Depreciation

Our purpose in studying

depreciation is to
understand its impact on
taxes so that this impact
can be included in our
economic analysis.
What are the tax effects on
the cash flow diagram?
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Depreciation
The cost of fixed assets must be
recorded as expenses on a firms
balance sheet and income statement.
Unlike costs such as labor,
maintenance, and material, the costs of
fixed assets are not treated simply as
expenses to be accounted for in the
year that they are acquired.
Instead, they are capitalized.
Their costs are distributed by
subtracting them as expenses from
gross income one part at a time over
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a number of periods.

Depreciation
Depreciable Life the period of
time over which the asset is
capitalized.
Matching Concept A fraction of
the cost of the asset is
chargeable as an expense in each
of the accounting periods in
which the asset provides service
to the firm.
Depreciation is NOT a real cash 3

Depreciable Assets
By U.S. tax law, depreciable
property:
1. Must be used in business or held
for production of income.
2. Must have a definite service life,
and that life must be longer than
1 year.
3. Must be something that wears
out, decays, gets used up,
becomes obsolete, or loses value
from natural causes.
4
You can NEVER depreciate land!

Cost Basis
Cost Basis the total cost
claimed as an expense over
an assets life. Includes:
Actual Cost
Some incidental expenses:
Freight
Site Preparation
Installation
These are the costs reqd to put the asset
into service!
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Cost Basis
Used in figuring
depreciation deductions.
Used in calculating the gain
or loss to the firm if the
asset is sold or salvaged.

Cost Basis
If the asset is purchased by trading
in a similar asset, the difference
between the book value and trade
in allowance must be considered in
determining the cost basis of the
new asset.
If the trade-in allowance exceeds
the book value, the difference
(unrecognized gain) needs to be
subtracted from the cost basis of
the new asset.
If the book value exceeds the
trade-in allowance, the difference
(unrecognized loss) needs to be 7

Depreciation Methods
We will cover five methods:
Straight Line
Declining Balance
Sum of Years Digits
Units of Production
MACRS Modified
Accelerated Cost
Recovery System
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Notation
I = Cost Basis; Initial Price
plus installation expenses.
S = Salvage Value
Dn = Depreciation in Year n
Bn = Book Value in Year n
N = estimated years of useful
life
n = the year currently under
consideration
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Computer PBX Example

Initial Cost = $8,000
Installation = $2,000
Salvage = $1,000
Useful Life = 4 years
MACRS Property Class = 5
years

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Straight Line Method

Dn = ( I S )
N
Bn = I Dn (n)
Where:
I = Cost Basis; Initial Price plus
installation expenses.
S = Salvage Value
Dn = Depreciation in Year n
Bn = Book Value remaining in Year n

N = estimated years of useful life

n = the year currently under
consideration

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Declining Balance
1
Method
=
(Multiplier)
N

= % reduction each year

Dn = I (1 )n1
Bn = I (1 )n
Typical multipliers are 150% and 200%.
200% is also called Double Declining Balance
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(DDB).

Sum of Years Digits

Method

SOYD = 1 + 2 + 3 + +

N
= N(N+1)
2
Dn = ( N n + 1 ) ( I S )
SOYD
Bn = Bn1 Dn
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Units of Production
Method
Dn =

Service Units Consumed During Year n

(IS)

Total Service Units

Bn = I

Service Units Consumed During Year n (

IS)

Total Service Units

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MACRS
Prior to 1981, taxpayers
could choose among
several methods when
depreciating assets for tax
purposes.
With the Economic
Recovery Act of 1981, ACRS
was required and MACRS
was instituted in 1986.
MACRS is a simpler, more

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Recovery
Period

MACRS Property
ADR ClassClasses
Midpoint

Applicable Property

ADR 4

Special tools for plastic / fabricated

metal parts mfg; motor vehicles

4 < ADR 10

Autos, light trucks, high-tech / R&D

equip., computerized phone switches

10 < ADR 16

Mfg equip., office furniture, fixtures

10

16 < ADR 20

Vessels, barges, tugs, railroad cars

15

20 < ADR 25

Waste-water plants, telephone

distribution plants, other utilities

20

25 ADR

Municipal sewers, electric power plants

(years)

27.5

Residential rental property

39

Non-residential real property, elevators

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MACRS Depreciation
Class:
3
5
7
10
15
Schedule
Year
200% DB
200% DB
200% DB
200% DB
150% DB
1

33.33

20.00

14.29

10.00

5.00

44.45

32.00

24.49

18.00

9.50

14.81*

19.20

17.49

14.40

8.55

7.41

11.52*

12.49

11.52

7.70

11.52

8.93*

9.22

6.93

7.54

8.92

7.37

6.23

8.93

6.55*

5.90*

4.46

6.55

5.90

6.56

5.91

10

6.55

5.90

11

3.28

5.91

12
13
14
15
16

5.90
* MACRS switches to straight line depreciation.
Table values shown are percentages.

5.91
5.90
5.91
2.95
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MACRS
Dn = (Year n MACRS Class Table Value)( I )
n

Bn = ( I )[1 (

Year n MACRS Class Table Values )

j=1
NOTE: If selling an asset BEFORE the final year of depreciation:
Selling year depreciation is Dn value lower, and

Selling year book value is Dn value higher!

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