Accounting for Depreciation and Income Taxes - Engineering Economics

Applied Software Project Management

Engineering EconomicsEngineering Economics

Accounting for Depreciation and Income Taxes Accounting for Depreciation and Income Taxes

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Accounting Depreciation Book Depreciation Methods Tax Depreciation Methods How to Determine “Accounting Profit” Corporate Taxes

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Depreciable PropertyDepreciable Property

For the purposes of U.S. tax law. any depreciable property has the following characteristics.

1. It must be used in business or held for the production of income.

2. It must have a definite service life, which 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.

Depreciable property includes buildings, machinery, equipment, vehicles, and some intangible properties.

Inventories are not depreciable property. because they are held primarily for sale to customers in the ordinary course of business.

If an asset has no definite service life, the asset cannot be depreciated. For example, you can never depreciate land.

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Cost BasisCost Basis

The cost basis of an asset represents the total cost that is claimed as an expense over an asset's life i.e. the sum of the annual depreciation expenses.

Cost basis generally includes the actual cost of an asset and all incidental expenses, such as freight, site preparation, and installation.

This total cost, rather than the cost of the asset only, must be the basis for depreciation charged as an expense over an asset's life.

Besides being used in figuring depreciation deductions, an asset's cost basis is used in calculating the gain or loss to the firm if the asset is ever sold or salvaged.

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Cost BasisCost Basis

Rockford Corporation (page 272)

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Useful Life and Salvage ValueUseful Life and Salvage Value

How long will an asset be useful to the company? Asset Depreciation Ranges: guidelines specify a range of lives for

classes of assets, based on historical data. allowing taxpayers to choose a depreciable life within the specified range for a given asset

Example (page 273) The salvage value of an asset is an asset's estimated value at the

end of its life; It is the amount eventually recovered through sale, trade-in, or

salvage. The eventual salvage value of an asset must be estimated when the

depreciation schedule for the asset is established. If this estimate subsequently proves to be inaccurate, then an

adjustment must be made

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Applied Software Project ManagementDepreciation Methods: Book and Depreciation Methods: Book and Tax DepreciationTax Depreciation

Most firms calculate depreciation in two different ways, depending on the intention of the calculation

Book depreciation method– Used in reporting net income to investors and stockholders– Used in pricing decisions

Tax depreciation method– Used in calculating income taxes for the IRS– Used in engineering economics

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Straight-Line MethodStraight-Line Method

The straight-line method (SL) of depreciation interprets a fixed asset as an asset that provides its services in a uniform fashion. That is, the asset provides an equal amount of service in each year of its useful life.

In other words, the depreciation rate is 1/N, where N is the depreciable life

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Straight-Line MethodStraight-Line Method

Consider the following data on an automobile: (page 275) Cost basis of the asset (I) = $10,000; Useful life (N) = 5 years: Estimated salvage value (S) = $2,000. Compute the annual depreciation allowances and the resulting book

values, using the straight-line depreciation method. Given: I = $10,000, S = $2.000, and N = 5 years. Find: Dn and Bn for n = 1 to 5.

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Declining-Balance MethodDeclining-Balance Method

The stream of services provided by a fixed asset may decrease over time: in other words, the stream may be greatest in the first year of an asset's service life and least in its last year.

This pattern may occur because the mechanical efficiency of an asset tends to decline with age, because maintenance costs tend to increase with age or because of the increasing likelihood that better equipment will become available and make the original asset obsolete.

This reasoning leads to a method that charges a larger fraction of the cost as an expense of the early years than of the later years.

This method, the declining-balance method is most widely used.




The declining-balance method of calculating depreciation allocates a fixed fraction of the beginning book balance each year

α = (1/N) (multiplier)




Consider the following data on an automobile: (page 275) Cost basis of the asset (I) = $10,000; Useful life (N) = 5 years: Estimated salvage value (S) = $2,000. Compute the annual depreciation allowances and the resulting book

values, using double-declining-balance depreciation method. Given: I = $10,000, S = $2.000, and N = 5 years. Find: Dn and Bn for n = 1 to 5.




α = (1/N) (multiplier)α = (1/5) (2) = 40%



Units-of-Production Method Units-of-Production Method

Straight-line depreciation can be useful only if the machine is used for exactly the same amount of time each year

units-of-production method: depreciation charge for a period is then related to the number of service units consumed in that period


S)(IUnitsServiceTotal

nYearDuringConsumedUnitsServicenD


Units-of-Production Method Units-of-Production Method

A truck for hauling coal has an estimated net cost of $55,000 and is expected to give service for 250,000 miles, resulting in a $5,000 salvage value. Compute the allowed depreciation amount for truck usage of 30,000 miles.

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

Find: Depreciation amount in this year.



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MACRS MACRS

MACRS– Modified Accelerated Cost Recovery System– Scheme Used to depreciate property– the salvage value of property is always treated as zero



MACRS Recovery Periods MACRS Recovery Periods

MACRS Recovery Periods: lifespan of property created by MARCS scheme

Computers, automobiles. and light trucks are written off over 5 years by using 200% DB and then switching to SL depreciation.

Most types of manufacturing equipment are depreciated over 7 years, but some long-lived assets are written off over 10 years. Most equipment write-offs are calculated by using the 200%-DB method and then switching to SL depreciation, an approach that allows for faster write-offs in the first few years after an investment is made.



MACRS Recovery Periods MACRS Recovery Periods

Sewage-treatment plants and telephone-distribution plants are written off over 15 years by using 150% DB and then switching to SL depreciation.

Sewer pipes and certain other very long-lived equipment are written off over 20 years by using 150% DB and then switching to SL depreciation.

Investments in residential rental property are written off in straight-line fashion over 27.5 years.

On the other hand, nonresidential real estate (commercial buildings) is written off by the SL method over 39 years


Applied Software Project ManagementMACRS Depreciation: MACRS Depreciation: Personal PropertyPersonal Property

Half-Year Convention: All assets are placed in service at midyear and that they will have

zero salvage value. A half-year of depreciation is allowed for the first year that property

is placed in service. A full year's depreciation is allowed in each of the remaining years

of the asset's recovery period, and The remaining half-year's depreciation is incurred in the year

following the end of the recovery period. A half-year of depreciation is also allowed for the year in which the

property is disposed of, or is otherwise retired from service, anytime before the end of the recovery period



Switching from the DB Method to the SL Method: The MACRS asset is depreciated initially by the DB method and then by the SL method. Consequently, the MACRS scheme adopts the switching convention illustrated in previous Section



MACRS Depreciation Schedules for Personal Property with Half-Year Convention (page 282)


Year 3 200%

DB

5 200%

DB

7 200%

DB

10 200%

DB

15 150%

DB

20 150%

DB

1 33.33%

2

3

4

5

6

7


Three year:– Straight line = 1/3 = 0.3333– 200% DB rate = 2(1/3) = 0.6667– S = 0– Year 1: ½ Year DDB Depreciation = 0.5 (0.6667) = 33.33%– Year 2: DDB Depreciation = 0.6667(1-0.3333) = 44.45%

SL Depreciation = (1/2.5)(1-0.3333) = 26.67%– Year 3: DDB Depreciation = 0.6667(1-0.3333-0.4445) = 14.81%

SL Depreciation = (1/1.5)(1-0.3333-0.4445) = 14.81%– Year 4:

SL Depreciation = 0.5(1/0.5)(1-0.3333-0.4445-0.1481) = 7.41%



Five year:– Straight line = 1/5 = 0.2– 200% DB rate = 2(1/5) = 0.4– S = 0– Year 1: ½ Year DDB Depreciation = 0.5 (0.4) = 20.00%– Year 2: DDB Depreciation = 0.4(1-0.2) = 32.00%

SL Depreciation = (1/4.5) (1-0.2) = 17.78%– Year 3: DDB Depreciation = 0.4(1-0.2-0.32) = 19.2%

SL Depreciation = (1/3.5) (1-0.2-0.32) = 13.71%– Year 4: DDB Depreciation = 0.4(1-0.2-0.32-0.192) = 11.52%

SL Depreciation = (1/2.5) (1-0.2-0.32-0.192) = 11.52%– Year 5: SL Depreciation = (1/1.5) (1-0.2-0.32-0.192-0.1152) =

11.52%– Year 6: ½ SL Depreciation = 0.5(1/0.5) (1-0.2-0.32-0.192-0.1152-

0.1152) = 5.76%www.hoasen.edu.vn 25


A taxpayer wants to place in service a $10,000 asset that is assigned to the five year MACRS class. Compute the MACRS percentages and the depreciation amounts for the asset.

Given: Five-year asset, half-year convention, α = 40%, and S = 0. Find: MACRS depreciation percentages Dn for a $10,000 asset.


Applied Software Project ManagementMACRS Depreciation: MACRS Depreciation: Real Property Real Property

Real properties classified into two categories:

1. residential rental property and

2. commercial building or properties. When depreciating such property. T

The straight-line method and the midmonth convention are used. For example, a property placed in service in March would be allowed 9.5 months depreciation for year one.

If it is disposed of before the end of the recovery period, the depreciation percentage must take into account the number of months the property was in service during the year of its disposal.

Residential properties are depreciated over 27.5 years, and commercial properties are depreciated over 39 years



On May 1, Jack Costanza paid $100,000 for a residential rental property. This purchase price represents $80,000 for the cost of the building and $20,000 for the cost of the land. Three years and five months later, on October 1 he sold the property for $130,000. Compute the MACRS depreciation for each of the four calendar years during which he owned the property.

Given: Residential real property with cost basis = $80,000; the building was put into service on May 1.

Find: The depreciation in each of the four tax years the property was in service.


MACRS Depreciation: MACRS Depreciation: Real Property Real Property


The midmonth convention assumes that the property is placed in service on May 15, which gives 7.5 months of depreciation in the first year.

Remembering that only the building (not the land) may be depreciated.

We compute the depreciation over a 27.5-year recovery period, using the SL method:




Year Calculation Dn Recovery Percentage

1 (7.5/12)(80,000-0)/27.5 1,818

2 (80,000-0)/27.5 2,909

3 (80,000-0)/27.5 2,909

4 (9.5/12)(80,000-0)/27.5 2,303




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Applied Software Project ManagementTreatment of Depreciation Treatment of Depreciation ExpensesExpenses

If project revenues exceed project costs - it has generated a profit, or income.

If the project reduces a firm's wealth – i.e. project costs exceed project revenues - the project has resulted in a loss

Any profit generated will be taxed. The accounting measure of a project's after-tax profit during

a particular time period is known as net income.


Applied Software Project ManagementTreatment of Depreciation Treatment of Depreciation ExpensesExpenses

Capital expenditures must be capitalized, i.e. they must be systematically allocated as expenses over their depreciable lives.

When you acquire a piece of property that has a productive life extending over several years, you cannot deduct the total costs from profits in the year the asset was purchased.

Instead, a depreciation allowance is established over the life of the asset, and an appropriate portion of that allowance is included in the company's deductions from profit each year.

Because it plays a role in reducing taxable income, depreciation accounting is of special concern to a company



Calculation of Net IncomeCalculation of Net Income

Project revenue: the income earned by a business as a result of providing products or services to customers. Revenue comes from sales of merchandise to customers and from fees earned by services performed for clients or others.

Project expenses: are costs incurred in doing business to generate the revenues of the specified operating period.

Some common expenses are the cost of goods sold (labor, material, inventory, supplies), depreciation, the cost of employees' salaries, the operating costs (the cost of renting buildings, the cost of insurance coverage), and income taxes.




Taxable income = gross income – expenses Income taxes = (tax rate) X (taxable income)




A company buys a numerically controlled (NC) machine for $28,000 (year zero) and uses it for five years, after which time it is scrapped. The allowed depreciation deduction during the first year is $4,000. as the equipment falls into the seven-year MACRS-property category. (The first-year depreciation rate is 14.29%.) The cost of the goods produced by this NC machine should include a charge for the depreciation of the machine. Suppose the company estimates the following revenues and expenses, including the depreciation for the first operating year:

Gross income = $50,000; Cost of goods sold = $20.000; Depreciation on NC machine = $4,000: Operating expenses = $6,000. If the company pays taxes at the rate of 40% on its taxable income,

what is its net income during the first year from the project‘?




Given: Gross income and expenses as stated; income-tax rate = 40%. Find: Net income.


Item Amount

Gross Income 50,000

Expense

Cost of goods sold 20,000

Depreciation 4,000

Operation Expense 6,000

Taxable Income 20,000

Tax (40%) 8,000

Net Income 12,000

Applied Software Project ManagementOperating Cash Flow versus Net Operating Cash Flow versus Net IncomeIncome

Certain expenses are not really cash outflows. Depreciation and amortization are the best examples of this type of expense.

Even though depreciation (or amortization expense) is deducted from revenue for tax or book purposes on a yearly basis no cash is paid to anyone, except when the asset was purchased.

Net income (accounting profit) is important for accounting purposes

Cash flows are more important for project-evaluation purposes

Operating cash flow = net income + noncash expense (i.e., depreciation).



For the situation described in Example above, assume that (1) all sales are cash sales and (2) all expenses except depreciation were paid during year one. How much cash would be generated from operations?

Given: Net-income components as in Example above Find: Cash flow from operation.




Item Amount Cash Flow

Gross Income

Expense

Cost of goods sold

Depreciation

Operation Expense

Taxable Income

Tax (40%)

Net Income

Cash Flow from operation


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Applied Software Project ManagementIncome Taxes on Operating Income Taxes on Operating IncomeIncome

The corporate-tax-rate structure for 2003: There are four basic rate brackets (15%, 25%. 34%, and

35%) plus two surtax rates (5% and 3%) based on taxable incomes.

U.S. tax rates are progressive: that is. Businesses with lower taxable incomes are taxed at lower rates than those with higher taxable incomes.

Marginal tax rate is defined as the rate applied to the last dollar of income earned



A mail-order computer company sells personal computers and peripherals. The company leased showroom space and a warehouse for $20,000 a year and installed $290,000 worth of inventory-checking and packaging equipment. The allowed depreciation expense for this capital expenditure ($290,000 total) amounted to $58,000. The store was completed and operations began on January 1.The company had a gross income of $1,250,000 for the calendar year. Supplies and all operating expenses other than the lease expense were itemized as follows:



Merchandise sold in this year: 600,000 Employee salaries and benefits: 150,000 Other supplies and expenses: 90,000

Total: 840,000 Compute the taxable income for this company. How

much will the company pay in federal income taxes for the year? What is its average corporate tax rate?

Given: Income, foregoing cost information, and depreciation amount.

Find: Taxable income, amount paid in federal income taxes, and average corporate tax rate.



First we compute the taxable income as follows:

Gross revenue: 1,250,000

Expenses: 840,000

Lease expense: 20,000

Depreciation: 58,000

Taxable income: 332,000 Income tax: 112,710 AV Tax rate = 112,710/320,000 = 33.9%



Gain Taxes on Asset DisposalsGain Taxes on Asset Disposals

When a depreciable asset used in business is sold for an amount that differs from its book value, the gains or losses have an important effect on income taxes.

The gains or losses are found as:

Gains(losses) = salvage value - book value The gains, known as depreciation recapture, are taxed

as ordinary income under current tax lawGains = salvage value - book value

= (salvage value – cost basic) + (cost basic – book value)

Capital Gains Ordinary Gains




A company purchased a drill press costing $230,000 in year zero. The drill press, classified as seven-year recovery property, has been depreciated by the MACRS method. If it is sold at the end of three years for (1) $150,000 or (2) $100,000, compute the gains (losses) for each situation. Assume that both capital gains and ordinary income are taxed at 34%.

Given: Seven-year MACRS asset, cost basis = $230.000, sold three years after purchase

Find: Gains or losses. tax effects and net proceeds from the sale if sold for $150,000 or $100,000




the first three years of a seven-year MACRS property are 14.29%, 24.49%, and 17.49%. Respectively

Depreciation = 230,000(14.29%+24.49%+17.49%/2)

= 109,308 Book value = Cost basic – depreciation

= 230,000 – 109,308 = 120,692 Case 1: S = 150,000

book value < salvage value < cost basic

gain = 150,000 – 120,692 = 29,308

Tax = 0.34 * 29,308 = 9965

Net income from sale = 150,000 – 9965 = 140,035 Case 2: S = 100,000

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Case 2: S = 100,000

salvage value < book value < cost basic

loss = 100,000 – 120,692 = -20,692

Gain Tax = 0.34 * 20,692 = 7035

Net sale = 100,000 + 7035 = 107,035


Applied Software Project ManagementComputation of After Tax Computation of After Tax Cash Flow ATCFCash Flow ATCF

Certain new machinery, when place in service, is estimated to cost 180,000. It is expected to reduce net annual operating expenses by 36,000 per year for 10 years and to have a 30,000 salvage value (market value MV) at the end of the 10th year.

(a)Develop the ATCFs and BTCFs

(b)Calculate the before-tax and after-tax IRR. Assume that the firm is in the federal taxable income bracket of 335,000 to 10,000,000 and that the state income tax rate is 6%. State income taxes are deductible from federal taxable income. This machine is in MACRS (GDS) five-year property class



(c) Suppose the machinery had been classified in the 10-year MACRS property class. Calculate the new after-tax PW and after-tax IRR. Why are these results different than the results in (b)



(a) & (b)


i 12.38%

YearINCOME

(A)DEP

FACTORDEP (B)

Taxable INCOME

(C ) = (A) + (B)

CF for INCOME TAX (D) = -0.40(C )

After-Tax Cash Flow

(E) = (A) + (D)

Discount Factor

0 -180,000 -180,000 1.00 -180000.001 36,000 20.00% -36000 0 0 36,000 0.89 32034.172 36,000 32.00% -57600 -21,600 8208 44,208 0.79 35004.413 36,000 19.20% -34560 1,440 -547.2 35,453 0.70 24979.484 36,000 11.52% -20736 15,264 -5800.32 30,200 0.63 18934.175 36,000 11.52% -20736 15,264 -5800.32 30,200 0.56 16848.346 36,000 5.76% -10368 25,632 -9740.16 26,260 0.50 13036.417 36,000 0.00% 0 36,000 -13680 22,320 0.44 9859.878 36,000 0.00% 0 36,000 -13680 22,320 0.39 8773.689 36,000 0.00% 0 36,000 -13680 22,320 0.35 7807.16

10 36,000 0.00% 0 36,000 -13680 22,320 0.31 6947.1110 30,000 0.00% 0 30,000 -11400 18,600 0.31 5789.25

PW(i) 14.05IRR 10% 12% 12.38%PW() 17208.86 2587.48 14.05


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Accounting for Depreciation and Income Taxes - Engineering Economics

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