Depreciation Methods Lecture No 31 Chapter Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Book Depreciation Methods • Purpose: Used in reporting net income to stockholders/investors • Types of Depreciation Methods o Straight-line method o Declining balance method o Unit production method Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Straight-Line (SL) Method Principle: A fixed asset as providing its service in a uniform fashion over its life Formula o Annual depreciation Dn = (I − S) / N, and for all n o Book value Bn = I − n (D) where I = cost basis S = Salvage value N = depreciable life Example: • I = $10,000 • S = $2,000 • N = years constant Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Declining Balance (DB) Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Example: o o o o I = $10,000 S = $778 N = years α = 0.40 D n Bn (1 ) n Bn I(1 )n where < α < 2(1/N) Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 9.5: DB Switching to SL Given: o Depreciation Base =$10,000 o Salvage Value = o Depreciation rate = 200% DB o Depreciable life = years Without Switching Find: When switching to SL • SL Dep Rate = 1/5 • α = (200%) (1/5) = 0.40 Contemporary Engineering Economics, th edition Park Note: Without switching, we have not depreciated the entire cost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits Copyright © 2016 by Pearson Education, Inc All Rights Reserved Case 1: S < BN • Switch from DB to SL after n’ Contemporary Engineering Economics, th edition Park Example: S = Copyright â 2016 by Pearson Education, Inc All Rights Reserved Case 2: S > BN • No further depreciation after n” • Example: S = $2,000 Note: Tax law does not permit a business to depreciate assets below their salvage value Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Units-of-Production Method • Given: I = $55,000, S = $5,000, total Principle: Service units will be consumed in a non-timephased fashion service unit = 250,000 miles, service units consumed = 30,000 miles • Find: Dn • Solution: Formula: Service units consumed � � during year n Dn (I _ S ) � � Total service units � � � � � � � � I = Initial investment S = Salvage value Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Tax Depreciation Purpose: To determine the income taxes owed for the IRS • Assets placed in service prior to 1981 o Used the book depreciation methods (SL, DB, SOYD) • Assets placed in service from 1981 to 1986 o Used the ACRS (Accelerated Cost Recovery System) Table • Assets placed in service from 1986 to present o Used the MACRS (Modified ACRS) Table Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Modified Accelerated Cost Recovery Systems (MACRS) Personal Property • Depreciation schedule based on the DB method switching to SL • Half-year convention • Zero salvage value Real Property • SL Method • Mid-month convention • Zero salvage value Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved MACRS Depreciation Schedules for Personal Property with Half-Year Convention Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Comparison Between DDB with Switching to SL and MACRS Method Conventional DDB Method o o o o Cost basis: $10,000 Salvage value: $0 Depreciable life: years DB rate: 200% MACRS Method o Property class: 5-year o Salvage value: $0 o Half-year convention Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved MACRS for Real Property Types o 27.5-year (residential) o 39-year (commercial) SL Method Mid-month convention Zero salvage value Example: D1 = (9.5/12)(100%/27.5) = 2.8788% Placed a residential property in service in March Find the depreciation allowance in year Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Depletion • Depletion is the physical reduction of natural resources (not time-phased) • Two types of depletion o Cost depletion o Percentage depletion Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cost Depletion Concept: Units-ofproduction method Cost depletion formula Example: o Cost basis = $120,000, o Total recoverable volume = 1.5MBF o Amount sold this year = 0.5 MBF o Allowed depletion this year? Depletion allowance = 0.5 MBF $120,000 1.5 MBF $40, 000 Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Percentage Depletion Concept: Based on a prescribed percentage of the gross income from the property during the tax year Example 9.11 • Given: • Solution Basis = $30 million, Total recoverable volume = 120,000 ounces of gold, Amount sold this year = 18,000 ounces, Gross income = $16,425,000, Depletion expenses = $12,250,000 • Find: Maximum depletion allowance Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Calculating the Allowable Depletion Deduction for Federal Tax $2,463,750 $2,088,000 $2,088,000 �$30, 000, 000 � Cost depletion = � (45, 000) � � 300, 000 � $4,500, 000 Contemporary Engineering Economics, th edition Park $4,500,000 Copyright © 2016 by Pearson Education, Inc All Rights Reserved Summary • Because it employs accelerated methods of depreciation and shorter-than-actual depreciable lives, the MACRS (Modified Accelerated Cost Recovery System) gives taxpayers a break: It allows them to take earlier and faster advantage of the taxdeferring benefits of depreciation • The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted It only changes the timing of the payment Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Summary • Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation • Given the frequently changing nature of depreciation and tax law, we must use whatever percentages, depreciable lives, and salvage values mandated at the time an asset is acquired Contemporary Engineering Economics, th edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ...Book Depreciation Methods • Purpose: Used in reporting net income to stockholders/investors • Types of Depreciation Methods o Straight-line method o Declining... Inc All Rights Reserved Tax Depreciation Purpose: To determine the income taxes owed for the IRS • Assets placed in service prior to 1981 o Used the book depreciation methods (SL, DB, SOYD) •... faster advantage of the taxdeferring benefits of depreciation • The total amount of taxes to pay remains unchanged regardless of depreciation methods adopted It only changes the timing of the