Depreciation Methods

Chapter 10

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Basic Idea
The capital investments of a corporation in
tangible assets (equipment, computers,
vehicles, buildings and machinery) are
commonly recovered on the books of the
corporation through depreciation.
Although the depreciation amount is not an
actual cash flow, the process of depreciating an
asset, also referred to as capital recovery,
accounts for the decrease in an assets value
because of age, wear and obsolescence.
Even though an asset may be in excellent
working condition, the fact that it is worth less
(has less value), is taken into account.
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Depreciation
An income tax system generally does
not allow a deduction for the cost of an
asset in the year that it is purchased.
Instead, it spreads out the deduction
over a period roughly consistent with
the asset's useful economic life.
The amount allowed as an annual
deduction roughly reflects the
reduction in the value of the capital
asset as it ages, and is called
depreciation.
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Why Do Capital Assets Depreciate?

A capital asset might depreciate -- fall in value as it
ages over its useful life -- for several reasons.
One reason is that as it ages it gets closer to the
end of its useful life. The value of an asset is the
present discounted value of the net cash flow it can
produce.
Older assets have fewer years left to produce
income, and therefore are worth less than otherwise
similar, yet newer, assets that will produce an
income flow over a longer life span.
Another reason is that capital assets wear out as
they age, and so are less productive, or require
more maintenance, than do newer capital assets.
Certain types of quality improvements in similar
new assets will also reduce the value of older assets
due to obsolescence.
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Significance of Depreciation
Economic depreciation measures the
expected decline in the real market
value of the asset in each period.
Depreciation lowers income taxes via
the relation:
Taxes = (income - deductions)(tax
rate)

Depreciation Amounts
Federal tax law states that: Any productive asset
with a finite life (greater than one year) must be
depreciated for tax purposes rather than
expensed in the year of purchase.
Depreciation amounts represent a prorated amount
per year that can be treated as an expense
(deduction) but is not a real cash flow.
Depreciation amounts represent a form of tax
savings to the profitable firm.
Assume a tax rate of 30% of taxable income.
For every $1 of eligible deductions the resultant
tax savings is:
(0.30)($1.00) = $0.30.
$1 of additional deductions saves the firm $0.30.
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Depreciation
Depreciation is the reduction in value of an
asset.
The method used to depreciate an asset is a
way to account for the decreasing value of
the asset to the owner and to represent the
diminishing value of the capital funds
invested in it.
The annual depreciation amount Dt does not
represent an actual cash flow, nor does it
necessarily reflect the actual usage pattern
of the asset during ownership.
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Terminology
Book value represents the remaining,
capital investment (not yet depreciated) on
the books after the total amount of
depreciation charges (to date) have been
subtracted from the basis. The book value
(BV) is usually determined at the end of
each year.
Market Value (MV) is the amount realized
from sale on the open market.
Salvage Value (S) is the estimated tradein value or market value at the end the
assets useful life.
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Important Terms
First Cost or Unadjusted Basis (B)
Initial purchase price + all costs incurred in placing the
asset in service
Recovery Period (n)
Depreciable life of the asset in question often set by
law
Depreciation Rate (dt)
The fraction of the first cost removed by depreciation
each year
Personal Property
All property except real estate used in the pursuit of
profit or gain
Real Property
Real estate and improvements, buildings and certain
structures
Land is Real Property, but by law is NOT depreciable for tax purposes

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Book vs Tax Depreciation

Depreciation may be performed for two reasons:

1. Use by a corporation or business for internal financial accounting
(book depreciation).
2. Use in tax calculations per government regulations (tax depreciation).
The methods applied for these two purposes may or may not utilize the
same formulas.
Book depreciation indicates the reduced investment in an asset based upon
the usage pattern and expected useful life of the asset. There are classical,
internationally accepted depreciation methods used to determine book
depreciation: straight line, declining balance, and the infrequently used
sum-of-year digits method.
Tax depreciation is important because it is tax deductible; it can be
subtracted from income when calculating the amount of taxes due each
year. However, the tax depreciation amount must be calculated using a
government approved method.
Tax depreciation must be calculated using MACRS; book depreciation may
be calculated using any classical method or MACRS.
MACRS has the DB and SL methods, in slightly different forms, embedded in
it, but these two methods cannot be used directly if the annual depreciation
is to be tax deductible.
Many U.S. companies still apply the classical methods for keeping their own
books, because these methods are more representative of how the usage
patterns of the asset reflect the remaining capital invested in it. Additionally,
most other countries still recognize the classical methods of straight line
and declining balance.
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Depreciation Models
There are several models for depreciating
assets. The straight line (SL) model is used
historically.
Accelerated models, such as the declining
balance (DB) model, decrease the book
value to zero (or to the salvage value) more
rapidly than the straight line method.
For the classical methods, straight line,
declining balance, and sum-of-year digits
(SYD), there are Excel functions available to
determine annual depreciation.
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Depreciation Models (2)

Straight Line (SL)
It writes off capital investment linearly over n years.
The estimated salvage value is always considered.
This is the classical, nonaccelerated depreciation model.
Declining Balance (DB)
(also known as fixed percentage or uniform percentage method)
The model accelerates depreciation compared to straight line.
The book value is reduced each year by a fixed percentage.
The most used rate is twice the SL rate; called double declining balance (DDB).
It has an implied salvage that may be lower than the estimated salvage.
It is not an approved tax depreciation method in the United States. It is
frequently used for book depreciation purposes.

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Straight Line

If an asset has a first cost of $50,000 with a

$10,000 estimated salvage value after 5 years,
Calculate the annual depreciation.

Solution

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Double Declining Balance (DDB)

A fiber optics testing device is to be DDB depreciated. It has a first
cost of $25,000 and an estimated salvage of $2500 after 12 years.
(a) Calculate the depreciation and book value for years 1 and 4.
(b) Calculate the implied salvage value after 12 years.

Solution
The DDB fixed depreciation rate is d = 2/n = 2/12 = 0.1667 per
year.
Year 1: D1 = (0.1667)(25,000)(1 - 0.1667)1-1 = $4167
BV1 = 25,000(1 - 0.1667)1 = $20,833
Year 4: D4 = (0.1667)(25,000)(1 - 0.1667)4-1 = $2411
BV4 = 25,000(1 - 0.1667)4 = $12,054
Implied S = 25,000(1 - 0.1667)12 = $2803

Since the estimated S = $2500 is less than $2803, the asset is not fully

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DB compared with DDB

Freeport-McMoRan Mining Company has purchased a
computer-controlled gold ore grading unit for $80,000.
The unit has an anticipated life of 10 years and a
salvage value of $10,000.
Use the DB and DDB methods to compare the schedule
of depreciation and book values for each year.

Freeport-McMoRan Copper & Gold Inc. (FCX) is a leading international mining company with headquarters in
Phoenix, Arizona. FCX operates large, long-lived, geographically diverse assets with significant proven and
probable reserves of copper, gold and molybdenum. FCX has a dynamic portfolio of operating, expansion and
growth projects in the copper industry and is the worlds largest producer of molybdenum. The companys
portfolio of assets includes the Grasberg mining complex, the world's largest copper and gold mine in terms of
recoverable reserves; significant mining operations in the Americas, including the large scale Morenci/Safford
minerals district in North America and the Cerro Verde and El Abra operations in South America; and the potential
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world-class Tenke Fungurume development project in the Democratic Republic of Congo.

Solution
An implied DB depreciation rate is determined using

d = 1 (10,000/80,000) 1/10 = 0.1877

0.1877 < 2/n = 0.2, so this DB model does not exceed twice
the straight line rate.
Table 161 presents the Dt values using Equation [16.5] and the
BVt values from Equation [16.9] rounded to the nearest dollar. For
example, in year t = 2, the DB results are:

D2 = d(BV1) = 0.1877(64,984 next slide) = $12,197

BV2 = 64,984 - 12,197 = $52,787
Because we round off to even dollars, $2312 is calculated for
depreciation in year 10, but $2318 is deducted to make BV10 = S

= $10,000 exactly. Similar calculations for DDB with d = 0.2

result in the depreciation and book value series in Table 161.
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DB compared with DDB

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