CHAPTER 6

DEPRECIATION AND INCOME

TAXES

DEPRECIATION
Decrease in value of physical properties
with passage of time and use
Accounting concept establishing annual
deduction against before-tax income
- to reflect effect of time and use on assets
value in firms financial statements

- to match yearly fraction of value used by asset

in production of income over assets economic
life

PROPERTY IS DEPRECIABLE IF
IT MUST :
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

DEPRECIABLE PROPERTY
TANGIBLE - can be seen or touched
personal property - includes assets such as
machinery, vehicles, equipment, furniture, etc...

real property - anything erected on, growing on,

or attached to land
(Since land does not have a determinable life
itself, it is not depreciable)

INTANGIBLE - personal property, such as

copyright, patent or franchise

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 is removed or it is retired from
service

DEPRECIATION METHODS
Time Implemented
Method
Before 1981
(SL) Straight-Line
(DB) Declining Balance
(SYD) Sum-of-the-years-digits
> 1980 > 1987
(ACRS) Accelerated Cost
Recovery System
Implemented by (ERTA)
Economic
RecoveryTax Act of
1981
>1986
(MACRS) Modified Accelerated
Cost Recovery System
Brought
about by (TRA 86)
TaxReform Act of 1986

DEPRECIATION CONCEPTS
Adjusted
Adjusted cost
cost basis
basis --- allowable
allowable adjustment
adjustment
(increase
(increase or
or decrease)
decrease) to
to original
original cost
cost
basis,
basis, used
used to
to calculate
calculate depreciation
depreciation and
and
depletion
depletion deductions
deductions
Basis,
Basis, or
or cost
cost basis
basis --- also
also called
called
unadjusted
unadjusted cost
cost --- initial
initial cost
cost of
of acquiring
acquiring
an
an asset,
asset, plus
plus sales
sales tax,
tax, transportation,
transportation, and
and
normal
normal costs
costs of
of making
making asset
asset serviceable
serviceable

DEPRECIATION CONCEPTS
Book Value (BV) -- Worth of depreciable

property as shown on accounting records

-- Original cost basis of property, including
adjustments, less allowable depletion or
depreciation deductions
-- Represents amount of capital remaining
invested in property and must be recovered in
future through accounting
(Book Value)k=
adjusted cost basis - kj=1 (depreciation deduction)j

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

DEPRECIATION CONCEPTS
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.

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

DEPRECIATION CONCEPTS

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

DEPRECIATION CONCEPTS
The following terms are used in the classical
(historical) depreciation method equations:
N = depreciable life of the asset in years
B = cost basis, including allowable adjustments
d k = annual depreciation deduction in year k (1< k <N)
d k* = cummulative depreciation through year k
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

STRAIGHT-LINE (SL) METHOD

Simplest depreciation method
Assumes constant amount is depreciated
each year over depreciable (useful) life
d k = ( B - SVN ) / N
d k* = kdk for 1 < k < N
BVk = B - d k*
This method requires an estimate of the
final SV ( also the final book value at the
end of year N )

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 used
R = 1.5 / N when 150%
declining balance used
d1=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,
its permissible to switch from this to straight-line method
so assets SVN will be zero or other desired value

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 =
) / ( Estimated lifetime production in units )

( B - SVN

ACCELERATED COST
RECOVERY SYSTEM (ACRS)
Recognizes an asset as belonging to
one of four (tangible) property
classes
IRS prescribes the specific series of
depreciation per property class
Rates are based on 150% Declining
Balance depreciation, switching to
Straight-Line

MODIFIED ACCELERATED COST RECOVERY

SYSTEM (MACRS)

The principal method for computing depreciation

deductions for property in engineering projects.
Applies to most tangible depreciable property placed in
service after December 31, 1986
SVN is defined to be 0 ; useful life estimates are not used
directly in calculating depreciation amounts
Consists of two systems for computing depreciation
deductions:
1. The General Depreciation System (GDS)
2. The Alternative Depreciation System (ADS)
Provides longer recovery period and uses only
straight-line method of depreciation
Assets depreciated under ADS include property
placed in any tax-exempt use and property used
predominantly outside the U.S.

INFORMATION NEEDED TO CALCULATE

MACRS DEPRECIATION
1. The cost basis
2. The date the property was placed in
service
3. The property class and recovery period
4. The MACRS depreciation used (GDS or
ADS)
5. The time convention that applies (half
year)

GENERAL DEPRECIATION SYSTEM

(GDS) BASIC INFORMATION
1. Tangible depreciable property assigned to one of
six personal property classes (3, 5, 7, 10, 15 and
20-year) - Corresponds to GDS recovery period;
personal depreciable property not corresponding
to these periods is considered 7-yr property class.
2. Real property assigned to two real property
classes -- nonresidential real property and
residential rental property.
3. GDS recovery period is 39 years for
nonresidential real property (31.5 years if in
service before May 13, 1993) and 27.5 years for
residential rental property.

ALTERNATIVE DEPRECIATION SYSTEM

(ADS) BASIC INFORMATION
1. ADS recovery period for tangible personal
property is normally the same as the class life of
the property, with some exceptions ( i.e., asset
class 00.12 and 00.22 )
2. Any tangible personal property that does not fit
into one of the asset classes is depreciated using
a 12-year ADS recovery period
3. ADS recovery period for nonresidential real
property is 40 years

CALCULATING DEPRECIATION DEDUCTIONS

UNDER MACRS
Depreciation
Depreciation
Class
Class

Personal
Personal
Method
Method

Approach
Approach
Property
Property

GDS
3-,
GDS
3-, 5-,
5-, 77- 200%
200% DB
DB method
method
10-year
with
when
10-year
with switch
switch to
to SL
SL
when
deduction
deduction greater
greater
GDS
15GDS
15- &
& 2020- 150%
150% DB
DB method
method
year
with
when
year
with switch
switch to
to SL
SL
when
deduction
deduction greater
greater
GDS
residential
GDS
residential SL
SL over
over fixed
fixed GDS
GDS recovery
recovery
&
& real
real rental
rental periods
periods
ADS
personal
ADS
personal &
&SL
SL method
method over
over fixed
fixed ADS
ADS
real
recovery
real
recovery periods
periods

HALF-YEAR
HALF-YEAR TIME
TIME CONVENTIONS
CONVENTIONS FOR
FOR
MACRS
MACRS DEPRECIATION
DEPRECIATION
CALCULATIONS
CALCULATIONS
All assets placed in service during the year
are treated as if use began in the middle of
the year -- 1/2- year depreciation is allowed
If asset is disposed of before the full
recovery period is used, only half of the
normal depreciation deduction can be taken
for that year

MACRS (GDS) PROPERTY CLASSES AND CLASS LIFE

GDS
Class
GDS Property
Property Class
Class and
and
Class Life
Life Depreciation
Depreciation
Method
Method
3-year,
44 years
3-year, 200%
200% DB
DB with
with
years or
or less
less switchover
switchover to
to
SL
SL
5-year,
More
5-year, 200%
200% DB
DB with
with
More than
than 44 years
years switchover
switchover
to
to
to SL
SL
to less
less than
than 10
10 years
years
7-year,
10
7-year, 200%
200% DB
DB with
with
10 years
years to
to less
less than
than
switchover
16
switchover to
to SL
SL
16
10-year,
16
10-year, 200%
200% DB
DB with
with
16 years
years to
to less
less than
than
switchover
20
switchover to
to SL
SL
20
15-year,
20
15-year, 150%
150% DB
DB with
with
20 years
years to
to less
less than
than
switchover
25
switchover to
to SL
SL
25
20-year,
25
20-year, 150%
150% DB
DB with
with
25 years
years or
or more
more switchover
switchover
to
to SL
SL
27.5
N
27.5 year,
year, SL
SL
N // A
A
39-year,
N
39-year, SL
SL
N // A
A

MACRS DEPRECIATION
GDS OR ADS ?

MACRS DEPRECIATION
GDS OR ADS ?

GDS
Ascertain property
class;
Same as recovery
period for personal

ADS
Ascertain recovery
period

MACRS DEPRECIATION
GDS OR ADS ?

GDS
Ascertain property
class;
Same as recovery
period for personal

Obtain recovery rates

ADS
Ascertain recovery
period

Compute depreciation
amount;
Assets cost basis
SL = -------------------------Recovery period

MACRS DEPRECIATION
GDS OR ADS ?

GDS
Ascertain property
class;
Same as recovery
period for personal

Obtain recovery rates

Compute depreciation
deduction in year k (dk)
by multiplying cost basis
by recovery period.

ADS
Ascertain recovery
period

Compute depreciation
amount;
Assets cost basis
SL = -------------------------Recovery period

Compute depreciation
deduction in year k (dk)

DEPLETION
Used
Used to
to indicate
indicate the
the decrease
decrease in
in the
the
value
value of
of the
the resource
resource base
base when
when
natural
natural resources
resources are
are being
being consumed
consumed
in
in producing
producing products
products or
or services.
services.
Term
Term most
most commonly
commonly used
used in
in
connection
connection with
with mining
mining properties,
properties, oil
oil
and
and gas
gas wells,
wells, timberlands,
timberlands, etc...
etc...
Amounts
Amounts charged
charged as
as depletion
depletion cannot
cannot
be
be used
used to
to replace
replace sold
sold resources
resources

PAYMENTS TO RESOURCE
OWNERS
Annual payments to resource
owners consist of two parts:
1. Earned profit
2. Portion of owners capital
returned, marked as depletion

TWO WAYS TO COMPUTE

DEPLETION ALLOWANCE
1. Cost method
Applies to all types of property and is more
widely used method
Depletion unit is determined by dividing
adjusted cost basis by the number of units
to be mined or harvested
Depletion allowance for tax year is the
product of the number of units sold times
the depletion unit

TWO WAYS TO COMPUTE

DEPLETION ALLOWANCE
2. The Percentage Method
Based on percentage of years gross income,
provided amount charged does not exceed 50% of
net income (before deduction of depletion
allowance)
Can be used for most types of metal mines,
geothermal deposits and coal mines
Can not be used for timber and, in most cases, is
not applicable to oil and gas
When percentage method applies, depletion
allowance must be calculated by cost and
percentage method -- the larger of the two applies

TYPES OF TAXES

1. Income taxes - assessed as a function of gross revenues

minus allowable deductions
- levied at federal, most state, and some municipal
governments
2. Property taxes - assessed as a function of owned
property value;
- independent of income or profit of firm
- levied at municipal, county, and / or state level
3. Sales taxes - assessed on purchases of goods and
services
- independent of gross income or profits
- relevent to engineering studies as added cost
4. Excise taxes - assessed on sale of certain nonessential
goods and services
- independent of business income and profit
- cost ultimately to consumer, despite original target

BEFORE-TAX MARR
( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~
~ After Tax
MARR

BEFORE-TAX MARR
( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~
~ After Tax
MARR
After-tax MARR
~
Before-tax MARR -------------------------------~
( 1 - effective tax rate )

BEFORE-TAX MARR
~
( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~ After Tax
MARR
After-tax MARR
~
~
Before-tax MARR -------------------------------( 1 - effective tax rate )

If the asset is nondepreciable and there are no

gains or losses on disposal, tax credits, or other
types of deductions involved this approximation
in the equation above is exact

BEFORE-TAX MARR
( Before Tax MARR ) [ ( 1- effective income tax rate ) ] ~
~ After Tax
MARR
After-tax MARR
~
Before-tax MARR -------------------------------~
( 1 - effective tax rate )

If the asset is nondepreciable and there are no

gains or losses on disposal, tax credits, or other
types of deductions involved this approximation
in the equation above is exact
Otherwise, some degree of error is introduced,
since the factors cited affect amount and timing
of income tax payments

CALCULATING TAXABLE INCOME

- NET INCOME BEFORE TAXES ( NIBT ) Calculate Gross Income
Gross Profits ( revenues from sales - cost of
goods sold )
+ income from dividends, interest, rent,
royalties, and gains (losses) from sale or
exchange of capital assets

Deduct all ordinary and necessary

operating expenses to conduct business
Include interest but exclude capital investments

Deduct depreciation
taxable income = gross income - all expenses - depreciation

NET INCOME AFTER TAXES

(NIAT)
The income after taxes have
been deducted from the
taxable income or Net Income
Before Taxes
Net Income After Taxes = NIBT - income taxes

EFFECTIVE (MARGINAL) CORPORATE

INCOME TAX RATE

As personal income tax rates are based on

income brackets, so, too, is corporate
income tax
Depending on the bracket a firms income
falls within, the marginal federal rate can
vary from 15% to a maximum of 39% (for
incomes between $100,000 and $335,000)
Incomes above $18,333,333 are taxed at a
flat rate of 35%
TRA 86 responsible for lowering maximum rate from
46% to 35%
Also created alternative minimum tax (AMT)

GAIN (LOSS) ON DISPOSAL OF A

DEPRECIABLE TANGIBLE ASSET
[ GAIN (LOSS) ON DISPOSAL ] N = MVN - BVN
If gain, referred to as depreciation recapture
Tax for gain (loss) is usually the same as
ordinary income gain (loss) -- effective
income tax rate, t
For capital asset sold or exchanged, gain
(loss) referred to as capital gain (loss)
capital assets are stocks, bonds, gold,
silver, other metals, and real property

BEFORE-TAX ECONOMIC ANALYSIS

NIBT = ( Rk Ek- dk )
Tk = - t ( Rk Ek dk )
Rk = revenues (and savings from the project: cash inflow from
project during period k
Ek = cash outflows during year k for deductible expenses and
interest
dk = sum of all noncash, or book costs during year k, such
as depreciation and depletion
t = effective income tax rate on ordinary income (federal,
state and other); assumed to remain constant during the
study period
Tk= income taxes paid during year k

ECONOMIC VALUE ADDED

(EVA)
An economic measure for estimating
wealth creation potential of capital
investments:
EVA = (Net Operating Profit After Taxes )k Cost of
Capital Used to Produce Profit)k
EVA = NOPATk . BVk-1
Where k = index for year in question (1 < k < N)

= after-taxMARR based on firms cost of capital

BVk-1= Beginning of year book value
N = the study (analysis) period in years

ECONOMIC VALUE ADDED

(EVA)
NOPATK = ( 1 t ) ( Rk Ek dk)
EVAk = ( 1 t ) ( Rk Ek dk) . BV
k-1
When k > 0, ATCFk = ( 1 t ) ( Rk Ek dk) + dk
When k = 0, ATCF0 = BV0
ATCFk = EVAk + . BV + dk
k
dk is the sum of all noncash, or book costs during
the year k, such as depreciation or depletion