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6 views

Chapter7 (1)

Uploaded by

koksemon007
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 29

CHAPTER

7
Depreciation And Income
Taxes

Created By : Eng.Maysa
Gharaybeh
Depreciati
on in value of physical properties with passage
Decrease
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
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
Depreciable Property (Tangible ,
Intangible

)
Tangible : can be seen or touched
personal property(‫ )ةلوقنمال الومالا‬: includes
assets such as machinery, vehicles,
equipment, furniture, etc...
real property(‫ )ةلوقنملا ريغ لا ومالا‬: 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( ‫ )تاءارب عارتخالا‬or
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.
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
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
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)
Additional
Recovery
Definitions
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.
Additional
Salvage Value (SV) : Estimated value of
Definitions
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
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.
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
Straight-Line (SL)
Method
Simplest depreciation method
Assumes constant amount is depreciated each
year over depreciable (useful) life

N = depreciable life
B = cost basis
dk = depreciaton in k
BVk = book value at end of k
SVN = salvage value
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
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, it’s
permissible to switch from this to straight-line method so asset’s 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 =


DB with Switchover
toDBSL
 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
Table 7-1 page
328
Taxable Income
(Before Taxable Income)
taxable income =
gross income - all expenses -
depreciation
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.
After Tax Economic
Analysis
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 = depreciation
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’ BTCFk = Before Tax
Cash Flow for year k ATCFk =
After Tax Cash Flow for
year k
The taxable income = ( Rk –
Ek- dk )
The income tax: Tk = - t
( Rk – Ek – dk ) BTCFk = Rk – Ek
ATCFk = BTCFk + Tk
= (Rk – Ek ) - t ( Rk – Ek –
dk )
= (1 – t)(Rk – Ek ) + t dk
Exampl
An asset is expected to produce a net cash
e:
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
BTC
0
1
F 70,000
-260,000
PW= -260,000 + 70,000 (P/A,10%,6)+
20,000(P/F,10%,6) =
2 70,000 -260,000 +70,000(4.3553) +20,000 (0.5645)=56,161
3 70,000 PW >0 it is acceptable alternative

4 70,000
5 70,000
SL = (260,000 -20,000)/6 =
6 70,000 40,000 per year
6 20,000
ATC
F
EOY A
BTC
B
Deprecia
C=A – B D= -
Taxa 0.4C
E=
A+D
F tion ble Income ATCF
Deductio Inco Tax
n me
0 -260,000 -260,000
1 70,000 40,000 30,000 -12,000 58,000
2 70,000 40,000 30,000 -12,000 58,000
3 70,000 40,000 30,000 -12,000 58,000
4 70,000 40,000 30,000 -12,000 58,000
5 70,000 40,000 30,000 -12,000 58,000
6 70,000 40,000 30,000 -12,000 58,000
6(mar 20,000 20,000 20,000
PW= -260,000 + 58,000 (P/A,10%,6)+
ket
value)
20,000(P/F,10%,6) =
-260,000 +58,000(4.3553) +20,000
(0.5645)=
3,897.4
PW >0 it is acceptable alternative

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