CONSIDERATION OF DEPRECIATION AND INCOME TAXES

METHODS & USAGE OF DEPRECIATION

CONSIDERATION OF DEPRECIATION AND INCOME TAXESDEPRECIATION

DEPRECIATION METHODS

DEPRECIATION AND INCOME TAXES

ECONOMIC VALUE ADDED (EVA)What is Depreciation? Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner.

Process of cost allocation, not asset valuation.Which Assets are Depreciated?Plant assets are tangible resources that are used in the operations of a business and are not intended for sale to customers.

They are also called property, plant, and equipment; plant and equipment; or fixed assets. Plant assets are subdivided into four classes: 1. Land such as a building site2. Land improvements such as driveways, parking lots3. Buildings such as stores, offices, factories and warehouses.4. Equipment such as office furniture, factory machine, delivery equipment

Depreciation applies to three classes of plant assets:

Land improvements, Buildings, DepreciableEquipment Assets

Land is not a depreciable asset.

Causes of DepreciationPhysical deterioration

Functional obsolescence

Economic obsolescence

Deterioration

Deterioration is the decay and disintegration which takes place in structures with the passage of time.

Deterioration operates to terminate the physical life of a building

Physical DeteriorationPhysical deterioration as a cause of depreciation is the result of wear and tear with usage and deterioration with age among others.

wear and tearrust, rot and decay

ObsolescenceObsolescence refers to those changes in usefulness of structures in certain neighborhoods which cause them to become less desirable or less useful.

Obsolescence operates to terminate the economic life of a building.Functional Obsolescence Functional Obsolescence is loss in value of a property resulting from changes in tastes, preferences, technical innovations, or market standards.

new technologyinadequacy

Economic ObsolescenceEconomic obsolescence is a loss of value as a result of impairment in utility and desirability caused by factors outside the propertys boundaries.

External or Locational obsolescence. Measuring DepreciationCostEstimated Useful LifeEstimated Salvage Value (residual value or scrap value)COSTCost will include all expenditures incurred by the business to bring the asset to its required location and to make it ready for use. COSTThe acquisition cost of land improvements, buildings, and equipment includes all costs of acquisition and preparation for useSales taxTransportationInstallationRepair cost prior to useESTIMATED USEFUL LIFE Estimated useful life is the length of the service period expected from the asset. years, units of output, miles, or another measure. Changing the Useful Life of a Depreciable AssetEstimating the useful life of each plant asset poses an accounting challenge.

Generally accepted accounting principles require the business to report the nature, reason, and effect of the accounting change on net income.

Willamette Industries, Inc.

1998 Due to technologic advances 1999

$89 million, $146million or or$0.80 a share $1,32 a share

65 percent improvement in earnings per share!

ESTIMATED SALVAGE VALUE

Estimated salvage value - also called scrap value or residual value - is the expected cash value of an asset at the end of its useful life. Cost

Useful LifeSalvage ValueFactors in Measuring Depreciation21METHODS & USAGE OFDEPRECIATION

Straight-Line (SL)Declining-Balance (DB)Units-of-Production (UOP)There are three types of methods used in depreciation.These are: METHODS & USAGE OF DEPRECIATIONSTRAIGHT-LINE METHOD: The simplest and most often used technique, in which the company estimates the salvage value of the asset, after the length of time over which it will be used to generate revenues (useful life), and will recognize a portion of that original cost in equal increments over that amount of time. METHODS & USAGE OF DEPRECIATION Imagine a truck bought on 01.01.2001 at an amount $41,000 and a usefuful life of 5 years or 100,000 miles can be driven.And also salvage value of the truck is $1,000.

Data Item Amount Cost Of Truck...................................................................................................$41000Less:Salvage Value.........................................................................................($1,000)Depreciable Cost.............................................................................................$40,000Estimeted Useful Life: Years.........................................................................................................5 Years Units Of Production........................................................................100,000 Miles

METHODS & USAGE OF DEPRECIATIONStraight-Line Depreciation: (Cost-Salvage Value)/Useful Life,In Years =($41,000-$1,000)/5= $8,000 per year

Depreciation For The YearDateAssetCostDepreciation RateDepreciable CostDepreciation ExpenseAccumulated DepreciationBook Value01.01.2001$41,000$41,00012.31.20010.20* x$40,000$8,000$8,000$33,00012.31.20020.20 x$40,000$8,000$16,000$25,00012.31.20030.20 x$40,000$8,000$24,000$17,00012.31.20040.20 x$40,000$8,000$32,000$9,00012.31.20050.20 x$40,000$8,000$40,000$1,000*1/5 year=0.20 per yearMETHODS & USAGE OF DEPRECIATIONDECLINING-BALANCE METHOD:Declaning-balance method also known as reducing-balance method , is a type of accelerated depreciation because it recognizes a higher depreciation cost earlier in an asset's lifetime.Also theres an accerelated method for declining-balance method that is called double-declining-balance(DDB). In DDB the assets decreasing book value is multiplied by a constant percentage that is 2 times bigger than DB.METHODS & USAGE OF DEPRECIATION

Declining-BalanceMETHODS & USAGE OF DEPRECIATION

METHODS & USAGE OF DEPRECIATIONLets have a look at how these depreceiation amounts are calculated:

Fistly we compute the depreciation rate per year.A 5-year asset has a straight-line rate of 1/5, or 20% per year.A 10-year asset also has 1/10, or 10% and so on.In double-declining balance method,we multiply the depreciation rate by 2.

DDB Rate = [1/(useful life of the asset,in year)] x 2Then were going to find every years the depreciation amount:DDB For The 1st Year: $41,000 x 0.40 = $16,400 DDB For The 2nd Year: ($41,000-16,400) x 0.40 = $9,840DDB For The 3rd Year: ($41,000-$16,400-$9,840) x 0.40 = $5,904DDB For The 4th Year: ($41,000-$16,400-$9,840-$5,904) x 0.40 = $3,542DDB For The 5th Year: ($41,000-$16,400-$9,840-$5,904-$3,542) - $1,000 =$4,314 (Final Depreciation Year) METHODS & USAGE OF DEPRECIATION

Double-Declining BalanceUnits Of Production Method (UOP)The UOP method determines depreciation expense based on the amount the asset is used. In the UOP, a fixed amount of depreciation goes with unit of output produced by the asset.

Units Of Production Method (UOP)The length of life of an asset is expressed in a form of productive capacity.

Units of usage can be expressed in quantitiy of goods produced, hours used, miles driven, for instance

Units Of Production Method (UOP)The depreciation expense of a period is determined by mutliplying usage by a fixed UOP rate of usage.Units Of Production Method (UOP)

Units Of Production Method (UOP)Our truck has an useful life of 100,000 miles.And assume that this truck is likely to be driven 20,000 miles the first year 30,000 the second,25,000 the third,15,000 the fourth, and 10,000 during the fifth.The amount of UOP depreciation each period varies with the number of units the asset produces. Units Of Production Method (UOP)UOP Depreciation Per Unit Of Output: (Cost-Residual Value)/Useful Life In Units Of Production= ($41,000-$1,000)/100,000 miles=$0,40 per mile Comparing Depreciation MethodsStraight-Line Method:

Comparing Depreciation MethodsDeclining Balance Method

Comparing Depreciation MethodsDouble-Declining Balance Method

Comparing Depreciation MethodsUnits of Production Method

Comparing Depreciation MethodsMany businesses use the straight line method in their financial statements and accelerated methods in their income tax returns.Accelerated methods result in higher depreciation expenses, thus a lower reported income.

Comparing Depreciation MethodsMost publicy owned companies want to appear as profitable as possibleas thier competitors. Therefore, majority of these companies straight-line method.Comparing Depreciation MethodsFor income tax purposes, finance experts usually want to report the lowest income to pay the lowest tax amount.Accelerated depreciation methods can reduce taxable income and so the tax payments decrease.YEARS Depreciation MethodsStraight-LineDeclining-BalanceDouble-Declining BalanceUnits-Of-ProductionDep.Exp.Dep.Exp.Dep.Exp.Dep.Exp.1st$8,000$8,200$16,400$8,0002nd$8,000$6,560$9,840$12,0003rd$8,000$5,248$5,904$10,0004th$8,000$4,198.4$3,542$6,0005th$8,000$15,793.6$4,314$4,000ConclusionAccounting principles and income tax laws both permit companies to use different depreciation methods in their financial statements and their income tax returns. Therefore, many companies use straight-line method in their financial statements and accelerated methods in their income tax returns.DEPRECIATION AND INCOME TAXESDEPRECIATION

Systemmatic allocation of the cost of a capital asset over a period of time for financial reporting purposes,tax purposes os both.

A noncash expense and thus does not affect cash from operations.

A tax deductable expense

DEPRECIATION AND INCOME TAXESThe higher the depreciation the lower income and the lower tax payment.Depreciation MethodsStraight-Line MethodDeclining Balance Method (DB)Units-of-Production Method (UOP)Accelerated Cost Recovery Method (ACRS)Modified Accelerated Cost Recovery Method (MACRS)

ACRS Prior to the Accelerated Cost Recovery System (ACRS) most capital purchases were depreciated using a straight line technique, that allowed for the depreciation of the asset over its useful life.ACRS was unique in three ways: property class lives were established, calculations were based on an estimated salvage value of zero, and shorter recovery periods were used to calculate annual depreciation. This resulted in an accelerated write off of capital costs (in comparison to that available using straight line depreciation) and was the source of the name.

Depreciation under ACRS = 2 x Straight Line Depreciation

MACRS Used only for income tax purposes Cost of asset ,including any other capitalized expenditures such as shipping and installation. The assets depreciable basis is not reduced by the estimated salvage value of the asset.MACRS GDS Property Classes Table

Property Class

Personal Property (all property except real-estate)

3-year property

Special handling devices for food and beverage manufacture.Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehiclesProperty with ADR class life of 4 years or less

5-year property

Information Systems; Computers / PeripheralsAircraft (of non-air-transport companies)ComputersPetroleum drilling equipmentProperty with ADR class life of more than 4 years and less than 10 years

7-year property

All other property not assigned to another classOffice furniture, fixtures, and equipmentProperty with ADR class life of more than 10 years and less than 16 years

10-year property

Assets used in petroleum refining and certain food productsVessels and water transportation equipmentProperty with ADR class life of 16 years or more and less than 20 years

15-year property

Telephone distribution plantsMunicipal sewage treatment plantsProperty with ADR class life of 20 years or more and less than 25 years

20-year property

Municipal sewersProperty with ADR class life of 25 years or more

Property Class

Real Property (real estate)

27.5-year property

Residential rental property (does not include hotels and motels)

39-year property

Non-residential real property

Class Identified by Asset Life (Years) Depreciation Method 3 DDB 5DDB10DDB20150% DB27,5SL39SLEconomic Value Added (EVA) What is Economic Value Added (EVA)?EVA is a value-based financial performance measure reflecting the absolute amount of shareholder value created or destroyed during each year.

What is Economic Value Added (EVA)? (cont.)It is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital.What is EVA?(cont.)A value-based financial performance measure A useful tool for choosing the most promising financial investments An effective protection against shareholder value destruction A tool suitable to control operations

Stern Stewart & CompanyOwns a registered trademark for EVA The proprietary component of what Stern Stewart & Co. does is the adjustments. The amortization of goodwill or capitalization of brand advertising and other similar adjustments are the translations that occur to Economic Profit to make it EVA.EVA Basic PremiseManagers are obliged to create value for their investors Investors invest money in a company because they expect returns There is a minimum level of profitability expected from investors, called capital charge Capital charge is the average equity return on equity markets; investors can achieve this return easily with diversified, long-term equity market investment EVA Basic Premise (cont.)Thus creating less return than the capital charge is economically not acceptable (especially from shareholders perspective) Investors can also take their money away from the firm since they have other investment alternativesEVA Simplified Calculation

EVA= OPBT - TAX - (TCE x COC) = NOPAT - (TCE x COC)OPBT: Operating Profit Before Tax TAX: Federal , state, county tax NPAT = Net Operating Profit Before Tax TCE: Total Capital Employed COC: Cost of Capital!!!! positive EVA indicates that this company creates value

EVA Simplified Calculation ExampleAssume that you have a firm with

IA = 100 In each year 1-5, assume that

ROCA = 15% DI = 10 (Investments are at beginning of each year)

WACCA = 10% ROCNew Projects = 15%

WACC = 10%Assume that all of these projects will have infinite lives. After year 5, assume thatInvestments will grow at 5% a year forever ROC on projects will be equal to the cost of capital (10%) Firm Value using EVA ApproachCapital Invested in Assets in Place = $ 100

EVA from Assets in Place = (0.15 - 0.10) (100) / 0.10 = $ 50

+ PV of EVA from New Investments in Year 1 = [(0.15 - 0.10)(10)/0.10] = $ 5

+ PV of EVA from New Investments in Year 2 = [(0.15 - 0.10)(10)/0.10]/1.12 = $ 4.55


+ PV of EVA from New Investments in Year 4 = [(0.15 - 0.10)(10)/0.10]/1.14 =$ 3.76


Value of Firm = $ 170.86EVA ImplementationStern Stewart & Co., the trademark owner of EVA, supports approximately 250 large companies around the world. EVA implementation results are highly correlated with stock prices. This measure can be maximized. Shareholders of the company will receive a positive value added when the return from the capital employed in the business operations is greater than the cost of that capital. EVA is an estimator for companys true economic value creationA good basis for management compensation systems to motivate managers to create shareholder value.EVA in Comparison with Other Economic MeasurementsEconomic Value Added is a tool more useful than rate of return (ROI) in controlling and steering day-to-day operations. EVA has not steering failures like ROI and EPS (maximizing these measures might lead to not optimal outcome; not max. shareholder value). EVA is a concept practically the same as Economic Profit (EP), Residual Income (RI) and Economic Value Management (EVM) Why is EVA also useful for small companies (even with less than 100 employees) ?Traditional performance measures used by small companies are unable to describe the companys true business results EVA calculation is simpleThe EVA concept is easy to understand and use EVA helps to understand the concept of profitability even by persons not familiar with finance and accounting Managers can make the EVA concept transparent to all employees in a short time Why is EVA also useful for small companies?(cont.)EVA reflects companys performance in dollars Positive EVA indicates value creation Negative EVA indicates value destruction Series of negative EVA is a signal that restructuring in a company may be neededEVA helps to convert a small companys strategy into objectives tangible for all employees EVA is a useful tool for allocation of a small companys scarce capital resources The EVA concept integrated in decisions making process improves its business performance because managers having deeper knowledge about capital and capital costWhy is EVA also useful for small companies?(cont.)What is Needed to Calculate Companys Economic Value Added (EVA)?Only following the information is needed for a calculation of a companys EVA: Companys Income Statement Companys Balance SheetEVA Implementation by a Small CompanyEVA calculation is just a starting point Permanent EVA improvement has to be the main management objective EVA has to be calculated periodically (at least every three months) Changes in EVA have to be analyzed EVA development is the basis for a companys financial and business policyHow can the Management in a Small Company Improve EVA?Try to improve returns with no or with only minimal capital investments Invest new capital only in projects, equipment, machines able to cover capital cost while avoiding investments with low returns Identify where capital employment can be reduced Identify where the returns are below the capital cost; divest those investments when improvements in returns are not feasible EVA DeficiencyTo transform traditional income statements into EVA ones, up to 164 adjustments need to be made Recommends inexpensive debts in order to reduce Cost of Capital (COC); a very questionable strategy for small businessesA passive accounting tool: measures past performance Because the business environment for small companies changes extremely quickly, a frequently financial evaluation is essentialConclusion

appropriate management tool for small business easy-to-calculate periodical EVA calculation and analysis can be done with minimal effort starting point for improvement in financial and business policy scarce capital resources of a small company can be more efficiently allocated result in a better business performance, because of better understanding the objectivesConclusion (cont.)Since EVA helps the organization to realize that capital is a costly resource the most immediate effect of EVA implementation is in most cases dramatic improvement in capital efficiency (improved capital turnover) Compared to conventional measures, EVA is an epochal measure since it can be maximized: it is the better the bigger EVA is.

Conclusion (cont.)EVA helps enormously the management and employees to see what should be real objective of the company, since it makes clear to all what profitability really is

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CONSIDERATION OF DEPRECIATION AND INCOME TAXES