Depreciation and Income Taxes

Introduction
1 lakh investment in life insurance and golddifferent lax liabilities (Example)
Income taxes usually represent a significant cash
outflow.
In this section we describe how after tax liabilities
and after-tax cash flows result in the after-tax
cash flow (ATCF) procedure.
Depreciation is an important element in finding
after-tax cash flows.
Taxable Income= Revenue- All expenses except
capital expenditure- Depreciation

Depreciation
Depreciation is a measure of the wearing out,
consumption or other loss of value of a
depreciable asset arising from use, effluxion of
time or obsolescence through technology and
market changes.
Depreciation is allocated so as to charge a fair
proportion of the depreciable amount in each
accounting period during the expected useful life
of the asset.
It is an accounting concept, a non-cash cost, that
establishes an annual deduction against beforetax income.

Depreciable Assets
Depreciable assets are assets which
1. are expected to be used during more than one
accounting period;
2. have a limited useful life; and
3. are held by an enterprise for use in the
production or supply of goods and services, for
rental to others, or for administrative purposes
and not for the purpose of sale in the ordinary
course of business.
4. it is not inventory, stock in trade, or investment
property

Determinants
Assessment of depreciation and the amount to
be charged in respect thereof in an accounting
period are usually based on the following three
factors:
1. Historical cost or other amount substituted for
the historical cost of the depreciable asset when
the asset has been revalued;
2. Expected useful life of the depreciable asset;
and
3. Estimated residual value of the depreciable
asset.

Useful Life
The useful life of a depreciable asset is shorter
than its physical life and is:
1. pre-determined by legal or contractual limits,
such as the expiry dates of related leases;
2. directly governed by extraction or
consumption;
3. dependent on the extent of use and physical
deterioration on account of wear and tear

Useful Life Contd..

4. Reduced by obsolescence arising from such
factors as:
a) technological changes;
b) improvement in production methods;
c) change in market demand for the product or
service output of the asset; or
d) legal or other restrictions.
Determination of the useful life of a depreciable
asset is a matter of estimation and is normally
based on various factors including experience
with similar types of assets.

Common Depreciation Terms

First cost P or unadjusted basis B: Total installed cost of asset
Book value BVt: Remaining undepreciated capital investment in year t

Recovery period n: Depreciable life of asset in years

Market value MV: Amount realizable if asset were sold on open market
Salvage value S: Estimated trade-in or MV at end of assets useful life

Depreciation rate dt: Fraction of first cost or basis removed each year t
Personal property: Possessions of company used to conduct business

Real property: Real estate and all improvements(land is not depreciable)

Half-year convention: Assumes assets are placed in service in midyear

Straight line (SL) Method:

Constant amount of depreciation each year over
the depreciable life of the asset.

N = depreciable life
B = cost basis
dk = depreciaton in k

BVk = book value at

end of k
SVN = salvage value

Example
Acme purchased a coordinate measurement
machine (CMM). The cost basis is $120,000
and it has a seven year depreciable life. Acme
estimates a salvage value of $22,000 at the
end of seven years. Determine the annual
depreciation amounts using SL depreciation.
Tabulate the annual depreciation amounts
and book value of the CMM at the end of each
year.

Declining Balance (DB) Method

It is constant percentage method
Determined by multiplying BV at beginning of
year by fixed percentage d
In this method d= 2/n if it is 200% DBM or
Double Declining Balance Method
d= 1.5/n if it is 150% declining balance
method

Declining Balance (DB) and

Double Declining Balance (DDB) Depreciation
Max rate for d is twice straight line rate, i.e., d 2/n
Cannot depreciate below salvage value
Depreciation for year t is obtained by either relation:
Dt = dB(1 d)t-1 = dBVt-1

Where: Dt = depreciation for year t

d = uniform depreciation rate (2/n for DDB)
B = first cost or unadjusted basis
BVt -1 = book value at end of previous year
Book value for year t is given by:
BVt = B(1 d)t

Example
A depreciable construction truck has a first
cost of $20,000 with a $4,000 salvage value
after 5 years.
Find the (a) depreciation, and
(b) book value after 3 years using 200% and
150% DBM.

Example: Double Declining Balance

A depreciable construction truck has a first cost of $20,000 with a
$4,000 salvage value after 5 years. Find the (a) depreciation, and
(b) book value after 3 years using DDB depreciation.
Solution:

(a) d = 2/n = 2/5 = 0.4

D3 = dB(1 d)t-1
= 0.4(20,000)(1 0.40)3-1
= $2880
(b) BV3 = B(1 d)t
= 20,000(1 0.4)3
= $4320

DB with switch to SL Method

The book value for the DB method never goes
to zero, because the book value is always
decreased by a fixed percentage.
If the implied S < estimated S, it is necessary
to stop charging further depreciation when
the book value is at or below the estimated
salvage value.
A switch from DB to SL method is suggested.
Use Textbook example

Switching Between Depreciation Methods

Switch between methods to maximize PW of depreciation
t=n

PWD =

Dt (P/F,i%,t)

t=1

A switch from DDB to SL in latter part of life is usually better

Can switch only one time during recovery period
Procedure to switch from DDB to SL:
1) Each year t compute DDB and SL depreciation using the relations
DDDB = d(BVt-1) and

DSL = BVt-1 / (n-t+1)

2) Select larger depreciation amount, i.e., Dt = max[DDDB, DSL]

3) If required, calculate PWD

Example

Cost Basis= 4000

Life= 10 Years
SV= 0
Apply 200% DDB with switch to SL Method

DDB to SL
Year

BV

DDB

SL

Amount
Selected

4000

800

400

800

3200

640

355.56

640

2560

512

320

512

2048

409.6

292.57

409.6

1638.4

327.68

273.07

327.68

1310.72

262.14

262.14

262.14 (Switch)

1048.58

209.72

262.14

262.14

786.44

167.77

262.14

262.14

534.30

134.22

262.14

262.14

10

262.16

107.37

262.14

262.14

3570.5

4000

Units-of-production Method
The units-of-production method can be used
when the decrease in value of the asset is
mostly a function of use, instead of time. The
cost basis is allocated equally over the number
of units produced over the assets life.