DEPRECIATION

Chapter 11
DEPRECIATION
• The word depreciation is defined as a “decrease in value.”
• This is somewhat ambiguous because value has several meanings. In
economic analysis, value may refer to either market value or value to
the owner.
• For example, an assembly line is far more valuable to the manufacturing firm
that it was designed for, than it is to a used equipment market. Thus, we now
have two definitions of depreciation:
• a decrease in value to the market or
• a decrease to the owner.
• Depreciation is an income tax deduction that allows a business to
recover the cost basis of certain property.
DEPRECIATION
• Deterioration
• A machine may depreciate because it is deteriorating, or wearing out and no
longer performing its function as well as when it was new.
• Car maintenance observed deterioration due to failure of individual parts (such
as fan belts, mufflers, and batteries) and the wear on components (such as
bearings, piston rings, and alternator brushes).
• Obsolescence
• Depreciation is also caused by obsolescence. A machine that is in excellent
working condition, and serving a needed purpose, may still be obsolete.
• Generations of computers have followed this pattern. The continuing stream of
newer models makes older ones obsolete.
DEPRECIATION
We now have three distinct definitions of depreciation:
1. Decline in market value of an asset.
2. Decline in value of an asset to its owner.
3. Systematic allocation of an asset’s cost over its depreciable life.
Depreciation and Expenses

• Business costs are generally either expensed or depreciated.

• Expensed items, such as labor, utilities, materials, and insurance, are part of
regular business operations and are “consumed” over short periods of time
(sometimes recurring).
• These costs do not lose value gradually over time.
• For tax purposes they are subtracted from business revenues when they
occur.
• Expensed costs reduce income taxes because businesses are able to write off
their full amount when they occur.
Depreciation and Expenses
• In contrast, business costs due to capital assets (buildings, forklifts, chemical plants, etc.)
are not fully depreciated when they occur.
• Capital assets lose value gradually and must be written off or depreciated over an
extended period.
• For instance, consider an injection-molding machine used to produce the plastic beverage
cups found at sporting events. The plastic pellets melted into the cup shape lose their
value as raw material directly after manufacturing. The raw material cost for production
material (plastic pellets) is expensed immediately. On the other hand, the
injection-molding machine itself will lose value over time, and thus its costs (purchase
price and installation expenses) are written off (or depreciated) over its depreciable life or
recovery period.
Depreciation and Expenses
• Depreciation is a noncash cost that requires no exchange of dollars.
• Companies do not write a check to someone to pay their depreciation
expenses.
• Rather, these are business expenses that are allowed by the
government to offset the loss in value of business assets.
• Depreciation deductions reduce the taxable income of businesses and
thus reduce the amount of taxes paid.
• Since taxes are cash flows, depreciation must be considered in
after-tax economic analyses.
Depreciation
In general, business assets can be depreciated only if they meet the
following basic requirements:
• The property must be used for business purposes to produce income.
• The property must have a useful life that can be determined, and this
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.
Types of Business Property

• The rules for depreciation are linked to the classification of business

property as either tangible or intangible.
• Tangible property is further classified as either real or personal.
•
• Many different types of property that wear out, decay, or lose value
can be depreciated as business assets
• For example: copy machines, helicopters, buildings, interior
furnishings, production equipment, and computer networks. Almost
all tangible property can be depreciated.
• One important and notable exception is land, which is never
depreciated.
• Land does not wear out, lose value, or have a determinable useful life
and thus does not qualify as a depreciable property. Rather than
decreasing in value, most land becomes more valuable as time
passes.
• In addition to the land itself, expenses for clearing, grading,
preparing, planting, and landscaping are not generally depreciated
because they have no fixed useful life.
• Other tangible property that cannot be depreciated includes factory
inventory, containers considered as inventory, and leased property.
Depreciation Calculation Fundamentals
HISTORICAL DEPRECIATION METHODS

• straight-line,
• sum-of-the years’-digits,
• and declining balance methods
Straight-Line Depreciation
• To calculate the constant annual depreciation charge, the total
amount to be depreciated, B − S, is divided by the depreciable life, in
years, N
Sum-of-Years’-Digits Depreciation

• Another method for allocating an asset’s cost minus salvage value over its
depreciable life is called sum-of-years’-digits (SOYD) depreciation.
• This method results in larger than-straight-line depreciation charges during
an asset’s early years and smaller charges as the asset nears the end of its
depreciable life.
• Each year, the depreciation charge equals a fraction of the total amount to
be depreciated (B−S). The denominator of the fraction is the sum of the
years’ digits.
• For example, if the depreciable life is 5 years, 1+2+3+4 + 5 = 15 = SOYD.
Then 5/15, 4/15, 3/15, 2/15, and 1/15 are the fractions from Year 1 to Year
5. Each year the depreciation charge shrinks by 1/15 of B − S. Because this
change is the same every year, SOYD depreciation can be modeled as an
arithmetic gradient, G.
Declining Balance Depreciation

• Declining balance depreciation applies a constant depreciation rate to

the property’s declining book value.
• These are 150 and 200% of the straight-line rate. Since 200% is twice
the straight-line rate, it is called double declining balance, or DDB
MODIFIED ACCELERATED COST RECOVERY
SYSTEM (MACRS)
• The modified accelerated cost recovery system (MACRS) is a
depreciation system used for tax purposes in the U.S.
• MACRS depreciation allows the capitalized cost of an asset to be
recovered over a specified period via annual deductions.
• The modified accelerated cost recovery system (MACRS) allows a
business to recover the cost basis of certain assets that deteriorate
over time.
• MACRS allows for faster depreciation in the first years of an asset's
life and slows depreciation later on.
• Salvage values are assumed to be zero in MACRS
• The modified accelerated cost recovery system (MACRS) is the proper
depreciation method for most assets.
• MACRS allows for greater accelerated depreciation over longer time
periods. This is beneficial since faster acceleration allows individuals
and businesses to deduct greater amounts during the first few years
of an asset's life, and relatively less later.
• Depreciation using MACRS can be applied to assets such as computer
equipment, office furniture, automobiles, fences, farm buildings,
racehorses, and so on.
• There are two key MACRS deprecation systems.
• General depreciation system (GDS)
• Alternative depreciation system (ADS).
• These two systems have different recovery periods and depreciation
methods.
• For the most part, GDS is used, although in special cases ADS can be
used.
• The general depreciation system uses the declining balance method, which
allows for a larger deprecation expense to be recorded in the early years
and smaller amounts in the later years.
• The alternative deprecation system allows depreciation to be taken over a
longer period of time.
• The GDS is best used for assets that depreciate quickly, such as computers
and other technology.
• Meanwhile, the ADS must be used in certain instances, such as property
used in a farming business, property that is exempt from taxation, or any
property used outside the U.S. ADS must also be used for any listed
property used 50% or less in a business during the tax year.
Assets and Useful Life in Years
Description of Assets Useful Life (Years)
Tractors, racehorses, rent-to-own property, etc. 3
Automobiles, buses, trucks, computers, office
5
machinery, breeding cattle, furniture, etc.
Office furniture, fixtures, agricultural machinery, railroad
7
track, etc.
Vessels, tugs, agricultural structure, tree or vine bearing
10
fruits or nuts, etc.
Municipal waste water treatment plant, restaurant
property, natural gas distribution line, land
15
improvements, such as shrubbery, fences, and
sidewalks, etc.
Farm buildings, certain municipal sewers, etc. 20
Water utility property, certain municipal sewers, etc. 25
Any building or structure where 80% or more of its gross
27.5
rental income is from dwelling units
An office building, store, or warehouse that is not
residential property or has a class life of less than 27.5 39
years
• Once the MACRS property class is known, as well as the
placed-in-service date and the cost basis, the year-to-year
depreciation deductions can be calculated for GDS assets over their
depreciable life using
Percentage Tables (by Internal Revenue
Service (IRS))
• Remember the key points in using MACRS:
• (1) what type of asset you have, and whether it qualifies as
depreciable property,
• (2) the amount you are depreciating [cost basis], and
• (3) when you are placing the asset in service.
Solution is Explained in next slide
Years DDB SL MACRS (%rate) Cumulative
1 =(2/5)x(100-0)=40 =(100-0)/5 = 20 Select greater depreciation by 20
As in MACRS 1st year is considered st
As in MACRS 1 year is considered compare both values of DDB and
as half year depreciation so divide it as half year depreciation so divide SL, we select:
by 2 i.e. 40/2 = 20 it by 2 i.e. 20/2 = 10
20 (DDB)

2 =(2/5)x(100-20)=32.2 =(100-20)/4.5 = 17.78 32.2 (DDB) 52.2

3 =(2/5)x(100-52.2)=19.20
4.5 year is taken, because the first
year is considered as half year so
remaining half year is added to
succeeding years in SL method i.e.
4+0.5= 4.5
=(100-52.2)/3.5 = 13.71 19.20 (DDB) 71.20

4 =(2/5)x(100-71.20)=11.52 =(100-71.20)/2.5 = 11.52 11.52 (Select SL) 82.72

5 =(2/5)x(100-82.72)=6.912 =(100-82.72)/1.5 = 11.52 11.52 (SL) 94.24
6 = (1/2)x 11.52 5.76 (SL) 100
Alternate Method for Example 11-5
Years MACRS (% rate, pt) Depreciation (dt) = (pt x cost Book Value (BVt)
Take values from basis )
Table 11-3 (see slide
38)
1
20.00% 20% x 100 = 20 100-20 =80

2
32.00% 32.00% x 100 =32 80-32 = 48

3
19.20% 19.20% x100 =19.20 48-19.20 = 28.8

4
11.52% 11.52% x100 =11.52 28.8-11.52=17.28

5
11.52% 11.52% x100= 11.52 17.28-11.52=5.76

6
5.76% 5.76% x100 = 5.76 5.76-5.76= 0

Total 100