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Slide 1 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets
Slide 2 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation
Slide 3 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income.
Slide 4 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time.
Slide 5 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation
Slide 6 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?)
Slide 7 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land?
Slide 8 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis
Slide 9 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance
Slide 10 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10
Slide 11 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation
Slide 12 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method
Slide 13 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life
Slide 14 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n
Slide 15 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method.
Slide 16 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value
Slide 17 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years
Slide 18 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0
Slide 19 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values.
Slide 20 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2
Slide 21 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n
Slide 22 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units
Slide 23 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table
Slide 24 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value
Slide 25 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications
Slide 26 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table
Slide 27 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL
Slide 28 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL
Slide 29 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080
Slide 30 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879%
Slide 31 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12)
Slide 32 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction
Slide 33 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties
Slide 34 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties.
Slide 35 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics 35 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.
Slide 36 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics 35 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. (c) 2001 Contemporary Engineering Economics 36 Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. 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: 1. The cost basis of the asset, 2. The salvage value of the asset, 3. The depreciable life of the asset, and 4. The method of its depreciation.
Slide 37 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics 35 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. (c) 2001 Contemporary Engineering Economics 36 Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. 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: 1. The cost basis of the asset, 2. The salvage value of the asset, 3. The depreciable life of the asset, and 4. The method of its depreciation. (c) 2001 Contemporary Engineering Economics 37 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 tax-deferring benefits of depreciation. Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation.
Slide 38 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics 35 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. (c) 2001 Contemporary Engineering Economics 36 Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. 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: 1. The cost basis of the asset, 2. The salvage value of the asset, 3. The depreciable life of the asset, and 4. The method of its depreciation. (c) 2001 Contemporary Engineering Economics 37 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 tax-deferring benefits of depreciation. Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. (c) 2001 Contemporary Engineering Economics 38 Depletion is a cost allocation method used particularly for natural resources. Cost depletion is based on the units-of-production method of depreciation. Percentage depletion is based on a prescribed percentage of the gross income of a property during a tax year. 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.
Slide 39 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics 35 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. (c) 2001 Contemporary Engineering Economics 36 Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. 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: 1. The cost basis of the asset, 2. The salvage value of the asset, 3. The depreciable life of the asset, and 4. The method of its depreciation. (c) 2001 Contemporary Engineering Economics 37 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 tax-deferring benefits of depreciation. Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. (c) 2001 Contemporary Engineering Economics 38 Depletion is a cost allocation method used particularly for natural resources. Cost depletion is based on the units-of-production method of depreciation. Percentage depletion is based on a prescribed percentage of the gross income of a property during a tax year. 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. (c) 2001 Contemporary Engineering Economics 39
Slide 40 - (c) 2001 Contemporary Engineering Economics 1 Chapter 10 Depreciation Asset Depreciation Factors Inherent to Asset Depreciation Book Depreciation Tax Depreciation Depletion Repairs or Improvements to Depreciable Assets (c) 2001 Contemporary Engineering Economics 2 Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation (c) 2001 Contemporary Engineering Economics 3 Why Do We Need to Consider Depreciation? Gross Income -Expenses: (Cost of goods sold) (Depreciation) (operating expenses) Taxable Income - Income taxes Net income (profit) Business Expense: Depreciation is viewed as part of business expenses that reduce taxable income. (c) 2001 Contemporary Engineering Economics 4 Depreciation Concept Economic Depreciation Purchase Price – Market Value (Economic loss due to both physical deterioration and technological obsolescence) Accounting Depreciation A systematic allocation of cost basis over a period of time. (c) 2001 Contemporary Engineering Economics 5 Asset Depreciation Depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Physical depreciation Functional depreciation Book depreciation Tax depreciation (c) 2001 Contemporary Engineering Economics 6 Factors to Consider in Asset Depreciation Depreciable life (how long?) Salvage value (disposal value) Cost basis (depreciation basis) Method of depreciation (how?) (c) 2001 Contemporary Engineering Economics 7 What Can Be Depreciated? Assets used in business or held for production of income Assets having a definite useful life and a life longer than one year Assets that must wear out, become obsolete or lose value A qualifying asset for depreciation must satisfy all of the three conditions above. Can you depreciate land? (c) 2001 Contemporary Engineering Economics 8 Cost Basis (c) 2001 Contemporary Engineering Economics 9 Cost Basis with Trade-In Allowance (c) 2001 Contemporary Engineering Economics 10 (c) 2001 Contemporary Engineering Economics 11 Types of Depreciation Book Depreciation In reporting net income to investors/stockholders In pricing decision Tax Depreciation In calculating income taxes for the IRS In engineering economics, we use depreciation in the context of tax depreciation (c) 2001 Contemporary Engineering Economics 12 Book Depreciation Methods Purpose: Used to report net income to stockholders/investors Types of Depreciation Methods: Straight-Line Method Declining Balance Method Sum of the Years’ Digits Method Unit Production Method (c) 2001 Contemporary Engineering Economics 13 Straight – Line (SL) Method Principle A fixed asset as providing its service in a uniform fashion over its life Formula Annual Depreciation Dn = (I – S) / N, and constant for all n. Book Value Bn = I – n (D) where I = cost basis S = Salvage value N = depreciable life (c) 2001 Contemporary Engineering Economics 14 Example 10.3 – Straight-Line Method n Dn Bn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life n (c) 2001 Contemporary Engineering Economics 15 Declining Balance Method Principle: A fixed asset as providing its service in a decreasing fashion Formula Annual Depreciation Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. (c) 2001 Contemporary Engineering Economics 16 Example 10.4 – Declining Balance Method n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D1 D2 D3 D4 D5 B1 B2 B3 B4 B5 0 0 1 2 3 4 5 Total depreciation at end of life n $10,000 $8,000 $6,000 $4,000 $2,000 Annual Depreciation Book Value (c) 2001 Contemporary Engineering Economics 17 Example 10.5 DB Switching to SL SL Dep. Rate = 1/5 a (DDB rate) = (200%) (SL rate) = 0.40 Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years (c) 2001 Contemporary Engineering Economics 18 (a) Without switching (b) With switching to SL 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. Case 1: S = 0 (c) 2001 Contemporary Engineering Economics 19 Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values. (c) 2001 Contemporary Engineering Economics 20 Sum-of-Years’ Digits (SOYD) Method Principle Depreciation concept similar to DB but with decreasing depreciation rate. Charges a larger fraction of the cost as an expense of the early years than of the later years. Formula Annual Depreciation Book Value where SOYD=N(N+1)/2 (c) 2001 Contemporary Engineering Economics 21 Example 10.7 – Sum-of-years’ digits method D1 D2 D3 D4 B1 B2 B3 B4 B5 $10,000 $8,000 $6,000 $4,000 $2,000 0 0 1 2 3 4 5 Total depreciation at end of life I = $10,000 N = 5 years S = $2,000 SOYD = 15 n 1 2 3 4 5 Dn (5/15)(8,000)=$2,667 (4/15)(8,000)=$2,133 (3/15)(8,000)=$1,600 (2/15)(8,000)=$1,067 (1/15)(8,000)=$533 Bn $7,333 5,200 3,600 2,533 2,000 n (c) 2001 Contemporary Engineering Economics 22 Units-of-Production Method Principle Service units will be consumed in a non time-phased fashion Formula Annual Depreciation Dn = Service units consumed for year total service units (c) 2001 Contemporary Engineering Economics 23 Tax Depreciation Purpose: Used to compute income taxes for the IRS Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD) Assets placed in service from 1981 to 1986 Use ACRS Table Assets placed in service after 1986 Use MACRS Table (c) 2001 Contemporary Engineering Economics 24 Modified Accelerated Cost Recovery Systems (MACRS) Personal Property Depreciation method based on DB method switching to SL (see page 468) Half-year convention Zero salvage value Real Property SL Method Mid-month convention Zero salvage value (c) 2001 Contemporary Engineering Economics 25 MACRS Property Classifications (c) 2001 Contemporary Engineering Economics 26 MACRS Table (c) 2001 Contemporary Engineering Economics 27 MACRS Rate Calculation Example 10.9 Asset cost = $10,000 Property class = 5-year DB method = Half-year convention, zero salvage value, 200% DB switching to SL (c) 2001 Contemporary Engineering Economics 28 Year (n) 1 2 3 4 5 6 Calculation in % (0.5)(0.40)(100%) 20% (0.4)(100%-20%) 32% SL = (1/4.5)(80%) 17.78% (0.4)(100%-52%) 19.20% SL = (1/3.5)(48%) 13.71% (0.4)(100%-71.20%) Switch to SL 11.52% SL = (1/2.5)(29.80%) 11.52% SL = (1/1.5)(17.28%) 11.52% SL = (0.5)(11.52%) 5.76% MACRS (%) DDB DDB DDB SL SL (c) 2001 Contemporary Engineering Economics 29 Conventional DB Switching to SL MACRS with half-year convention 2,000 3,200 1,920 1,152 1,152 576 4,000 2,400 1,440 1,080 1,080 (c) 2001 Contemporary Engineering Economics 30 MACRS for Real Property 27.5-year (Residential) 39-year (Commercial) SL Method Zero salvage value Mid-month convention Example: placed an asset (residential property) in March D1 = (9.5/12)(100%/27.5) = 2.879% (c) 2001 Contemporary Engineering Economics 31 Percentage Depletion vs. Cost Depletion Cost depletion = ($30,000,000/300,000)(45,000) = $4,500,000 Allowable deduction = $2,088,000 Select cost depletion with $4,500,000 Percentage Depletion (Example 10.12) (c) 2001 Contemporary Engineering Economics 32 Calculating the Allowable Depletion Deduction (c) 2001 Contemporary Engineering Economics 33 Percentage Depletion Allowances for Mineral Properties (c) 2001 Contemporary Engineering Economics 34 Repairs and Improvements Principle: Any repairs or improvements extends the life of the asset, the depreciation amount also needs to be adjusted. Book Depreciation: Change the current book value and spread the value over the extended life. Tax Depreciation: Treat the repairs or improvements as separate MACRS properties. (c) 2001 Contemporary Engineering Economics 35 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. (c) 2001 Contemporary Engineering Economics 36 Accounting depreciation can be broken into two categories: 1. Book depreciation—the method of depreciation used for financial reports and pricing products; 2. 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: 1. The cost basis of the asset, 2. The salvage value of the asset, 3. The depreciable life of the asset, and 4. The method of its depreciation. (c) 2001 Contemporary Engineering Economics 37 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 tax-deferring benefits of depreciation. Many firms select straight-line depreciation for book depreciation because of its relative ease of calculation. (c) 2001 Contemporary Engineering Economics 38 Depletion is a cost allocation method used particularly for natural resources. Cost depletion is based on the units-of-production method of depreciation. Percentage depletion is based on a prescribed percentage of the gross income of a property during a tax year. 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. (c) 2001 Contemporary Engineering Economics 39 (c) 2001 Contemporary Engineering Economics 40