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Chapter 16

Depreciation Models

Depreciation Definition
Depreciation is the reduction of an assets value over time.
Brought on by:
Wear and tear, Use, Deterioration, Obsolescence

Deprecation represents a proper charge against future income produced by the


asset in question.

TANGIBLE - can be seen or touched


Personal property - includes assets such as machinery, vehicles, equipment, furniture,
etc
Peal 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

Personal Property
Personal property is the income-producing, tangible
possessions of a corporation used to conduct business.
Not to be confused with an individuals personal property like
clothes, furniture, etc.

Included are:
most manufacturing and service industry property vehicles,
manufacturing equipment, materials handling devices,
computers, and networking equipment, telephone equipment
office furniture, refining process equipment, and much more.

Real Property
Real property includes real estate and all improvements
office buildings manufacturing structures, warehouses,
apartments, and other structures.

Land itself is considered real property, but it is not


depreciable because it has an infinite life land can
never be depreciated for tax purposes.

Importance of Depreciation
Taxes law defines the concept of taxable income as:
Gross Income Real Cash Expenses interest Depreciation amounts

Tax Due ={Taxable Income}(Tax Rate)


Tax law permits the reduction of Gross Income by a category of
elements termed deductions

Wages and salaries;


Cost of materials;
Utilities;
Interest Paid on debt;
State and local taxes paid;

Depreciable?
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

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

Types of Depreciation
Book Depreciation
Value of the asset on the firms accounting records at any
given point in time.
Used for internal managerial decision making.
Management is free to use any method they so choose to
compute book depreciation amounts

Tax Depreciation
Used by a firm for state and federal income tax reporting
Follows strict rules and regulations.

Depreciation Terms
The Basis (B) of an asset is:
Purchase cost plus,
Delivery costs plus,
Installation costs and,

Any other costs associated with installing and preparing the asset for use.

Book Value of an Asset (BVt)


The remaining, undepreciated capital investment on the firms books after
the accumulated amounts of depreciation have been subtracted from the
original cost basis.
BVs are usually updated at the end of the firms accounting year.

Market Value
Market Value (MVt)
Market value is the estimated amount realizable if the asset were
sold on the open market.
Because of the structure of depreciation laws, the book value and
market value may substantially differ.
For example, a commercial building tends to increase in market
value, but the book value will decrease as depreciation charges are
taken

Salvage Value
Salvage Value (SV) is the estimated trade-in or market
value at the end of the asset's useful life
Expressed as an estimated dollar amount or as a percentage
of the first cost
Salvage values are estimated up-front at the time of the
original purchase.
Generally speaking, one cannot depreciate an asset below its
estimated salvage value.

Recovery Period-n
Recovery Period (in years) is the depreciable life n of the asset
in years.
Recovery Period -- Number of years over which basis of
property is recovered through accounting process.
Normally the useful life for classical methods

Also known as the Depreciable Life

Depreciation Models
Basic (traditional) models are:
Straight-Line Method (SL),
Sum-of-the-Years Digits Method (SYD),
Declining Balance Method (DB).

Today, the MACRS Method (a form of


declining balance-modified).

Straight-Line: The Standard (SL)


SL depreciation is the standard from which all other plans are compared.
Assumes the book value declines in a uniform manner down to a specified
salvage value S over n time periods.
Notation (to be followed herein)
t = the year (t = 1,2, , n)
Dt = Annual depreciation charge,
B = The first cost or unadjusted basis,
S = Estimated Salvage Value at t = n,
n = The Recovery Period,
d = The Depreciation Rate = 1/n

Dt ( B S ) d
Dt

BS
n

Declining Balance Method (DB)

Provides greater depreciation amounts in the early time periods over the SL
method.
Requires assuming a DB rate normally taken to equal 2 x SL rate.
Given the DB rate,
Dt for year t is found by multiplying the beginning of time period book value by
the rate.

The maximum DB rate set by law is:


dMAX = 2(1/n), or twice what the straight rate would be.

This is called The Double Declining Balance Rate.


If d = 1.5 (SL rate), it is termed the 150% DB rate.
d can never exceed 2(1/n), but can be less!

DB Equations
Dt ( d ) BVt 1

[16.5]

dt ( d ) B(1 d )t 1
DB if BVt-1 Not Known
Dt ( d ) B (1 d ) t 1

BVt B(1 d )t
BVt BVt 1 D

[16.7]
[16.8]
[16.9]

[16.6]

DB: Implied Salvage Value


From equations 16.4 16.9 there is no mention of the
salvage value S!
DB does not directly use the estimated salvage value.
DB has its own implied salvage value.
The pure DB method will never depreciate an asset
down to a 0 salvage value.
S BVn B (1 d ) n

Implied d = 1 (S/B)1/n

[16.11]

MACRS Recovery Periods


For Personal Property the following MACRS recovery
periods apply:
3- years,5-years,7-years,10-years,15-years and, 20-years.

Property Classes
27-Year Property: (Real Property)
Residential rental property (homes and mobile homes).
39-Year Property (Real Property)
Nonresidential real property attached to the land, but NOT
the land itself.

Property Classes Examples


3-Year Property:
Special manufacturing and handling devices, tractors and racehorses.

5-Year Property:
Computers and peripherals, Duplicating equipment, Automobiles, trucks,
buses, Cargo containers, Some manufacturing equipment.

7-Year Property Class:


Office furniture, Some manufacturing equipment, Railroad cars, engines
and tracks, Agricultural machinery, Petroleum equipment and natural gas
equipment,
All property not in another class!

The 7-year class is the default class!

Book Value Plot for Classical Methods


For SL, DB, and MACRS we have:

SL book values decline in a


linear fashion down to a
specified salvage value.
The DB method allows the book
value to accelerate faster since
the DB plot of book value is
below the SL book values
MACRS also permits
accelerated book values, but is
not as good as the pure DB
method permits.

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