2. Depreciation concepts:
Asset Depreciation: Fixed assets, such as equipment and real estate, are economic resources
that are acquired to provide future cash flows. Generally, depreciation can be defined as a
gradual decrease in the utility of fixed assets with use and time.
Economic Depreciation: Purchase Price – Market Value (Economic loss due to both physical
deterioration and technological obsolescence)
Physical depreciation can be defined as a reduction in an asset’s capacity to perform its
intended service due to physical impairment.
Functional depreciation can occur as a result of changes in the organization or in technology
that decrease or eliminate the need for an asset. •Eg. Obsolescence is attributable to
advances in technology, a declining need for the services performed by an asset, and the
inability to meet increased quantity or quality demands.
Accounting Depreciation: A systematic allocation of cost basis over a period of time.
The acquisition of fixed assets is an important activity for a business organization, whether the
organization is starting up or acquiring new assets to remain competitive. Like other
disbursements, the cost of these fixed assets must be recorded as expenses on a firm’s balance
sheet and income statement.
However, unlike costs such as maintenance, material, and labour costs, the cost of fixed
assets are not treated simply as expenses to be accounted for in the year that they are
acquired. Rather, these assets are capitalized; that is, their costs are distributed by subtracting
them as expenses from gross income, one part at a time over a number of periods. The
systematic allocation of the initial cost of an asset in parts over a time, known as the asset’s
depreciable life, is what we mean by accounting depreciation.
3. Depreciation
Depreciation is the decrease in value of physical properties(fixed assets) with the
passage of time and use. It is a non cash expense that reduces the value of an asset as
a result of wear and tear or age and obsolescence.
In accounting terms, depreciation is defined as the reduction of recorded cost of
a fixed asset in a systematic manner until the value of the asset becomes zero or
negligible. Depreciation represents how much of an asset's value has been used up.
An example of fixed assets are buildings, furniture, office equipment, machinery etc.. A
land is the only exception which cannot be depreciated as the value of land
appreciates with time.
Depreciation allows a portion of the cost of a fixed asset to tie to the revenue
generated by the fixed asset. This is mandatory under the matching principle as
revenues are recorded with their associated expenses in the accounting period when
the asset is in use. This helps in getting a complete picture of the revenue generation
transaction.
It is an accounting concept that establishes an annual deduction against before tax
income such that the effect of time and use on asset’s value can be reflected in a firm’s
financial statements.
The main function of depreciation accounting is to account for the cost of fixed assets
in a pattern that matches their decline in value over time.
4. Factors to consider in asset depreciation
Depreciable life (how long?)
Salvage value (disposal value)
Cost basis (depreciation basis)
Method of depreciation (how?)
What can be depreciated?
Depreciable property is property for which depreciation is allowed under government
income tax laws and regulations.
Assets used in business or held for production of income
Assets having a definite 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.
Cost basis:
The cost basis of an asset represents the total cost that is claimed as an expense over
the asset’s life (i.e. the sum of the annual depreciation expense).
The cost basis generally includes the actual cost of the asset and all other incidental
expenses, such as freight, site preparation, and installation.
6. Book depreciation method
Purpose: Used to report net income to stockholders/investors
Types of Depreciation Methods:
1. Straight-Line Method
2. Accelerated methods
Declining Balance Method
Sum of the Years’ Digits Method
Sinking Fund Method
Straight Line method
It is the simplest way to work out the loss of value of an asset over time. Straight line basis is
calculated by dividing the difference between an asset's cost and its expected salvage
value by the number of years it is expected to be used.
In this method a fixed sum of amount is charged as the depreciation amount throughout the
lifetime of the asset such that the accumulated sum at the end of the life of an asset is
exactly equal to the purchase value of the cost. i.e. the value of the assets will become
zero.
Formula: •Annual Depreciation = (I – S) / N, and constant for all n.
•Book Value = I – n (D) [cost basis- total depreciation charges made to date]
where I = cost basis S = Salvage value N = depreciable life.
8. Accelerated methods
This concept of depreciation recognizes that 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 kind of 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. Any such method is called an
accelerated method.
1. Declining balance method/ Diminishing balance method(DB):
-Also known as fixed percentage or uniform percentage method. In this method, book
value is multiplied by the fixed rate
Declining balance rate α = (1/N) * multiplier (could be 150% or 200% or 250% of SLM )
-The most commonly used multipliers are double(200%) the straight line rate, for this
reason it is also called Double Declining Balance method.
-Suppose a business has an asset with Rs. 1000 original cost, Rs. 100 Salvage value, and
5 years useful life. The straight line depreciation rate = ( 100%/5)= 20% per year and with
double declining balance method the rate = 20%* 2= 40% .
9. Formula:
For any year n, depreciation charge,
= α
TDB( Total declining balance) at the end of year n can be calculated by using:
TDB=
The book value is given by,
=I(1-α
Eg(DDB): Consider the following accounting information for a computer system.
Cost Basis of the asset, I, = Rs. 10,000 Useful life, N, = 5 years Estimated Salvage Value,
S, = Rs. 778
Compute the annual depreciation allowances and the resulting book values using the
double declining depreciation method.
Solution:
The book value at the beginning of the first year is Rs. 10,000.
The declining balance rate (α) is (1/5) *2=40%
The depreciation deduction for the first year will be 4000; [40% * 10,000=4,000]
The book value at the beginning of second year is 6,000; [ I(1-α
10. Similarly we get the values as shown in the table
Issues regarding salvage value
Salvage value is not always equal to the final book value. When
we have to make the adjustments in our depreciation analysis methods.
Two cases arise, case 1: when
case 2: when < S
Case 1: When
-This is the situation in which we have not depreciated the entire cost of the asset.
-To reduce the book value of an asset to its salvage value as quickly as possible, it can
be done by switching from declining balance to straight line.
-The switch from DB to SL depreciation can take place in any of the ‘n’ years. (optimal
year)
-The switching rule is as follows: If depreciation by DB in any year is less than(or equal
to) the depreciation by SL then we would switch to and remain with SL method for the
duration of the project’s depreciable life.
n
1 10,000 4000 6000
2 6,000 2400 3600
3 3,600 1440 2160
4 2,160 864 1296
5 1296 518 778
11. The SL depreciation in any year n is calculated by:
(book value at the beginning of year n-salvage value)/Remaining useful life at the
beginning of year n
Eg: If in the above example(DDB) the salvage value is zero, (S=0) Determine the
optimal time to switch from DB to SL depreciation and the resulting depreciation
schedule.
Solution, first computing the
DDB depreciation for each
year
0
12. Here,
The book value is Rs. 778 at the end of year 5 which is greater than zero, therefore we
use the switching fundamentals.
Second we compute the SL depreciation for each year then compare SL to DDB
depreciation for each year and use the decision rule for when to change.
The optimal year is 4 in this case.
Third, use the SL depreciation method for the remaining depreciable year from the
optimal year.
If switched to SL at
beginning of the
year
SL depreciation DDB Depreciation Decision
1 (10000-0)/5= 2000 <4000 Do not switch
2 (6000-0)/4=1500 <2400 Do not switch
3 (3600-0)/3=1200 <1440 Do not switch
4 (2160-0)/2=1080 >864 Switch to SL
13. The depreciationschedule is:
Case 2: When
-Inthis case we must re-adjust our analysis because tax lawdoesn’t permit us to depreciate the asset below their salvage value.
-If the book value is lower thanS, at any period, thenthe depreciationamount are adjusted so that =S.
Say inthe above example S= 2000, compute the DDB depreciationschedule.
Year DDB with switching to SL End of year book value
1 4000 6000
2 2400 3600
3 1440 2160
4 1080 1080
5 1080 0
EOY
1 0.4*10,000=4000 10,000-4000=6000
2 0.4*6000= 2400 6000-2400=3600
3 0.4*3600=1440 3600-1440=2160
4 0.4*2160=864>160 2160-160=2000
5 0 2000-0=2000
14. Sum-of-years’ digit (SOYD) method
- This method results in larger charges during the early years and smaller charges as
the asset nears the end of its useful life.
- The depreciation each year is calculated as [{N-n+1}(I-S)]/SOYD
- SOYD= 1+2+3+…………………+N= {N(N+1)}/2
Eg.
15. Sinking Fund Method
- In this method of depreciation, the book value decreases at increasing rates with
respect to the life of the asset.
- The fixed sum depreciated at the end of every time period earns an interest at the
rate of i% compounded annually.
Let,
P = first cost of the asset
F = salvage value
N = life of the asset
i = rate of return compounded annually (rate of interest)
A = annual equivalent amount of depreciation
=book value of the asset at the end of period k
= depreciation charge at the end of the period t
To find the annual equivalent amount (A) A = (P-F)*(A/F, i%, N)
To find the depreciation charge (Dt ) Dt = (P-F)*(A/F , i%, N)*(F/P, i%, t-1)
To find book value at the end of period t, = P – (P-F)*(A/F, i%, N)(F/A, i%, t)
16. Eg:
Compute the depreciation charge and book value in each year using sinking fund
method. Cost of Asset (P) = Rs. 1,00,000 Salvage value (F) = Rs. 20,000 Life of the asset
(N) = 8 years Interest rate (i) = 12%
Annual depreciation charge A = (P-F)(A/F,12%,8) = (1,00,000 – 20,000)(0.083) = Rs. 6,504
Depreciation at the end of 1st year (D1) = Rs. 6,504
Depreciation at the end of 2nd year (D2) = 6,504 + 6,504*0.12 = Rs. 7,284.48
Depreciation at the end of 3rd year (D3) = {6504 + (6504+7284.48)*0.12} = Rs. 8158.62
17. Tax Depreciation
• Purpose: Used to compute income taxes for the IRS (Internal Revenue Service)
•Assets placed in service prior to 1981 Use book depreciation methods (SL, BD, SOYD)
•Assets placed in service from 1981 to 1986 Use ACRS Table
•Assets placed in service after 1986 Use MACRS Table
Modified accelerated cost recovery systems(MACRS):
Depreciation method based on DB method switching to SL
Half-year convention
Zero salvage value
Historically, for both tax and accounting purposes, an asset’s depreciable life was
determined by its estimated useful life; it was intended that the asset be fully
depreciated at approximately the end of its useful life. The MACRS scheme, however,
totally abandoned this practice, and simpler guidelines were established that created
several classes of assets, each with a more or less arbitrary life called a recovery
period.
Note; Recovery periods do not necessarily bear any relationship to expected useful
lives.
19. MACRS Depreciation rules
Under earlier depreciation methods, the rate at which the value of an asset declined was
estimated and was then used as the basis for tax depreciation. Thus, different assets were
depreciated along different paths over time.
The MACRS method, however, established prescribed depreciation rates, called recovery
allowance percentages, for all assets within each class. These rates are shown in the table.
The yearly recovery, or depreciation expense, is determined by multiplying the asset’s
depreciation base by the applicable recovery allowance percentage.
20. Half-year convention
The MACRS recovery percentages shown in the table 9.3 use the half-year convention, that
is, it is assumed that all assets are placed in service at midyear and that they will have zero
salvage value. As a result, only a half year of depreciation is allowed for the first year that
property is placed in service. With half of one year’s depreciation being taken in the first
year, 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 taken in the year following the
end of the recovery period.
Eg: Here, SL rate= 1/5=0.20
DDB rate= 1/5*200%=40%
S for MACRS = 0
22. TAX
Tax types:
1. Direct tax
a. Property tax
b. Income tax
I- Personal income tax
II- Corporate income tax
2. Indirect Tax
c. Import/ Export tax
d. Sales/Service tax
e. VAT
23. Corporate tax
A corporate tax, also called corporation tax or company tax, is a direct tax imposed by a jurisdiction on
the income or capital of corporations or analogous legal entities. Many countries impose such taxes at
the national level, and a similar tax may be imposed at state or local levels. The taxes may also be
referred to as income tax or capital tax. Partnerships are generally not taxed at the entity level. A
country's corporate tax may apply to:
1. corporations incorporated in the country,
2. corporations doing business in the country on income from that country,
3. foreign corporations who have a permanent establishment in the country, or
4. corporations deemed to be resident for tax purposes in the country.
Company income subject to tax is often determined much like taxable income for individual
taxpayers. Generally, the tax is imposed on net profits. In some jurisdictions, rules for taxing
companies may differ significantly from rules for taxing individuals. Some types of entities may be
exempt from tax.
Countries may tax corporations on its net profit and may also tax shareholders when the corporation
pays a dividend.
A corporate tax is tax on the profits of a corporation. The taxes are paid on a company's
operating earnings, which is revenue minus cost of goods sold (COGS),
general and administration (G&A) expenses, selling and marketing, research and
development, depreciation, and other operating costs.
Corporate tax rates vary widely by country, with some countries considered to be tax havens due to
their low rates. Corporate taxes can be lowered by various deductions, government subsidies, and
tax loopholes, and so the effective corporate tax rate, the rate a corporation actually pays, is
usually lower than the statutory rate, the stated rate before any deductions.
25. After tax cash flow
The after tax cash flow is the net proceeds from an income-producing property, after
all costs ( salaries & wages, rent, interest, advertising, depreciation, amortization,
depletion, taxes, mortgage interest, maintenance costs, etc.) of owning and operating
the property have been deducted.
The amount remaining after expenses, mortgage payments, and income taxes have
been deducted from the gross income of an investment property is the after-tax cash
flow.
Cash flow calculations
-Cash flow before taxes(CFBT)= Net operating income minus debt service minus capital
additions plus loan proceeds plus interest earned.
*net operating income or (earnings before interest and tax): gross scheduled income
minus vacancy allowance minus operating expenses( Depreciation, rent etc)
*debt service: is the total loan payment including principal and interest
*capital additions: are improvements to the property having a useful life of more than
one year and likely to increase the life of the property
*loan proceeds: proceeds obtained from subsequent financing.
Tax= Taxable income* Tax percentage
-Cash flow after taxes(CFAT)= CFBT minus income tax liability plus depreciation
26. Cash flow calculations:
Eg: Say you have a property with ten tenants each paying Rs. 1,000 per month( Rs. 120,000 per year). You
estimate a vacancy and credit loss of 5%. The property has operating expenses of Rs. 45,600 per year,
and a first mortgage payment of Rs. 36,326 per year. In month six, you add a new roof at the cost of Rs.
20,000 and take out Rs. 20,000 second mortgage to cover the cost of that construction. What is your
property’s cash flow before tax(CFBT)?
Solution:
a) Gross scheduled income= Rs. 120,000 b) Vacancy= Rs. 6,000
c) Gross schedule income-vacancy(a-b)= 120,000-6000 d) Gross operating income= Rs. 114,000
e) Operating expenses= Rs. 45,600
f) Gross operating income- operating expenses(d-e)= 114,000-45,600
g) Net operating income = Rs. 68,400
h) Cash flow before tax(CFBT)= Net operating income- debt service-capital addition+ loan proceed=
68,400-36,326-20,000+20,000= Rs. 32,074
If your tax liability in year one is Rs. 7,000 than what is your property’s cash flow after taxes(CFAT)?
CFBT (32,074) - taxes due (7,000) = CFAT (Rs. 25,074)
27. Understanding Cash Flow After Taxes (CFAT) and depreciation
CFAT after taxes is a measure of cash flow that takes into account the impact of taxes
on profits. This measure is used to determine the cash flow of an investment or project
undertaken by a corporation. To calculate the after-tax cash flow, depreciation must be
added back. Depreciation is a non-cash expense that represents the declining
economic value of an asset but is not an actual cash outflow. (Remember that
depreciation is subtracted as an expense to calculate profits. In calculating CFAT, it is
added back in.)
Here is the formula for calculating CFAT: CFAT = net income(after tax) + depreciation +
amortization + other non-cash charges
For example, let’s assume a project with an operating income of $2 million has a
depreciation value of $180,000. The company pays a tax rate of 35%. The net income
generated by the project can be calculated as:
Earnings before tax(EBT)= $2 million- $180,000= $1820,000
Net income = $1,820,000 - (35% x $1,820,000)
Net income = $1,820,000 - $637,000
Net income = $1,183,000
CFAT = $1,183,000 + $180,000
CFAT = $1,363,000
Depreciation is an expense that acts as a tax shield. However, as it is not an actual cash
flow, it must be added back to the after-tax income.
![Book depreciation method
Purpose: Used to report net income to stockholders/investors
Types of Depreciation Methods:
1. Straight-Line Method
2. Accelerated methods
Declining Balance Method
Sum of the Years’ Digits Method
Sinking Fund Method
Straight Line method
It is the simplest way to work out the loss of value of an asset over time. Straight line basis is
calculated by dividing the difference between an asset's cost and its expected salvage
value by the number of years it is expected to be used.
In this method a fixed sum of amount is charged as the depreciation amount throughout the
lifetime of the asset such that the accumulated sum at the end of the life of an asset is
exactly equal to the purchase value of the cost. i.e. the value of the assets will become
zero.
Formula: •Annual Depreciation = (I – S) / N, and constant for all n.
•Book Value = I – n (D) [cost basis- total depreciation charges made to date]
where I = cost basis S = Salvage value N = depreciable life.](https://image.slidesharecdn.com/chapter7ee-250812040319-1f8ea8d6/85/Chapter-7-EE-pptx-engineering-econonmics-chapter-seven-6-320.jpg)
![Formula:
For any year n, depreciation charge,
= α
TDB( Total declining balance) at the end of year n can be calculated by using:
TDB=
The book value is given by,
=I(1-α
Eg(DDB): Consider the following accounting information for a computer system.
Cost Basis of the asset, I, = Rs. 10,000 Useful life, N, = 5 years Estimated Salvage Value,
S, = Rs. 778
Compute the annual depreciation allowances and the resulting book values using the
double declining depreciation method.
Solution:
The book value at the beginning of the first year is Rs. 10,000.
The declining balance rate (α) is (1/5) *2=40%
The depreciation deduction for the first year will be 4000; [40% * 10,000=4,000]
The book value at the beginning of second year is 6,000; [ I(1-α](https://image.slidesharecdn.com/chapter7ee-250812040319-1f8ea8d6/85/Chapter-7-EE-pptx-engineering-econonmics-chapter-seven-9-320.jpg)
![Sum-of-years’ digit (SOYD) method
- This method results in larger charges during the early years and smaller charges as
the asset nears the end of its useful life.
- The depreciation each year is calculated as [{N-n+1}(I-S)]/SOYD
- SOYD= 1+2+3+…………………+N= {N(N+1)}/2
Eg.](https://image.slidesharecdn.com/chapter7ee-250812040319-1f8ea8d6/85/Chapter-7-EE-pptx-engineering-econonmics-chapter-seven-14-320.jpg)
