Depreciation

Engr 360 Engineering Econ. 11.1

Depreciation The word “depreciate” means to decrease or diminish in value. Equipment, machinery, & other assets will depreciate because of: 1. Normal wear-and-tear (deterioration due to use); 2. Obsolescence (no longer needed; or replaced by more efficient options).

Depreciation can be defined in several ways: 1. A decrease in market value (accepted value of property at any given time; i.e., its value to potential buyers.); 2. A decrease in value from the owner’s perspective; 3. Systematic allocation of an asset’s initial cost over its depreciable life.

Engr 360 Engineering Econ. 11.2

Depreciation (contin.)

Any equipment with a useful life of more than one year, and which wears out or becomes obsolete with time, is eligible for depreciation analysis.

In contrast to expensed costs (which reduce income taxes because companies are able to write-off their full amount when they occur), costs due to depreciated assets are not fully written off at the time of initial purchase. Instead, such depreciation costs are written off over an extended period known as the depreciable life or recovery period. Typically, this period is less than the actual useful life of the asset.

Depreciation deductions reduce the taxable income of companies and thus reduce the amount of taxes paid. Therefore, depreciation costs do impact the cash flows due to taxes.

Engr 360 Engineering Econ. 11.3

Types of Assets or Property

Government tax codes/rules for depreciation are linked to the type of property under consideration:

1. Tangible property (material goods that can be seen & touched)

a. Real property (land, crops, buildings, or anything attached to the land) b. Personal property (equipment, vehicles, furnishings, etc., which are tangible and not classified as real property)

2. Intangible property has value to the owner but is not material goods (patents, copyrights, trade names, franchises, endorsements)

Depreciation

• Definition– The allowance for wear and tear on equipment and

machinery– Amount of decreasing value in a capital asset allowed

to be deducted from a business tax return– Cost Recovery

• Rules – The rules for farm business depreciation are located in

the Farmer’s Tax Guide (Publication 225) from the IRS

What can be depreciated?

• You can depreciate property only if it meets the following requirements:– It is used in business or held for the production of

income.– It must be expected to last for more than one year. In

other words, it must have a useful life that extends substantially beyond the year it was placed in service.

– It is property that wears out, decays, gets used up, becomes obsolete, or looses value from natural causes.

• Depreciable property can be either tangible or intangible

Tangible Depreciable Property

• Purchased property you can see or touch– Livestock (purchased)– Machinery– Buildings and improvements, fences– Dams, ponds, or terraces– Irrigation systems and water wells– Partial business use

• You can claim depreciation on the part of a vehicle used in the business (ex - 1/2 business value of a truck)

Intangible Depreciable Property

• Purchased property that has value that you cannot readily see or touch– Computer Software– Copyrights, patents, etc

What cannot be depreciated?

• Property placed into service and disposed of in the same year.

• Land (land can never be depreciated)• Inventory

– You cannot depreciate property held for resale in the normal course of business

• Leased property– The value of the lease is already showing up as a rental

expense

• Raised Market Livestock (Because there is no cost to recover)

Depreciation

• Allocating the expense of a resource which lasts > 1 year.

• e.g. tractors, barns, bulls, fences.• Calculation

– Need to know:• 1. Purchase Price – Cost • 2. Useful Life – Life• 3. Salvage Value – S.V.• 4. Depreciation Method – Meth

Depreciation . . . key terms• Depreciation: the process of

systematically allocating the cost of an asset over its useful life

• Salvage value: the estimated value of an asset at the end of its useful life

• Depreciable cost: an asset’s acquisition cost less its salvage value

• Book value: an asset’s cost less its accumulated depreciation

• Three factors to consider when computing depreciation: cost, estimated useful life, and salvage value Slide 8.8

Depreciation Methods: Straight Line

• Annual Depreciation = (cost-salvage value) /useful lifeOr

• Annual Depreciation = (cost–salvage value)*R

– Where R is the annual straight- line percentage rate found by dividing 100% by the useful life (100% / useful life)

Depreciation Methods: Sum of the Year’s Digits (SOYD)

• Annual Depreciation = (cost-salvage value) * RL/ SOYD Where– RL= remaining years of useful life as of the beginning of the

year for which depreciation is being computed.– SOYD= sum of all the number from 1 through the estimated

useful life. For example for a 5-year useful life, SOYD would be 1+2+3+4+5=15 and it would be 55 for a 10 year useful life.

– Highest the first year and then declines by a constant amount after.

Depreciation Method: Declining Balance

• Annual Depreciation is = (Book Value at Beginning of Year) * RWhere– R is a constant percentage value or rate.

• A variation on this is double declining balance.

• Can’t have a zero salvage value.

Depreciation Method: Partial Year Depreciation

• For an asset purchase during the year the depreciation should be prorated for the amount of time that asset was used during the year.

Depreciation Methods MACRS - Modified Accelerated Cost Recovery

System (Half Year Conventions)• 150% Declining

Balance -– Only Option

• GDS - General Depreciation System

• Straight Line– Either Option

• GDS - General Depreciation System

• ADS - Alternative Depreciation System

– Longer time for depreciation

Depreciation Methods Older (less common ways of depreciation)

• ACRS (Acellerated Cost Recovery System)– Used on Property Placed in

Service before 1987

– Cannot be used on property placed in service after 1987 (you must use MACRS)

• Straight Line – Standard method of

depreciation with a similar amount taken out each year

– Does not have the advantage of a half year convention which means you must wait to start later

Number of Years Allowed for Depreciation

• Consult the Farmer’s Tax Guide (Publication 225) to find out the specific lengths of time for depreciation– Cattle (Breeding) >> 5 yrs GDS, 7 yrs ADS

– Hogs (Breeding) >> 3 yrs GDS, 3 yrs ADS

– Fences >> 7 yrs GDS, 10 yrs ADS

– Single use farm buildings >> 10 yrs GDS, 15 yrs ADS

– Grain Bins >> 7 yrs GDS, 10 yrs ADS

Advantages of theDeclining Balance Method

• More Depreciation Claimed early in the live of the asset– Year 1 would be 15 % versus 10 %SL– Year 2 would be 25.5 % versus 20 % SL

***Good if you know you will have too much income (problems) immediately in the next couple of years

Advantages of Straight Line

• More depreciation expense is claimed per year later in the life of the asset– Year 5 would be 20 % versus 16.66% MACRS– Year 6 would be 10 % versus 8.33% MACRS

**Good if you do not predict to have income problems (need the depreciation) in the next couple of years, but want to be safe in the future

Advantages of ADS

• Allows for the depreciation to be spread out over a longer number of years.

• Could be an advantage for emergency purchases, i.e. - those not made for a direct impact on income taxes (save it for later when you might need it!)

Summary

• Depreciation allows “cost recovery” on capital asset purchases in the farm business

• Depreciation is a non-cash expense on your schedule F (farm profit or loss statement)

• Record Depreciation on Tax Form 4562

• Section 179 Deduction ($25,000 for 2003) - Allows a 1 time deduction to help on major farm purchases

• Two main methods - MACRS and Straight Line

• Know the rules - they are always changing, stay on top of them so you can maximize your after-tax income.