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Chapter 8 Depreciation and Income Taxes

Chapter 8 Depreciation and Income Taxes. Asset Depreciation Book Depreciation Tax Depreciation How to Determine “Accounting Profit” Corporate Taxes. Depreciation. Definition : Loss of value for a fixed asset Example : You purchased a car worth $15,000 at

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Chapter 8 Depreciation and Income Taxes

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  1. Chapter 8 Depreciation and Income Taxes • Asset Depreciation • Book Depreciation • Tax Depreciation • How to Determine “Accounting Profit” • Corporate Taxes

  2. Depreciation Definition: Loss of value for a fixed asset Example: You purchased a car worth $15,000 at the beginning of year 2000. Depreciation

  3. Depreciation Concept Depreciation is viewed as a part of business expenses that reduce taxable income. Economic Depreciation (Purchase Price – Market Value) Economic losses due to both physical deterioration and technological obsolescence) • Accounting Depreciation • Systematic allocation of the initial cost of an asset in parts over time or decline in value over timeknown as its depreciable life.

  4. Asset Depreciation Physical depreciation Economic depreciation the gradual decrease in utility in an asset with use and time Functional depreciation Depreciation Book depreciation Accounting depreciation The systematic allocation of an asset’s value in portions over its depreciable life—often used in engineering economic analysis Tax depreciation

  5. Factors to Consider in Asset Depreciation • What is the depreciable life of the asset? • What is asset’s value at the end of its useful life? • What is the cost of the asset? • What method of depreciation do we choose?

  6. What Can Be Depreciated? • Assets used in business or held for production of income • Assets having a definite service (useful) life and a life • longer than one year • Assets that must wear out, become obsolete or lose value • A qualifying asset for depreciation must satisfy all of the three conditions above. Depreciable property includes buildings, machinery, equipment, vehicles, and some intangible properties. If an asset has no definite service life, the asset can not be depreciated such as land.

  7. Example 8.1 Cost Basis of an asset represents the total cost that is claimed as an expense over an asset's life and generally includes the followings

  8. Types of Depreciation • Book Depreciation • Firms report depreciation and net income to investors / stockholders (as balance sheet or income statement) • In pricing decision • Tax Depreciation • In calculating income taxes for the IRS • In engineering economics, we use depreciation in the context of tax depreciation

  9. Book Depreciation Methods • Three different methods can be used to calculate the periodic depreciation allowances for financial reporting. • Types of Depreciation Methods: • Straight-Line Method • Declining Balance Method • Unit Production Method

  10. Straight – Line (SL) Method • Principle • A fixed asset as an asset that provides its services in a • uniform fashion. That is, the asset provides equal amount of • service in each year of its useful life. • Formula • Annual Depreciation • Dn = (I – S) / N, and constantfor all n. • Book Value • Bn = I – n (D) • where I = cost basis • S = Salvage value • N = depreciable life

  11. Example 8.2 – Straight-Line Method Annual Depreciation $10,000 Book Value D1 Total depreciation at end of life I = $10,000 N = 5 Years S = $2,000 D = (I - S)/N $8,000 D2 $6,000 D3 B1 D4 nDnBn 1 1,600 8,400 2 1,600 6,800 3 1,600 5,200 4 1,600 3,600 5 1,600 2,000 $4,000 B2 B3 D5 B4 $2,000 B5 0 1 2 3 4 5 n

  12. Declining Balance Method • Principle: • A fixed asset as providing its service in a decreasing • fashion. • Formula The fraction,  = (1/N) (multiplier) • Annual Depreciation • Book Value where 0 < a < 2(1/N) Note: if  is chosen to be the upper bound,  = 2(1/N), we call it a 200% DB or double declining balance method. As N increases,  decreases.

  13. n 0 1 2 3 4 5 Dn $4,000 2,400 1,440 864 518 Bn $10,000 6,000 3,600 2,160 1,296 778 D5 Annual Depreciation Example 8.3 – Declining Balance Method Book Value $10,000 Total depreciation at end of life D1 $8,000 $6,000 D2 B1 $4,000 B2 D3 $2,000 D4 B3 $778 B5 0 B4 1 2 3 4 5 n

  14. Example 8.4Declining Balance (DB) Switching to SL Asset: Invoice Price $9,000 Freight 500 Installation 500 Depreciation Base $10,000 Salvage Value 0 Depreciation 200% DB Depreciable life 5 years • SL Dep. Rate = 1/5 • a (DDB rate) = (200%) (SL rate) • = 0.40

  15. Case 1: S = 0 (a) Without switching (b) With switching to SL Note: Without switching, we have not depreciated the entire cost of the asset and thus have not taken full advantage of depreciation’s tax deferring benefits. The rule is; if DB depreciation in any year is less than (or equal to) the depreciation amount calculated by SL, switch to and remain with the SL method for the duration of the asset’s depreciable life.

  16. Case 2: S = $2,000 Note: Tax law does not permit us to depreciate assets below their salvage values.

  17. (I - S) Units-of-Production Method • Principle • The number of service units will be consumed in that period. • Formula • Annual Depreciation • Service units consumed for year • Dn = • total service units

  18. Example 8.5 • Given: I = $55,000, S = $5,000, Total service units = 250,000 miles, usage for this year = 30,000 miles • Solution:

  19. Modified Accelerated Cost Recovery Systems (MACRS) Personal Property (includes assets such as machinery, vehicles, equipment, furniture, and similar items) • Depreciation method based on DB method switching to SL • Half-year convention • Zero salvage value Real Property [Real properties are classified into two categories: 1. residential rental property and 2. commercial building or properties] • SL Method • Mid-month convention • Zero salvage value

  20. MACRS Property Classifications (IRS Publication 534) ADR: Asset Depreciation Range

  21. MACRS Table The percentages shown in the table use the half year convention, all the assetsare placed in service at mid-year and will have zero salvage value.

  22. Example 8.6 MACRS Depreciation Asset cost = $10,000 Property class = 5-year recovery period DB method = Half-year convention, zero salvage value, 200% DB switching to SL 20% $2000 11.52% $1152 Full 32% $3200 Full 19.20% $1920 Full 11.52% $1152 Full 5.76% $576 1 2 3 4 5 6 Half-year Convention

  23. Taxable Income and Income Taxes Item Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income

  24. Example 8.8 - Net Income Calculation

  25. Capital Expenditure versus Depreciation Expenses (7-year MACRS property) 1 2 3 4 5 6 7 8 0 Capital expenditure (actual cash flow) $28,000 0 1(14.29) 2 (24.49) 3 (17.49) 4 (12.49) 7 (8.93) 6 (8.92) 7 (8.93) 8 (5.76) $1,250 $2,500 $2,500 $3,500 $2,500 $4,000 $4,900 $6,850 Allowed depreciation expenses (not cash flow)

  26. Example 8.9 – Cash Flow versus Net Income

  27. Net income versus net cash flow Net cash flows = Net income + non-cash expense (depreciation) $50,000 Net income $12,000 Net cash flow $40,000 $4,000 Depreciation Income taxes $8,000 $30,000 Gross revenue $6,000 Operating expenses $20,000 $10,000 $20,000 Cost of goods sold $0

  28. U.S. Corporate Tax Rate (2005)Marginal tax rate is defined as the rate applied to the last dollar of income. Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $0 + 0.15(D) $7,500 + 0.25 (D) $13,750 + 0.34(D) $22,250 + 0.39 (D) $113,900 + 0.34 (D) $3,400,000 + 0.35 (D) $5,150,000 + 0.38 (D) $6,416,666 + 0.35 (D) (D) denotes the taxable income in excess of the lower bound of each tax bracket

  29. Marginal and Effective (Average) Tax Rate for a Taxable Income of $16,000,000

  30. Example 8.10 - Corporate Income Taxes Facts: Capital expenditure $290,000 (allowed depreciation) $58,000 Gross Sales revenue $1,250,000 Expenses: Cost of goods sold $840,000 Depreciation $58,000 Leasing warehouse $20,000 Question: Taxable income?

  31. Taxable income: • Gross income $1,250,000 • - Expenses: • (cost of goods sold) $840,000 • (depreciation) $58,000 • (leasing expense) $20,000 • Taxable income $332,000 • Income taxes: • First $50,000 @ 15% $7,500 • $25,000 @ 25% $6,250 • $25,000 @ 34% $8,500 • $232,000 @ 39% $90,480 • Total taxes $112,730

  32. Average tax rate: • Total taxes = $112,730 • Taxable income = $332,000 • Marginal tax rate: • Tax rate that is applied to the last dollar earned • 39%

  33. Disposal of Depreciable Asset • If a MACRS asset is disposed of during the recovery period, • Personal property: the half-year convention • is applied to depreciation amount for the year of disposal. • Real property: the mid-month convention is • applied to the month of disposal.

  34. Depreciation recapture Depreciation recapture is taxed as ordinary income. Gains = Salvage value – book value = (Salvage value - cost basis) Capital gains + (Cost basis – book value) Ordinary gains

  35. Capital Gains and Ordinary Gains Capital gains Total gains Ordinary gains or depreciation recapture Book value Salvage value Cost basis

  36. Full Full Half 8.92 8.92 14.29 24.49 17.49 12.49 8.92 Gains or Losses on Depreciable Asset Example 8.11: A Drill press: $230,000 Project year: 3 years MACRS: 7-year property class Salvage value: $150,000 at the end of Year 3 Total Dep. = 230,000(0.1429 + 0.2449 + 0.1749/2) = $109,308 Book Value = 230,000 -109,308 = $120,693 Gains = Salvage Value - Book Value = $150,000 - $120,693 = $29,308 Gains Tax (34%) = 0.34 ($29,308) = $9,965 Net Proceeds from sale = $150,000 - $9,965 = $140,035

  37. Disposal of a MACRS Property and Its Effect on Depreciation Allowances

  38. Calculation of Gains or Losses on MACRS Property

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