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Depreciation And Income Taxes
CHAPTER 7
Depreciation
Decrease in value of physical properties with passage 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 yearwear out, decay, get used up, become obsolete,
or lose value from natural causesnot be inventory, stock in trade, or investment
property
Depreciable Property (Tangible , Intangible )
Tangible : can be seen or touched
personal property( المنقولة includes : (االموالassets such as machinery, vehicles, equipment, furniture, etc...
real property( المنقولة غير anything : (االموالerected 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( االختراع )or franchise (براءات معين ,امتياز إعفاء )
When Depreciation Starts And StopsDepreciation 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
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
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)
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 Definitions Recovery Period :Number of years over which
basis of property is recovered through accounting process.
Normally the useful life for classical methodsProperty class for General Depreciation
System (GDS) under MACRSClass Life for Alternative Depreciation
System (ADS)Recovery Rate :Percentage for each year of
MACRS recovery period used to calculate an annual depreciation deduction.
Recovery Period :Number of years over which basis of property is recovered through accounting process.
Normally the useful life for classical methodsProperty class for General Depreciation
System (GDS) under MACRSClass Life for Alternative Depreciation
System (ADS)Recovery Rate :Percentage for each year of
MACRS recovery period used to calculate an annual depreciation deduction.
Additional Definitions Salvage Value (SV) : Estimated value of
property at the end of useful life. expected selling price of property when asset
can no longer be used productivelynet 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
Salvage Value (SV) : Estimated value of 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.
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 yearsB = cost basis, including allowable adjustmentsd 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) MethodSimplest depreciation methodAssumes constant amount is depreciated each year
over depreciable (useful) life
N = depreciable lifeB = cost basisdk = depreciaton in k
BVk = book value at end of k
SVN = salvage value
Declining Balance (DB) MethodSometimes called constant percentage method or Matheson formulaAssumed annual cost of depreciation is fixed percentage of BV at
beginning of yearR is constant R = 2 / N when 200% declining balance OR R = 1.5 / N
when 150% declining balance used
d 1 = 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 MethodNot based on the idea that decrease in value of
property is a function of timeDecrease in value is mostly a function of useMethod 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 to SLDB 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 328d k = ( B - SVN ) / N
But the basis B from Col(1)Changed every year and N is the remaining years As followes :
Year (3)
1 4,000/10 years =400
2 3,200/9 year = 355.65
3 2,560/8years = 320
And so on
We select the largest depreciation amount .
ثــالثة cمe الظgل : iهk الل cولcرس قال قال cهe عن الله رضiي qكi مال iنe ب iأنس eعن
ثالثة : " : cمe الظgل وسلم عليه الله هc صلى cرiفeيغ ال eم cل فظcهk هc ، الل cرiفeيغ eم cل cهc ، وظ ك cرe يت ال eم cل ال وظ kذiي ال cمe الظgل فأمkا ،
cهk الل cه cرiفeيغcك eر eم , : } فالش� cل لظ ك eر الش� kنi إ cهk الل قال } ، cه cرiفeيغ kذiي ال cمe الظgل وأمkا eفcسهcمe عظiيم أن iبادiالع cمe cل فظ
eمiه� رب eن وبي eمcنهe بي ال- - فiيما kذiي ال cمe الظgل وأمkا ، وجل عز ، cهc ك cرe بعeض�ا يت eمcضهeعc ب iبادiالع cمe cل مiنe , فظ eمcضهeبع gصcيق kى حت
eجامiع " : ال صحiيح انظر qضeيحة , : 3961بعiحk1927الص
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
Example:
An asset is expected to produce a net cash 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 BTCFB)develop ATCF C) Calculate the PW for both CFs
BTCF0 -260,000
1 70,000
2 70,000
3 70,000
4 70,000
5 70,000
6 70,000
6 20,000
PW= -260,000 + 70,000 (P/A,10%,6)+ 20,000(P/F,10%,6) = -260,000 +70,000(4.3553) +20,000 (0.5645)=56,161PW >0 it is acceptable alternative
SL = (260,000 -20,000)/6 =40,000 per year
ATCFEOY A
BTCF BDepreciation Deduction
C=A – B Taxable Income
D= - 0.4CIncome Tax
E= A+D ATCF
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(market value)
20,000 20,000PW= -260,000 + 58,000 (P/A,10%,6)+ 20,000(P/F,10%,6) = -260,000 +58,000(4.3553) +20,000 (0.5645)= 3,897.4PW >0 it is acceptable alternative