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Unformatted text preview: CHAPTER 6 CHAPTER DEPRECIATION AND INCOME DEPRECIATION TAXES TAXES DEPRECIATION DEPRECIATION • Decrease in value of physical properties Decrease with passage of time and use with • Accounting concept establishing annual Accounting deduction against before-tax income deduction - to reflect effect of time and use on asset’s value in firm’s financial statements value - to match yearly fraction of value used by asset in production of income over asset’s economic life life PROPERTY IS DEPRECIABLE IF IT MUST : IT • be used in business or held to produce be income income • have a determinable useful life which is have longer than one year longer • wear out, decay, get used up, become wear obsolete, or lose value from natural causes obsolete, • not be inventory, stock in trade, or not investment property investment DEPRECIABLE PROPERTY DEPRECIABLE • TANGIBLE - can be seen or touched personal property - includes assets such as personal machinery, vehicles, equipment, furniture, etc... machinery, real property - anything erected on, growing on, real or attached to land or (Since land does not have a determinable life (Since itself, it is not depreciable) itself, • INTANGIBLE - personal property, such as INTANGIBLE copyright, patent or franchise copyright, WHEN DEPRECIATION STARTS AND STOPS AND • Depreciation starts when property is placed Depreciation starts in service for use in business or for production of income production • Property is considered in service when Property ready and available for specific use, even if not actually used yet not • Depreciation stops when cost of placing it Depreciation stops in service is removed or it is retired from service service DEPRECIATION METHODS DEPRECIATION Time Implemented Method Before 1981 (SL) Straight-Line (DB) Declining Balance (DB) (SYD) Sum-of-the-years-digits (SYD) > 1980 > 1987 (ACRS) Accelerated Cost 1980 Recovery System Recovery Implemented by (ERTA) Implemented Economic RecoveryTax Act of 1981 1981 >1986 (MACRS) Modified Accelerated Cost Recovery System Cost Brought about by (TRA 86) Brought TaxReform Act of 1986 TaxReform DEPRECIATION CONCEPTS DEPRECIATION • Adjusted cost basis -- allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation and depletion deductions depletion • Basis, or cost basis -- also called unadjusted cost -- initial cost of acquiring an asset, plus sales tax, transportation, and normal costs of making asset serviceable normal DEPRECIATION CONCEPTS DEPRECIATION • Book Value (BV) -- Worth of depreciable property as shown on accounting records property -- Original cost basis of property, including adjustments, less allowable depletion or depreciation deductions depreciation -- Represents amount of capital remaining invested in property and must be recovered in future through accounting future (Book Value)k= adjusted cost basis - Σ kjj=1 (depreciation deduction)j =1 (depreciation DEPRECIATION CONCEPTS DEPRECIATION • Market Value (MV) -- Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact advantage -- apporximates present value of what will be received through ownership of property, including time-value of money (or profit) including DEPRECIATION CONCEPTS DEPRECIATION • Recovery Period -- Number of years over which basis of property is recovered through accounting process. process. -- Normally the useful life for classical methods for -- Property class for General Depreciation System (GDS) under MACRS (GDS) -- Class Life for Alternative Depreciation System (ADS) (ADS) • Recovery Rate -- Percentage for each year of MACRS recovery period used to calculate an annual depreciation deduction. annual DEPRECIATION CONCEPTS DEPRECIATION • Salvage Value (SV) -- Estimated value of property Salvage at the end of useful life. -- expected selling price of property when asset can no longer be used productively can -- net salvage value used when expenses incurred in disposing of property; cash outflows must be deducted from cash inflows for final net salvage value value -- with classical methods of depreciation, estimated salvage value is established and used estimated -- with MACRS, the salvage value of depreciable property is defined to be zero DEPRECIATION CONCEPTS DEPRECIATION • Useful Life -- Expected (estimated) period of time property will be used in trade or business or to produce income; sometimes referred to as depreciable life. depreciable DEPRECIATION CONCEPTS DEPRECIATION The following terms are used in the classical The (historical) depreciation method equations: (historical) N = depreciable life of the asset in years B = cost basis, including allowable adjustments d k = annual depreciation deduction in year k (1< k <N) d k* = cummulative depreciation through year k k* BV k = book value at the end of year k BV BV N = book value at the end of the depreciable (useful) life BV SV N = salvage value at the end of year N SV R = the ratio of depreciation in any one year to the BV at the beginning of the year beginning STRAIGHT-LINE (SL) METHOD STRAIGHT-LINE • Simplest depreciation method • Assumes constant amount is depreciated Assumes each year over depreciable (useful) life each d k = ( B - SVN ) / N d k* = kdk for 1 < k < N kd BVk = B - d k** k • This method requires an estimate of the This final SV ( also the final book value at the end of year N ) end • Sometimes called constant percentage method or Sometimes Matheson formula Matheson • Assumed annual cost of depreciation is fixed percentage Assumed of BV at beginning of year of • R is constant is R = 2 / N when 200% declining balance used R = 1.5 / N when 150% declining balance used 1.5 d1=B(R) d k = B ( 1 - R ) k-1( R ) d k* = B [ 1 - (1 - R ) k ] (1 BV k = B ( 1 - R ) k BV BV N = B ( 1 - R ) N BV • Because declining balance method never reaches BV = 0, Because it’s permissible to switch from this to straight-line method DECLINING BALANCE (DB) METHOD DECLINING SUM-OF-THE-YEARS-DIGITS (SYD) METHOD SUM-OF-THE-YEARS-DIGITS 1. Number for each permissable year of life are listed in 1. reverse order reverse 2. Sum the digits of this reverse order 3. The depreciation factor for any year is the corresponding 3. number from the reverse order listing divided by the sum of those digits, or the following of 2 (N - k + 1 ) (N df = ----------------N(N+1) 4. Depreciation for any year is the product of thst year’s SYD depreciation factor and the difference between B and the final estimated SV final d k = ( B - SV N ) • df SUM-OF-THE-YEARS-DIGITS (SYD) METHOD • Book value at the end of year k Book 2(B - SVN) (B - SVN) BVk = B - ----------------- k + ----------- k (k + 1 ) N N (N + 1) • The cumulative depreciation through the The kth year kth d k* = B - BV k UNITS-OF-PRODUCTION METHOD UNITS-OF-PRODUCTION • Not based on the idea that decrease in value of property is a function of time value • Decrease in value is mostly a function of Decrease use use • Method results in cost basis (minus final Method SV) being allocated equally over the estimated number of units produced during useful life of asset. useful Depreciation per unit of production = ( B - SVN ) / ( Estimated lifetime production in units ) SV ACCELERATED COST RECOVERY SYSTEM (ACRS) RECOVERY • Recognizes an asset as belonging to Recognizes one of four (tangible) property classes classes • IRS prescribes the specific series of IRS depreciation per property class depreciation • Rates are based on 150% Declining Rates Balance depreciation, switching to Straight-Line Straight-Line • The principal method for computing depreciation The deductions for property in engineering projects. deductions • Applies to most tangible depreciable property placed in Applies service after December 31, 1986 service • SVN is defined to be 0 ; useful life estimates are not used directly in calculating depreciation amounts directly • Consists of two systems for computing depreciation Consists deductions: deductions: 1. The General Depreciation System (GDS) 1. 2. The Alternative Depreciation System (ADS) 2. Provides longer recovery period and uses only Provides straight-line method of depreciation straight-line Assets depreciated under ADS include property placed in any tax-exempt use and property used predominantly outside the U.S. predominantly MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS) SYSTEM INFORMATION NEEDED TO CALCULATE MACRS DEPRECIATION CALCULATE 1. The cost basis 2. The date the property was placed in 2. service service 3. The property class and recovery period 4. The MACRS depreciation used (GDS or 4. ADS) ADS) 5. The time convention that applies (half 5. year) year) GENERAL DEPRECIATION SYSTEM (GDS) BASIC INFORMATION (GDS) 1. Tangible depreciable property assigned to one of 1. six personal property classes (3, 5, 7, 10, 15 and 20-year) - Corresponds to GDS recovery period; personal depreciable property not corresponding to these periods is considered 7-yr property class. to 2. Real property assigned to two real property 2. classes -- nonresidential real property and residential rental property. residential 3. GDS recovery period is 39 years for 3. nonresidential real property (31.5 years if in service before May 13, 1993) and 27.5 years for residential rental property. ALTERNATIVE DEPRECIATION SYSTEM (ADS) BASIC INFORMATION (ADS) 1. ADS recovery period for tangible personal 1. property is normally the same as the class life of the property, with some exceptions ( i.e., asset class 00.12 and 00.22 ) class 2. Any tangible personal property that does not fit 2. into one of the asset classes is depreciated using a 12-year ADS recovery period 12-year 3. ADS recovery period for nonresidential real 3. property is 40 years property CALCULATING DEPRECIATION DEDUCTIONS UNDER MACRS UNDER Depreciation Depreciation Personal Method 3-, 5-, 710-year Approach Property Class 200% DB method with switch to SL when deduction when GDS GDS greater greater GDS GDS GDS GDS ADS ADS 150% DB method with switch to SL with when deduction greater when residential SL over fixed GDS recovery & real rental periods personal & SL method over fixed ADS real recovery periods 15- & 20year HALF-YEAR TIME CONVENTIONS FOR MACRS DEPRECIATION CALCULATIONS CALCULATIONS • All assets placed in service during the year All are treated as if use began in the middle of the year -- 1/2- year depreciation is allowed the • If asset is disposed of before the full If recovery period is used, only half of the normal depreciation deduction can be taken for that year for MACRS (GDS) PROPERTY CLASSES AND CLASS LIFE MACRS GDS Property Class and Class Life GDS Class Depreciation Method Depreciation 3-year, 200% DB with 4 years or less 3-year, switchover to SL 5-year, 200% DB with More than 4 years 5-year, More switchover to SL to less than 10 years switchover 7-year, 200% DB with 10 years to less than 7-year, 10 switchover to SL 16 switchover 10-year, 200% DB with 16 years to less than 10-year, 16 switchover to SL 20 switchover 15-year, 150% DB with 20 years to less than 15-year, 20 switchover to SL 25 switchover 20-year, 150% DB with 25 years or more 20-year, 25 switchover to SL switchover 27.5 year, SL N/A 27.5 39-year, SL N/A 39-year, MACRS DEPRECIATION GDS OR ADS ? MACRS DEPRECIATION GDS OR ADS ? GDS Ascertain property class; Same as recovery period for personal ADS Ascertain recovery period MACRS DEPRECIATION GDS OR ADS ? GDS Ascertain property class; Same as recovery period for personal ADS Ascertain recovery period Obtain recovery rates Compute depreciation amount; Asset’s cost basis SL = -------------------------Recovery period MACRS DEPRECIATION GDS OR ADS ? GDS Ascertain property class; Same as recovery period for personal ADS Ascertain recovery period Obtain recovery rates Compute depreciation amount; Asset’s cost basis SL = -------------------------Recovery period Compute depreciation deduction in year k (dk) by multiplying cost basis by recovery period. Compute depreciation deduction in year k (dk) DEPLETION DEPLETION • Used to indicate the decrease in the Used value of the resource base when natural resources are being consumed in producing products or services. in • Term most commonly used in Term connection with mining properties, oil and gas wells, timberlands, etc... and • Amounts charged as depletion cannot Amounts be used to replace sold resources be PAYMENTS TO RESOURCE OWNERS OWNERS Annual payments to resource owners consist of two parts: owners 1. Earned profit 2. Portion of owner’s capital 2. returned, marked as depletion returned, TWO WAYS TO COMPUTE DEPLETION ALLOWANCE DEPLETION 1. Cost method 1. Cost Applies to all types of property and is more widely used method widely Depletion unit is determined by dividing adjusted cost basis by the number of units to be mined or harvested to Depletion allowance for tax year is the product of the number of units sold times the depletion unit the 2. The Percentage Method TWO WAYS TO COMPUTE DEPLETION ALLOWANCE DEPLETION Based on percentage of year’s gross income, provided amount charged does not exceed 50% of net income (before deduction of depletion allowance) allowance) Can be used for most types of metal mines, geothermal deposits and coal mines geothermal Can not be used for timber and, in most cases, is not applicable to oil and gas not When percentage method applies, depletion allowance must be calculated by cost and percentage method -- the larger of the two applies 1. Income taxes - assessed as a function of gross revenues 1. minus allowable deductions minus - levied at federal, most state, and some municipal governments governments 2. Property taxes - assessed as a function of owned 2. property value; property - independent of income or profit of firm independent - levied at municipal, county, and / or state level 3. Sales taxes - assessed on purchases of goods and services services - independent of gross income or profits independent - relevent to engineering studies as added cost relevent 4. Excise taxes - assessed on sale of certain nonessential 4. goods and services goods - independent of business income and profit independent TYPES OF TAXES TYPES BEFORE-TAX MARR BEFORE-TAX ~ ( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~ After Tax Before MARR MARR BEFORE-TAX MARR BEFORE-TAX ~ ( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~ After Tax Before MARR MARR After-tax MARR Before-tax MARR ~ -------------------------------~ ( 1 - effective tax rate ) effective BEFORE-TAX MARR BEFORE-TAX ~ ( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~ After Tax Before MARR MARR ~ After-tax MARR Before-tax MARR ~-------------------------------( 1 - effective tax rate ) effective • If the asset is nondepreciable and there are no If gains or losses on disposal, tax credits, or other types of deductions involved this approximation in the equation above is exact BEFORE-TAX MARR BEFORE-TAX ~ ( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~ After Tax Before MARR MARR After-tax MARR Before-tax MARR ~ -------------------------------~ ( 1 - effective tax rate ) effective • If the asset is nondepreciable and there are no If gains or losses on disposal, tax credits, or other types of deductions involved this approximation in the equation above is exact • Otherwise, some degree of error is introduced, Otherwise, since the factors cited affect amount and timing of income tax payments of CALCULATING TAXABLE INCOME CALCULATING - NET INCOME BEFORE TAXES ( NIBT ) • Calculate Gross Income Gross Profits ( revenues from sales - cost of Gross goods sold ) goods + income from dividends, interest, rent, royalties, and gains (losses) from sale or exchange of capital assets capital • Deduct all ordinary and necessary Deduct operating expenses to conduct business operating Include interest but exclude capital investments • Deduct depreciation taxable income = gross income - all expenses - depreciation NET INCOME AFTER TAXES (NIAT) (NIAT) • The income after taxes have The been deducted from the taxable income or Net Income Before Taxes Before Net Income After Taxes = NIBT - income taxes • As personal income tax rates are based on As income brackets, so, too, is corporate income tax income • Depending on the bracket a firm’s income Depending falls within, the marginal federal rate can vary from 15% to a maximum of 39% (for incomes between $100,000 and $335,000) incomes • Incomes above $18,333,333 are taxed at a Incomes flat rate of 35% flat – TRA 86 responsible for lowering maximum rate from TRA 46% to 35% 46% – Also created alternative minimum tax (AMT) Also EFFECTIVE (MARGINAL) CORPORATE INCOME TAX RATE INCOME GAIN (LOSS) ON DISPOSAL OF A DEPRECIABLE TANGIBLE ASSET DEPRECIABLE [ GAIN (LOSS) ON DISPOSAL ] N = MVN - BVN GAIN • If gain, referred to as depreciation recapture • Tax for gain (loss) is usually the same as Tax ordinary income gain (loss) -- effective income tax rate, t • For capital asset sold or exchanged, gain For (loss) referred to as capital gain (loss) (loss) • capital assets are stocks, bonds, gold, capital silver, other metals, and real property BEFORE-TAX ECONOMIC ANALYSIS BEFORE-TAX NIBT = ( Rk – Ek- dk ) Tk = - t ( Rk – Ek – dk ) Rk = revenues (and savings from the project: cash inflow from project during period ‘k’ project Ek = cash outflows during year k for deductible expenses and interest interest dk = sum of all noncash, or book costs during year ‘k’, such as depreciation and depletion as t = effective income tax rate on ordinary income (federal, state and other); assumed to remain constant during the study period study Tk= income taxes paid during year ‘k’ ECONOMIC VALUE ADDED ECONOMIC (EVA) An economic measure for estimating An wealth creation potential of capital investments: investments: EVA = (Net Operating Profit After Taxes )k – Cost of Capital Used to Produce Profit)k Capital EVA = NOPATk – ι . BVk-1 BV Where k = index for year in question (1 < k < N) Where ι = after-tax MARR based on firm’s cost of after-tax capital BVk-1= Beginning of year book value capital BV N = the study (analysis) period in years ECONOMIC VALUE ADDED ECONOMIC (EVA) • NOPATK = ( 1 –t ) ( Rk – Ek –dk) • EVAk = ( 1 –t ) ( Rk – Ek –dk) – ι . BVk-1 BV When k > 0, ATCFk = ( 1 –t ) ( Rk – Ek –dk) + dk When k = 0, ATCF0 = BV0 • ATCFk = EVAk + ι . BVk + dk BV dk is the sum of all noncash, or book costs during the year k, such as depreciation or depletion the ...
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