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www.izmirekonomi.edu .tr L22: Book Depreciation ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

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L22: Book Depreciation. ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences. Chapter 8 Accounting for Depreciation and Income Taxes. Asset Depreciation Book Depreciation Tax Depreciation How to Determine “Accounting Profit” Corporate Taxes. - PowerPoint PPT Presentation

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Page 1: L22: Book Depreciation

www.izmirekonomi.edu.tr

L22: Book Depreciation

ECON 320 Engineering EconomicsMahmut Ali GOKCEIndustrial Systems EngineeringComputer Sciences

Page 2: L22: Book Depreciation

www.izmirekonomi.edu.tr

Chapter 8 Accounting for Depreciation and Income Taxes Asset Depreciation Book Depreciation Tax Depreciation How to Determine

“Accounting Profit” Corporate Taxes

Page 3: L22: Book Depreciation

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Depreciation• Definition: Loss of value for a fixed asset• Example: You purchased a car worth $15,000 at the beginning of year 2000.

Depreciatio

nEnd of Year

Market Value

Loss of Value

012345

$15,00010,000

8,0006,0005,0004,000

$5,0002,0002,0001,0001,000p

Page 4: L22: Book Depreciation

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Why Do We Consider Depreciation?

Gross Income -Expenses:(Cost of goods sold)(Depreciation)(operating expenses)

Taxable Income

- Income taxes

Net income (profit)

Business Expense: Depreciation is viewed as a part of business expenses that reduce taxable income.

Page 5: L22: Book Depreciation

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Depreciation Concept

Economic Depreciation

Purchase Price – Market Value(Economic losses due to both physical deterioration and technological obsolescence)

Accounting DepreciationA systematic allocation of the cost basis over a period of time.

Accounting depreciation is a way of writing off the investment on fixed assets by prorating over a certain period.

Page 6: L22: Book Depreciation

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Asset Depreciation

Depreciation

Economic depreciationthe gradual decrease inutility in an asset with

use and time

Accounting depreciationThe systematic allocation

of an asset’s value inportions over its

depreciable life—oftenused in engineeringeconomic analysis

Physicaldepreciation

Functionaldepreciation

Book depreciation

Taxdepreciation

Page 7: L22: Book Depreciation

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Factors to Consider in Asset Depreciation

Depreciable life (how long?)

Salvage value (disposal value)

Cost basis (depreciation basis)

Method of depreciation (how?)

Page 8: L22: Book Depreciation

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What Can Be Depreciated?

Assets used in business or held for production of income

Assets having a definite useful life and a life longer than one year

Assets that must wear out, become obsolete or lose value

A qualifying asset for depreciation must satisfy all of the three conditions above.

Page 9: L22: Book Depreciation

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Cost Basis

Cost of a new hole-punching machine (Invoice price) $62,500+ Freight 725

+ Installation labor 2,150

+ Site preparation 3,500

Cost basis to use in depreciation calculation

$68,875

Cost basis: Total cost claimed as expense over asset’s life

Page 10: L22: Book Depreciation

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Cost Basis with Trade-In Allowance

Old hole-punching machine (book value) $4,000

Less: Trade-in allowance 5,000

Unrecognized gains $1,000

Cost of a new hole-punching machine $62,500

Less: Unrecognized gains (1,000)

Freight 725

Installation labor 2,150

Site preparation 3,500

Cost of machine (cost basis) $67,875

Page 11: L22: Book Depreciation

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Asset Depreciation Range (years)

Assets Used Lower Limit Midpoint Life Upper Limit

Office furniture, fixtures, and equipment 8 10 12Information systems (computers) 5 6 7Airplanes 5 6 7Automobiles, taxis 2.5 3 3.5Buses 7 9 11Light trucks 3 4 5Heavy trucks (concrete ready-mixer) 5 6 7Railroad cars and locomotives 12 15 18Tractor units 5 6 7Vessels, barges, tugs, and water transportation system

14.5 18 21.5

Industrial steam and electrical generation and or distribution systems

17.5 22 26.5

Manufacturer of electrical and nonelectrical machinery

8 10 12

Manufacturer of electronic components, products, and systems

5 6 7

Manufacturer of motor vehicles 9.5 12 14.5Telephone distribution plant 28 35 42

Asset Depreciation Ranges as determined by IRS (Tax Offices)

Page 12: L22: Book Depreciation

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Types of Depreciation

Book DepreciationIn reporting net income to investors/stockholdersIn pricing decision

Tax DepreciationIn calculating income taxes for the IRS (Tax Offices)In engineering economics, we use depreciation in the context of tax depreciation

Page 13: L22: Book Depreciation

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Book Depreciation Methods

Purpose: Used to report net income to stockholders/investors

Types of Depreciation Methods: Straight-Line Method Declining Balance Method Unit Production Method

Page 14: L22: Book Depreciation

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Straight – Line (SL) Method

• Principle A fixed asset as providing its service in a uniform fashion over its life

• Formula•Annual Depreciation

Dn = (I – S) / N, and constant for all n.•Book Value

Bn = I – n (D)where I = cost basis

S = Salvage valueN = depreciable life

Page 15: L22: Book Depreciation

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Example 8.2 – Straight-Line Method

D1

D2

D3

D4

D5

B1

B2B3

B4

B5

$10,000

$8,000

$6,000

$4,000

$2,000

0 1 2 3 4 5

Total depreciation at end of life

n Dn Bn1 1,600 8,4002 1,600 6,8003 1,600 5,2004 1,600 3,6005 1,600 2,000

I = $10,000N = 5 YearsS = $2,000D = (I - S)/N

Annual Depreciation

Book Value

n

Page 16: L22: Book Depreciation

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Declining Balance Method• Principle: A fixed asset as providing its service in a decreasing fashion• Formula

• Annual Depreciation

• Book Value

1 nn BD 1)1( n

IB n )1( where 0 << 2(1/N)Note: if is chosen to be the upper bound, = 2(1/N),we call it a 200% DB or double declining balance method.

Page 17: L22: Book Depreciation

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Example 8.3 – Declining Balance Method

D1

D2

D3

D4D5

B1

B2

B3

B4 B5

$10,000

$8,000

$6,000

$4,000

$2,000

0 1 2 3 4 5

Total depreciation at end of life

$778

Annual Depreciation

Book Value

n012345

Dn

$4,0002,4001,440

864518

Bn$10,000

6,0003,6002,1601,296

778

INS

D B

I

B I

n n

n

nn

= $10, = years = $778 =

= ( -

0005

1

1

1

1

( )

n

Page 18: L22: Book Depreciation

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Example 8.4 DB Switching to SL

• SL Dep. Rate = 1/5=0.2• (DDB rate) = (200%) (SL rate)

= 0.40

Asset: Invoice Price $9,000Freight 500Installation 500

Depreciation Base $10,000Salvage Value 0Depreciation 200% DBDepreciable life 5 years

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n DepreciationBook Value

12345

10,000(0.4) = 4,000 6,000(0.4) = 2,400 3,600(0.4) = 1,440 2,160(0.4) = 864 1,296(0.4) = 518

$6,0003,6002,1601,296

778

n Book

Depreciation Value

12345

4,000 $6,0006,000/4 = 1,500 < 2,400 3,6003,600/3 = 1,200 < 1,440 2,1602,160/2 = 1,080 > 864 1,0801,080/1 = 1,080 > 518 0

(a) Without switching (b) With switching to SL

Note: Without switching, we have not depreciated the entirecost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits.

Case 1: S = 0Dn=(Bn-Salvage Value)/Remaining useful life

Dn is depreciation under straight line depreciation for year n

Page 20: L22: Book Depreciation

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Case 2: S = $2,000

End of Year

Depreciation Book Value

1 0.4($10,000) = $4,000 $10,000 - $4,000 = $6,000

2 0.4(6,000) = 2,400 6,000 – 2,400 = 3,600

3 0.4(3,600) = 1,440 3,600 –1,440 = 2,160

4 0.4(2,160) = 864 > 160 2,160 – 160 = 2,000

5 0 2,000 – 0 = 2,000

Note: Tax law does not permit us to depreciate assets belowtheir salvage values.

Page 21: L22: Book Depreciation

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Units-of-Production Method

• PrincipleService units will be consumed in a non

time-phased fashion

• Formula•Annual Depreciation

Dn = Service units consumed for yeartotal service units

(I - S)

Page 22: L22: Book Depreciation

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Example 8.5

Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles

Solution:

30,000 ($55,000 $5,000)250,000

3 ($50,000)25

$6,000

Dep