CHAPTER 7. Depreciation And Income Taxes. Created By : Eng.Maysa Gharaybeh

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1 CHAPTER 7 Depreciation And Income Taxes Created By : Eng.Maysa Gharaybeh

2 Depreciation Decrease in value of physical properties with passage of time and use. More specifically: Accounting concept establishing annual deduction against before-tax income to reflect effect of time and use on asset s value in firm s financial statements to match yearly fraction of value used by asset in production of income over asset s economic life

3 Property Is Depreciable if it Meets These Requirements : be used in business or held to produce income. have a determinable useful life which is longer than one year wear out, decay, get used up, become obsolete, or lose value from natural causes not be inventory, stock in trade, or investment property

4 Depreciable Property (Tangible, Intangible ) Tangible : can be seen or touched personal المنقولة) property (االموال : includes assets such as machinery, vehicles, equipment, furniture, etc... real غير المنقولة) property (االموال : anything erected on, growing on, or attached to land (Since land does not have a determinable life itself, it is not depreciable) براءات patent( Intangible : personal property, such as copyright, (إعفاء معين,امتياز) franchise or (االختراع

5 When Depreciation Starts And Stops Depreciation starts when property is placed in service for use in business or for production of income. Property is considered in service when ready and available for specific use, even if not actually used yet. Depreciation stops when cost of placing it in service has been recovered or when it is soled, whichever occurs first.

6 Additional Definitions Basis, or cost basis : (unadjusted cost ) initial cost of purchase an asset, plus sales tax, transportation, and normal costs of making asset serviceable Adjusted cost basis : allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation deductions Improvement of the asset increases the original cost basis Casualty or theft loss decrease the original cost basis

7 Additional Definitions Book Value (BV) : Worth of depreciable property as shown on company records Represents amount of capital remaining invested in property and must be recovered in future through accounting process (Book Value) k = k adjusted cost basis - Σ (depreciation deduction) j j=1

8 Additional Definitions Market Value (MV) : Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact approximates present value of what will be received through ownership of property, including time-value of money (or profit)

9 Additional Definitions Recovery Period :Number of years over which basis of property is recovered through accounting process. Normally the useful life for classical methods Property class for General Depreciation System (GDS) under MACRS Class Life for Alternative Depreciation System (ADS) Recovery Rate :Percentage for each year of MACRS recovery period used to calculate an annual depreciation deduction.

10 Additional Definitions Salvage Value (SV) : Estimated value of property at the end of useful life. expected selling price of property when asset can no longer be used productively net salvage value used when expenses incurred in disposing of property; cash outflows must be deducted from cash inflows for final net salvage value with classical methods of depreciation, estimated salvage value is established and used with MACRS, the salvage value of depreciable property is defined to be zero

11 Additional Definitions Useful Life : Expected (estimated) period of time property will be used in trade or business or to produce income; sometimes referred to as depreciable life.

12 The Classical Depreciation Methods N = depreciable life of the asset in years B = cost basis, including allowable adjustments d k = annual depreciation deduction in year k (1< k <N) d k* = cumulative depreciation through year k BV k = book value at the end of year k BV N = book value at the end of the depreciable (useful) life SV N = salvage value at the end of year N R = the ratio of depreciation in any one year to the BV at the beginning of the year

13 Straight-Line (SL) Method Simplest depreciation method Assumes constant amount is depreciated each year over depreciable (useful) life N = depreciable life B = cost basis d k = depreciaton in k BV k = book value at end of k SV N = salvage value

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15 Declining Balance (DB) Method Sometimes called constant percentage method or Matheson formula Assumed annual cost of depreciation is fixed percentage of BV at beginning of year R is constant R = 2 / N when 200% declining balance OR R = 1.5 / N when 150% declining balance used d 1 = B ( R ) d k = B ( 1 - R ) k - 1 ( R ) d k* = B [ 1 - (1 - R ) k ] BV k = B ( 1 - R ) k BV N = B ( 1 - R ) N Because declining balance method never reaches BV = 0, it s permissible to switch from this to straight-line method so asset s SV N will be zero or other desired value

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17 Units-of-Production Method Not based on the idea that decrease in value of property is a function of time Decrease in value is mostly a function of use Method results in cost basis (minus final SV) being allocated equally over the estimated number of units produced during useful life of asset. Depreciation per unit of production =

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19 DB with Switchover to SL DB method will NEVER reach BV =0 You can switch from DB to SL The switch over occurs in the year in which a larger depreciation amount is obtained from SL method

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21 Table 7-1 page 328 d k = ( B - SVN ) / N But the basis B from Col(1)Changed every year and N is the remaining years As followes : Year (3) 1 4,000/10 years = ,200/9 year = ,560/8years = 320 And so on We select the largest depreciation amount.

22 Taxable Income (Before Taxable Income) taxable income = gross income - all expenses - depreciation

23 The disposal of a depreciable asset can result in a gain or loss based on the sale price (market value) and the current book value A gain is often referred to as depreciation recapture, and it is generally taxed as the same as ordinary income. A loss is a capital loss. An asset sold for more than it s cost basis results in a capital gain.

24 After Tax Economic Analysis

25 R k = revenues (and savings from the project: cash inflow from project during period k E k = cash outflows during year k for deductible expenses and interest d k = depreciation t = effective income tax rate on ordinary income (federal, state and other); assumed to remain constant during the study period T k = income taxes paid during year k BTCF k = Before Tax Cash Flow for year k ATCF k = After Tax Cash Flow for year k

26 The taxable income = ( R k E k - d k ) The income tax: T k = - t ( R k E k d k ) BTCF k = R k E k ATCF k = BTCF k + T k = (R k E k ) - t ( R k E k d k ) = (1 t)(r k E k ) + t d k

27 Example: An asset is expected to produce a net cash inflows of 70,000 per year for the six year period, where the cost basis is 260,000 and the market value is 20,000. MARR is 10% use SL method.. A) develop BTCF B)develop ATCF C) Calculate the PW for both CFs

28 BTCF 0-260, , , , , , , ,000 PW= -260, ,000 (P/A,10%,6)+ 20,000(P/F,10%,6) = -260, ,000(4.3553) +20,000 (0.5645)=56,161 PW >0 it is acceptable alternative SL = (260,000-20,000)/6 = 40,000 per year

29 ATCF EOY A BTCF B Depreciation Deduction C=A B Taxable Income D= - 0.4C Income Tax E= A+D ATCF 0-260, , ,000 40,000 30,000-12,000 58, ,000 40,000 30,000-12,000 58, ,000 40,000 30,000-12,000 58, ,000 40,000 30,000-12,000 58, ,000 40,000 30,000-12,000 58, ,000 40,000 30,000-12,000 58,000 6(market value) 20,000 20,000 20,000 PW= -260, ,000 (P/A,10%,6)+ 20,000(P/F,10%,6) = -260, ,000(4.3553) +20,000 (0.5645)= 3,897.4 PW >0 it is acceptable alternative