Depreciation

 Book Depreciation

 Tax Depreciation

 How to Determine
“Accounting Profit”

 Corporate Taxes
The objective of Chapter 7 is to explain
how depreciation affects income taxes,
and how income taxes affect economic
decision making.
Depreciation is the decrease in value of
physical properties with the passage of time.

 It is an accounting concept, a non-cash cost, that

establishes an annual deduction against before-tax
income.
 It is intended to approximate the yearly fraction of
an asset’s value used in the production of income.
Property is depreciable if
 it is used in business or held to produce income.
 it has a determinable useful life, longer than one
year.
 it is something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural
causes.
 it is not inventory, stock in trade, or investment
property.
 Depreciation
Definition: Loss of value for a fixed asset
Example: You purchased a car worth $15,000 at the beginning of year 2000.

p
End of Market Loss of
Year Value Value
0 $15,000

Depreciation
1 10,000 $5,000
2 8,000 2,000

3 6,000 2,000

4 5,000 1,000

5 4,000 1,000
 Depreciation Concept
Depreciation is viewed as a part of business expenses that reduce taxable
income.

Economic Depreciation (Purchase Price – Market Value) Economic

losses due to both physical deterioration and technological
obsolescence)

Accounting Depreciation
Systematic allocation of the initial cost of an asset in parts over time
or decline in value over time known as its depreciable life.
 Asset Depreciation

Physical
Economic depreciation depreciation
the gradual decrease in
utility in an asset with
use and time Functional
depreciation

Depreciation
Accounting depreciation Book
The systematic allocation depreciation
of an asset’s value in
portions over its
depreciable life—often
used in engineering Tax
economic analysis depreciation
Factors to Consider in Asset Depreciation

 What is the depreciable life of the asset?

 What is asset’s value at the end of its useful life?

 What is the cost of the asset?

 What method of depreciation do we choose?

 What Can Be Depreciated?
 Assets used in business or held for production of income

 Assets having a definite service (useful) life and a life

longer than one year

 Assets that must wear out, become obsolete or lose value

A qualifying asset for depreciation must satisfy all of the three conditions
above. Depreciable property includes buildings, machinery, equipment,
vehicles, and some intangible properties. If an asset has no definite service
life, the asset can not be depreciated such as land.
Example 8.1 Cost Basis
of an asset represents the total cost that is claimed as an expense over an asset's
life and generally includes the followings

Cost of a new hole-punching machine

(Invoice price) $62,500
+ Freight 725
+ Installation labor 2,150
+ Site preparation 3,500
Cost of Machine (Cost basis) to use in $68,875
depreciation calculation
 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 5 6 7
Automobiles, taxis 2.5 3 3.5
Buses 7 9 11
Light trucks 3 4 5
Heavy trucks (concrete ready-mixer) 5 6 7
Railroad cars and locomotives 12 15 18
Tractor units 5 6 7
Vessels, barges, tugs, and water transportation system 14.5 18 21.5
Industrial steam and electrical generation and or 17.5 22 26.5
distribution systems
Manufacturer of electrical and non-electrical machinery 8 10 12
Manufacturer of electronic components, products, and 5 6 7
systems
Manufacturer of motor vehicles 9.5 12 14.5
Telephone distribution plant 28 35 42
 Types of Depreciation
 Book Depreciation
 Firms report depreciation and net income to investors /
stockholders (as balance sheet or income statement)
 In pricing decision

 Tax Depreciation
 In calculating income taxes for the IRS
 In engineering economics, we use depreciation in the
context of tax depreciation
 Book Depreciation Methods
 Three different methods can be used to calculate the periodic
depreciation allowances for financial reporting.

 Types of Depreciation Methods:

1. Straight-Line Method
2. Declining Balance Method
3. Sum of Digit Method (SOYD)
4. Unit Production Method
 Straight – Line (SL) Method
Principle
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 – SVn) / N, and constant for all n.
• Book Value
Bn = I – n (D)
where I = cost basis
SVn = Salvage value
N = depreciable life
Example 8.2 – Straight-Line Method
Annual Depreciation
$10,000
Book Value

Total depreciation at end of life

D1
$8,000 I = $10,000
D2
N = 5 Years
$6,000 S = $2,000
D3
D = (I - S)/N
B1 D4
$4,000 n Dn Bn
B2 1 1,600 8,400
B3 D5
2 1,600 6,800
$2,000 B4
3 1,600 5,200
B5
4 1,600 3,600
0 5 1,600 2,000
1 2 3 4 5 n
Pause and solve
Acme purchased a coordinate measurement machine
(CMM). The cost basis is $120,000 and it has a seven year
depreciable life. Acme estimates a salvage value of
$22,000 at the end of seven years. Determine the annual
depreciation amounts using SL depreciation. Tabulate the
annual depreciation amounts and book value of the CMM
at the end of each year.
 Declining Balance Method
Principle:
A fixed asset as providing its service in a decreasing
fashion.
Formula The fraction,  = (1/N) (multiplier)
• Annual Depreciation

Dn  Bn1   (1   ) n1
• Book Value
B  (1   ) n where 0 <  < 2(1/N)
Note: if  is chosen to be the upper bound,  = 2/N, we call it a 200% DB
or double declining balance method. As N increases,  decreases. R = 1.5/N
when 150% declining balance is being used.
 Example 8.3 – Declining Balance Annual Depreciation
Method
Book Value
$10,000 I = $10,000
 = 1/N
N = 5 years

Total depreciation at end of life

D1 S = $778
$8,000
Dn =  Bn 1
$6,000 =  I (1 -  n 1
D2 Bn  I (1   ) n
B1 n Dn Bn
$4,000
B2 0 $10,000
D3
1 $4,000 6,000
$2,000 2 2,400 3,600
D4 3 1,440 2,160
B3
$778 D5 4 864 1,296
0 B4 B5 5 518 778
1 2 3 4 5 n
Example 8.4
Declining Balance (DB) Switching to SL

Asset: Invoice Price $9,000

Freight 500
Installation 500
Depreciation Base $10,000
Salvage Value 0
Depreciation 200% DB
Depreciable life 5 years

• SL Dep. Rate = 1/5

•  (DDB rate) = (200%) (SL rate)
= 0.40
Sum of Digit Method (SYD)
Principle
The sum of the years' digits depreciation (SYD
depreciation) is one method for calculating accelerated
depreciation.

Doing so means that most of the depreciation associated

with an asset is recognized in the first few years of
its useful life. This method is also called the SYD method.
Applicable percentage = Number of years of estimated life
remaining at the beginning of the year
SYD

Example 8.5

ABC Company purchases a machine for

$100,000. It has an estimated salvage value of
$10,000 and a useful life of five years.
Note: This means that the total amount of depreciation will be $90,000
spread over its useful life of 5 years.
 Year Remaining Applicable Annual
estimated useful percentage Depreciation
life at beginning of
year

1 5 5/15 33.33% $30,000

2 4 4/15 26.67 24,000
3 3 3/15 20.00 18,000
4 2 2/15 13.33 12,000
5 1 1/15 6.67 6,000
Totals 15 100% $90,000
Pause and Solve

 A million–dollar ($ 1000,000) oil drilling rig has a 6 year

depreciable life and a $ 75,000 salvage value at the end of
the time. Show depreciation schedule using Straight line
depreciation, Double declining balance depreciation and
Sum of years digit depreciation. (6)
 Units-of-Production Method
Principle
 The number of service units will be consumed in that period.
 This method of charging depreciation on the asset is based on the
units produced during the year. The estimated total production of the
asset is the criteria for providing depreciation.
Formula
Example 8.6
 Given: I = $55,000, S = $5,000, Total service units = 250,000
miles, usage for this year = 30,000 miles

 Solution:
30, 000
Dep  ($55, 000  $5, 000)
250, 000
 3 
  ($50, 000)
 25 
 $6, 000
Solve the problem
Cube textiles purchased Year Production
machinery for $200000 on 1st January.
It has an estimated useful life of 10
years and an estimated residual value of
1-3 2000 units per year
₹20000. The firm sells the asset at the
residual value at the end of the 4-7 1500 units per year
10th year. The machine has an expected
production of 15000 units during its
useful life. Now the production 8-10 1000 units per year
pattern is as follows:
Depreciable Value = Original cost –scrap value
= 200,000-20,000 = $ 180,000
Annual depreciation = Depreciable value x
Units production during the year/Estimated total production

Year Annual Depreciation

1-3 180,000 x 2000/15,000 = $ 24,000
4-7 180,000 x 1500/15,000 = $ 18,000
8-10 180,000 x 1000/15,000 = $ 12,000
The Modified Accelerated Cost Recovery System (MACRS) is
the principle method for computing depreciation for
property in engineering projects.
It consists of two systems, the main system called

General Depreciation System (GDS) and

Alternative Depreciation System (ADS).

Modified Accelerated Cost Recovery Systems (MACRS)

Personal Property (includes assets such as machinery, vehicles, equipment,

furniture, and similar items)

 Depreciation method based on DB method switching to SL

 Half-year convention
 Zero salvage value

Real Property [Real properties are classified into two categories:

1. residential rental property and 2. commercial building or properties]

 SL Method
 Mid-month convention
 Zero salvage value
 MACRS Property Classifications (IRS Publication 534)

Recovery Period ADR Midpoint Class Applicable Property

3-year Special tools for manufacture of plastic

ADR  4 products, fabricated metal products, and
motor vehicles.
5-year Automobiles, light trucks, high-tech
4  ADR  10 equipment, equipment used for R&D,
computerized telephone switching systems
7-year Manufacturing equipment, office furniture,
10  ADR  16 fixtures
10-year Vessels, barges, tugs, railroad cars
16  ADR  20
15-year Waste-water plants, telephone- distribution
20  ADR  25 plants, or similar utility property.
20-year Municipal sewers, electrical power plant.
25  ADR
27.5-year Residential rental property

39-year Nonresidential real property including

elevators and escalators
ADR: Asset Depreciation Range
 MACRS Table The percentages shown in the table use the half year convention, all the assets are
placed in service at mid-year and will have zero salvage value.

 Cost of assets (I) = $120,000

 Salvage value(S)= $ 0
 Useful life = 5 year
 Depreciation = 3-year
property MACRS
Example 8.7 MACRS Depreciation
Asset cost = $10,000
Property class = 5-year recovery period
DB method = Half-year convention, zero salvage value,
200% DB switching to SL

20% 32% 19.20% 11.52% 11.52% 5.76%

$2000 $3200 $1920 $1152 $1152 $576

Full Full Full Full

1 2 3 4 5 6
Half-year Convention
Taxable Income and Income Taxes
Item

Gross Income
Expenses
Cost of goods sold (revenues)
Depreciation
Operating expenses
Taxable income
Income taxes

Net income
 Example 8.8 - Net Income Calculation
Item Amount
Gross income (revenue) $50,000
Expenses
Cost of goods sold 20,000
Depreciation 4,000
Operating expenses 6,000

Taxable income 20,000

Taxes (40%) 8,000
Net income $12,000
 Example 8.9 – Cash Flow versus Net Income
Item Income Cash Flow

Gross income (revenue $50,000 $50,000

Expenses
Cost of goods sold 20,000 -20,000
Depreciation 4,000
Operating expenses 6,000 -6,000

Taxable income 20,000

Taxes (40%) 8,000 -8,000
Net income $12,000
Net cash flow $16,000
Example 8.10 - 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?

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:
First $50,000 @ 15% $7,500
$25,000 @ 25% $6,250
$25,000 @ 34% $8,500
$232,000 @ 39% $90,480
Total taxes $112,730
Average tax rate:

Total taxes = $112,730

Taxable income = $332,000
$112,730
Average tax rate =
$332,000
 33.95%

Marginal tax rate:

Tax rate that is applied to the last dollar
earned
39%
Capital Gains and Ordinary Gains

Capital gains

Total gains
Ordinary gains
or
depreciation recapture

Cost basis Book value Salvage value

 There are many different types of taxes.

 Income taxes are assessed as a function of gross

revenues minus allowable expenses.
 Property taxes are assessed as a function of the value
of property owned.
 Sales taxes are assessed on the basis of purchase of
goods or services.
 Excise taxes are federal taxes assessed as a function of
the sale of certain goods or services often considered
nonnecessities.
We will focus on income taxes.
Taking taxes into account changes our
expectations of returns on projects, so
our MARR (after-tax) is lower.
The after-tax MARR should be at least the
tax-adjusted weighted average cost of
capital (WACC).

 = fraction of a firm’s pool of capital borrowed

from lenders
t = effective income tax rate as a decimal
ib = before-tax interest paid on borrowed capital
ea = after-tax cost of equity capital