Asset Depreciation Lecture No 30 Chapter Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Chapter Opening Story Delta Airlines has invested $100 million in improving luggage handling technology and equipment How does the cost of this baggage handling system be recognized in reporting the financial position of the airlines? At issue: What is the cost of owning a piece of equipment? Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Depreciation • Changes in Market Value End of Year 2015 2016 2017 2018 2019 2020 Contemporary Engineering Economics, th edition Park Estimated Market Value $25,000 19,000 16,000 14,000 12,000 10,000 Loss of Value $6,000 3,000 2,000 2,000 2,000 Copyright © 2016 by Pearson Education, Inc All Rights Reserved Depreciation Definition: Loss of value for a fixed asset Example: You purchased a vehicle worth $25,000 at the beginning of year 2016 Classification of Types of Depreciation Economic Depreciation Economic depreciation = Purchase price − market value Accounting Depreciation Based on matching concept; a fraction of the cost of the asset is chargeable as an expense in each of the accounting period Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Classification of Depreciation Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Why Do We Consider Depreciation? Business Expense: Depreciation is viewed as a part of business expenses that reduce taxable income Contemporary Engineering Economics, th edition Park Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income − Income taxes Net income (profit) Copyright © 2016 by Pearson Education, Inc All Rights Reserved Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved What Can Be Depreciated? o Assets used in business or held for production of income o Assets having a definite useful life and a life longer than one year o Assets that must wear out, become obsolete or lose value Any qualifying asset for depreciation must satisfy all of the three conditions above Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cost Basis Without Trade-in Allowance Contemporary Engineering Economics, th edition Park With Trade-in Allowance Copyright © 2016 by Pearson Education, Inc All Rights Reserved Useful Life and Salvage Value Useful life Adopt the Asset Depreciation Ranges (ADR) published by the IRS Salvage value Estimated asset value at the end of its useful life If not possible, a 10% rule (10% of the initial value) could be adopted for depreciation purpose Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Types of Depreciation Book Depreciation Used in reporting net income to investors/stockholders Used in pricing decision Tax Depreciation Used in calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Types of Depreciation Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Book versus Tax Depreciation: An Overview Component of Depreciation Book Depreciation Tax depreciation (MACRS) Based on the actual cost of the asset, plus all incidental costs such as freight, site preparation, installation, etc Cost basis Salvage value Same as for book depreciation Estimated at the outset of Salvage value is zero for all depreciation analysis If the depreciable assets final book value does not equal the estimated salvage value, we may need to make adjustments in our depreciation calculations Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Component of Depreciation Depreciable life Method of depreciation Book Depreciation Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs) Firms may select from the following: o Straight-line o Accelerated methods (declining balance, double declining balance, and sum-ofyears’ digits) o Units-of-proportion Contemporary Engineering Economics, th edition Park Tax depreciation (MACRS) Eight recovery periods—3, 5, 7, 10, 15, 20, 27.5, or 39 years—have been established; all depreciable assets fall into one of these eight categories Exact depreciation percentages are mandated by tax legislation but are based largely on DDB and straightline methods The SOYD method is rarely used in the U.S except for some cost analysis in engineering valuation Copyright © 2016 by Pearson Education, Inc All Rights Reserved Summary • • • The entire cost of replacing a machine cannot be properly charged to any one year’s production; rather, the cost should be spread (or capitalized) over the years in which the machine is in service The cost charged to operations during a particular year is called depreciation From an engineering economics point of view, our primary concern is with accounting depreciation, the systematic allocation of an asset’s value over its depreciable life Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved • • Accounting depreciation can be broken into two categories: Book depreciation—the method of depreciation used for financial reports and pricing products Tax depreciation—the method of depreciation used for calculating taxable income and income taxes; it is governed by tax legislation The four components of information required to calculate depreciation are (a) cost basis, (b) salvage value, (c) depreciable life, and (d) depreciation method Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... Accounting depreciation can be broken into two categories: Book depreciation the method of depreciation used for financial reports and pricing products Tax depreciation the method of depreciation. .. Depreciation Depreciable life Method of depreciation Book Depreciation Firms may select their own estimated useful lives or follow government guidelines for asset depreciation ranges (ADRs) Firms may... Reserved Depreciation Definition: Loss of value for a fixed asset Example: You purchased a vehicle worth $25,000 at the beginning of year 2016 Classification of Types of Depreciation Economic Depreciation