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Chapter 4_ Depreciation Schedule

financial modeling Depreciation Schedule

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7 views3 pages

Chapter 4_ Depreciation Schedule

financial modeling Depreciation Schedule

Uploaded by

Elaa Yaakoubi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 4: Depreciation Schedule

Depreciation is accounting for the aging of assets.


As a company uses an asset, its value typically decreases over time (wear and tear).
Asset value reduction must be offset by changes to other balance sheet (BS) items.
Asset value ↓ → expense recorded (reduces NI).
NI ↓ → Retained Earnings ↓ (in SE).
Depreciation is non-cash, so it’s added back in CF.
Depreciation Methods:
1. Straight-line: Equal expense yearly.
2. Accelerated: Higher expense in earlier years.

1. STRAIGHT-LINE DEPRECIATION
Spreads the cost of an asset evenly over its useful life.
Allocates an equal amount of depreciation expense each year.
Example (No Residual Value):
● Car purchase price = $50,000
● Useful life = 10 years
● Annual depreciation = $5,000
● Year 1: Car value = $45,000 ($50,000 - $5,000)
● Year 10: Car value = $0
● Accounts for wear and tear consistently each year.
● Residual value prevents depreciation from reducing asset value to
zero.
2. ACCELERATED DEPRECIATION
Allocates higher depreciation expenses in the early years of an asset's life and lower expenses in later years.
Purpose: Reduces taxable NI (Net Income) in the short term.
Lowers taxes by maximizing expenses upfront.
Useful for tax management and matching higher asset productivity in early years with higher depreciation.
Common Methods:
1. Declining Balance (DB): Higher depreciation in the first years, decreasing over time.
2. Sum of the Year’s Digits (SYD): Depreciation based on a fractional method using the sum of asset life years.
3. MACRS (Modified Accelerated Cost Recovery System): Standard method for tax purposes in the U.S., assigning
specific percentages of depreciation over different asset classes.

2.1. Declining Balance (DB):


Applies a percentage to the asset’s remaining value each year.
Example (Car, $50,000, 10-year life, 2.0 multiplier): 1/10 * 2=20%

2.2. Sum of the Year’s Digits (SYD): page 138


Allocates higher depreciation upfront, based on the sum of the years of the asset’s life.

/ Example (10-year life):1+2+3+...+10=55


For Year 1, the percentage will be 10/55, or 18.18%. For Year 2, the percentage will be 9/55, or 16.36%.
2.3. MACRS (Modified Accelerated Cost Recovery System): page 138-140
U.S. tax depreciation method with predefined percentages
Conventions: Half-year, mid-quarter (varies by asset placement timing).
Declining balance recalculates yearly based on net balance.
SYD applies percentage to the original asset value every year.
MACRS percentages vary; consult IRS tables for exact rates.
The half-year convention, shown in Table 4.3, assumes the asset is not placed in service
and does not begin depreciating until midyear.

The midyear convention assumes the asset is not placed in


service, and so does not start depreciating until midyear, so
an adjustment has been made to that first percentage.
⇒ first percentage is actually lower (33.33%) than the next
year’s percentage of 44.45%

3. DEFERRED TAXES:
3.1. Deferred Tax Asset (DTA):Asset on the balance sheet used to reduce future income tax expense.
Creation:
● Most commonly arises from Net Operating Loss (NOL) when expenses exceed sales.
● The IRS allows offsetting the NOL against taxable income from prior or future years.
Carryback/Carryforward Rules:
● Carryback: Offset NOL against taxable income from 2 to 5 prior years.
● Carryforward: Offset NOL against future taxable income for up to 20 years.
● Rules vary by business and IRS evaluation.
⇒ DTA represents potential tax savings in future periods, providing financial flexibility.
Example (Carryback):
● 2020 NOL = $1,000
● Apply to 2018 taxable income of $750 → Refund of $300 ($750 × 40%).
● $250 NOL remaining applies to 2019 taxable income of $1,500 → Refund of $100 ($250 × 40%).
● Total Refund = $400.
Example (Carryforward):
● 2020 NOL = $1,000
● Apply to 2018 taxable income of $100 → Refund of $40 ($100 × 40%).
● Remaining NOL = $900.
● Apply to 2019 taxable income of $200 → Refund of $80 ($200 × 40%).
● Total Refund = $120; remaining NOL = $700.
● This $700 becomes a Deferred Tax Asset (DTA) until used.

3.2. Deferred Tax Liability (DTL):


A liability created by temporary differences between GAAP income and tax income.
Often arises from different depreciation methods used for GAAP vs. tax reporting.
DTL represents taxes owed in the future as temporary differences reverse.
Short-term cash flow improves by deferring taxes.
Example:
● GAAP uses straight-line depreciation (SLD).
● Tax uses MACRS (accelerated depreciation).
Example:
● EBITDA: $100,000
● Asset Value: $50,000 (10-year life)
● SLD (GAAP): $5,000/year
● MACRS (Tax): $8,750 (Year 1 at 17.5%)
● Tax Rate: 40%

DTL=(8,750−5,000)×40%=1,500
4. PROJECTING DEPRECIATION:
A separate depreciation schedule helps project multiple depreciation methods (straight-line, accelerated) and deferred taxes
without cluttering the IS, CF, and BS.

4.1. Straight-Line Depreciation page 145 for details


Current Assets & CAPEX:
● Depreciate both existing assets and future CAPEX.
● This forms a tiered schedule, stacking depreciation each time CAPEX is added.
In IS, link projected depreciation from the depreciation schedule to the IS depreciation row (G33)
Copy to the right to update future years. Impact: EBIT, EBT, and NI update automatically.
Adjust PP&E useful life for overall depreciation changes.
Adjust CAPEX useful life to control future depreciation growth.
Large swings in depreciation usually reflect asset sales, write-downs, or new acquisitions.
The most accurate method involves detailed asset-level data (purchase date, cost, useful life).

4.2. PROJECTING DEFERRED TAXES


Deferred Taxes (DTL/DTA):
● Typically arise from GAAP vs. tax accounting differences (e.g., depreciation methods).
● Can also stem from carryforwards, tax credits, and other items beyond depreciation/amortization.
● Challenges in Modeling:
● Amazon’s 10-K (page 63) shows deferred taxes tied to multiple items, not just depreciation.
● Modeling each component is difficult due to limited 10-K disclosure.
Approach to Modeling:
● Simplification Strategy: Use the "Seven Methods of Projections" from Chapter 1.
● Most Conservative Method:
○ Apply the "last year" method.
○ This assumes deferred taxes stay consistent with the previous year.
○ Formula: G13 = F13\text{G13 = F13}G13 = F13
○ Copy forward through 2025.
Impact and Adjustments:
● Deferred taxes have limited impact on overall valuation.
● Assumption can be tweaked later or tested with different projection methods at the end of analysis.
● If no significant effect on valuation is observed, the conservative approach will suffice.
Move to the working capital schedule to finalize the cash flow statement (CF).

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