Engi Econ - Depreciation

For Recitation

Depreciation

• is the decrease in value of physical properties with the passage of time and use

• is an accounting concept that establishes an annual deduction against before-tax income such that the effect of time and use on an asset’s value can be reflected in a firm’s financial statements.

Depreciable property

is property for which depreciation is allowed under federal, state, or municipal income tax laws and regulations

property is depreciable if it meets the following basic requirements:

1. It must be used in business or held to produce income.

2. It must have a determinable useful life, and the life must be longer than one year.

3. It must be something that wears out, decays, gets used up, becomes obsolete, or loses value from natural causes.

4. It is not inventory, stock in trade, or investment property.

tangible or intangible

2 classifications of Depreciable Property

Tangible property

depreciable property that can be seen or touched

Personal property

Is a tangible property such as machinery, vehicles, equipment, furniture, and similar items.

real property

is a tangible property that is land and generally anything that is erected on, or attached to land

Intangible property

is personal property as a copyright, patent, or franchise

placed in service

• company can begin to depreciate it owns when the property begins to __

• when it is ready and available for a specific use, even if it is not actually used yet

straight-line (SL),

declining balance (DB),

sum-of the-digits (SYD)

In general, the following summary indicates the primary methods used for property placed in service during three distinct time periods.

Adjusted (cost) basis

the original cost basis of the asset, adjusted by allowable increases or decreases, is used to compute depreciation and depletion deductions

Book value (BV)

It is the original cost basis of the property, including any adjustments, less all allowable depreciation or depletion deductions. It thus represents the amount of capital that remains invested in the property and must be recovered in the future through accounting process.

Basis, or cost basis

• the initial cost of acquiring an asset (purchase price plus any sales taxes), including transportation expenses and other normal costs of making the asset serviceable for its intended use

• also called the unadjusted cost basis

Market value (MV)

the amount that will be paid by a willing seller for a property where each has equal advantage and is under no compulsion to buy or sell. The __approximates the present value of what will be received through ownership of the property, including the time value of money (or profit)

Recovery Period

• the number of years over which the basis of a property is recovered through the accounting process

• Classical methods: useful life

• Modified Accelerated Cost Recovery System (MACRS)

  • General Depreciation System (GDS): property class

  • Alternative Depreciation System (ADS): class life

Recovery rate

a percentage (expressed in decimal form) for each year of the MACRS recovery period that is utilized to compute an annual depreciation deduction.

Salvage value

the estimated value of a property at the end of its useful life. It is the expected selling price of a property when the asset can no longer be used productively by its owner.

• classical methods of depreciation: used in depreciation calculations

• MACRS: zero in value

net salvage value

This is used when the owner will incur expenses in disposing of the property, and these cash outflows must be deducted from the cash inflows to obtain a final net SV.

Useful life

the expected (estimated) period of time that a property will be used in a trade or business or to produce income. It is not how long the property will last but how long the owner expects to productively use it.

• Useful life is sometimes referred to as depreciable life. Actual useful life of an asset, however, may be different than its depreciable life

Straight-Line (SL) Method

is the simplest depreciation method. It asumes that a constant amount is appreciated each year over the depreciable (useful) life of the asset.

Declining Balance (DB) Method

• aka: constant percentage method or the Matheson formula

• it is assumed that the annual cost of depreciation is a fixed percentage of the BV at the beginning of the year. The ratio of the depreciation in any one year to the BV at the beginning of the year is constant throughout the life of the asset and is designated by R

Sum-of-the-Years-Digits (SYD) Method

In this depreciation method, the digits corresponding to the number for each permissible year of life are first listed in reverse order. The sum of these digits is then determined. The depreciation factor for any year is the number from the reverse ordered listing for that year divided by the sum of the digits.