Chapter 8

Depreciation

Depreciation terms
Definition:
Depreciation is the reduction in value of an asset over
time.

Depreciation represents the loss in value due to:

Use, and wear and tear on the asset

Deterioration over time

Obsolescence

Technological replacement

Depreciation terms
Depreciation is important because it affects the tax that
firms pay.
TAX = (PROFIT COSTS) (TAX RATE)
COSTS = EXPENSES + DEPRECIATION
Depreciation is a deduction from taxable income.
Obviously, a well-run firm wants to choose the
depreciation method that will minimize its taxable income.
To do so, the firm owner/employees must understand how
the depreciation methods work.

Depreciation terms
Depreciation: Example

A firm has $1,000,000 of taxable income.

If its tax rate is 25%, it would pay $250,000 in taxes ignoring
depreciation.
If it can deduct $50,000 in depreciation charges, its net taxable income
is $950,000.
Thus, it would pay taxes of 0.25 (950,000) = $237,500.
Depreciation saves 250,000 237,500 = 0.25(50,000) = 12,500.
If it could deduct more than $50,000 it would pay even less taxes.

Depreciation terms
Unlike other real expenses, depreciation is not an actual
cash flow amount.
Two types of depreciation used by corporations
Book depreciation -- Use by a corporation for
internal financial accounting

Tax depreciation -- Use in tax calculations for

government regulations.

Depreciation terms
Depreciation: Requirements

In general business assets can only be depreciated if

they meet the following basic requirements:
The property must be used for business purposes to
produce income
The property must have a useful life that can be
determined, and this life must be longer than one
year
The property must be an asset that decays, gets used
up, wears out, becomes obsolete, or loses value to
the owner from natural causes

Depreciation terms
Example: Joe runs a pizza restaurant. He classifies some of his costs as follows.

Cost Item
Pizza dough,
toppings
Delivery van
Employee wages

Type of Cost
Expense
Depreciation

Reason

2.

Must have a
useful life that
can be
determined, and
this life must be
longer than one
year

3.

Must be an
asset that
decays, gets
used up, wears
out, becomes
obsolete, or
loses value to
the owner from
natural causes

Life < 1 yr, loses value immediately

Meets 3 depreciation requirements

Expense

Life < 1 yr, loses value immediately

Furnishings for
dining room

Depreciation

Meets 3 depreciation requirements

New baking oven

Depreciation

Meets 3 depreciation requirements

Expense

Life < 1 yr, loses value immediately

Utilities for
refrigerator

1. Must be used
for business
purposes to
produce income

Depreciation terms
Classes of Business Property
Tangible property can be seen, touched, and felt.
Real property includes real estate and its
improvements, such as, buildings, factories, other
construction
Personal property Income-producing, tangible
property of a corporation, e.g., vehicles, equipment,
etc.
Intangible property is all property that has value to the
owner but cannot be directly seen or touched. Examples
include patents, trademarks, trade names, and
franchises.

Depreciation terms
Examples of depreciable business assets:
Copy machines, Helicopters, Buildings, Interior furnishing,
Production equipment, Computer networks
Many different types of properties that wear out, decay, or lose
value can be depreciated as business assets.
Examples of nondepreciable business assets:
Land: it does not wear out, lose value, or have a determinable
useful life. Indeed, often it increases in value.
Leased property: only the owner of property may claim
depreciation expenses.

Depreciation terms
Basis (First cost), B Total
cost of asset including
purchase, installation fees, etc.
Salvage, S
Estimated value
at end of
recovery period

BV, $

Book Value, BV
Remaining,
undepreciated
investment after all
depreciation to date is
removed

..

S
Time, years

Recovery period, n Depreciable life in years.

Tax and book depreciation lives often vary

Depreciation terms
Some additional terms to know
Depreciation rate, d rate for reducing the
value of assets using depreciation. (Rate is dt
when it varies each year t)
Market Value - the value others would place
on the property of interest.
Half-year convention assumes asset is
placed into initial service or disposed of in
midyear, regardless of when it actually
occurs. (Used in US-approved tax
depreciation method)

Depreciation terms
Some methods used in the US
and other countries
Straight Line (SL)
Standard against which other
methods are compared
Book value decreases
linearly over time
Declining Balance (DB)
Accelerated write-off
compared to SL method
Defers part of tax liability to
later in recovery period
Modified Accelerated Cost
Recovery System (MACRS)
Required tax depreciation
method in US since 1986

Straight Line (SL) Depreciation

Notation
BVt
B

D1

D2

n Recovery period in years

t year, t = 1, 2, , n
B First cost or basis for
depreciation
S Estimated salvage value at
end of recovery period
Dt Depreciation charge for
year t
dt Depreciation rate for year t
(d, if same each year)
BVt Book value after t years
of depreciation

Straight Line (SL) Depreciation

Depreciation charge for year t

Dt = B S = (B - S) d
n
Book value after t years of depreciation

BVt = BVt-1 - Dt = B - tDt

Depreciation rate for year t

dt = d = 1/n
Excel function to display Dt:
= SLN(B,S,n)

Straight Line (SL) Depreciation

Example 8.1: An asset has a first cost of B = $900, a useful
life of n = 5 years, and a salvage value of S = $70.
Dt = (B-S)/n = (900-70) / 5 = 830/5 = $166.
BVt = B - tDt = 900 166 t
Year,t

Dt

BVt

$900

166

734

166

568

166

402

166

236

166

70

Book Value

Initial
Cost

900

Salvage
Value

70
1

Useful Life

Declining Balance (DB)

Accelerated depreciation: higher depreciation charges in

the early years, and gradually decreasing charges in
subsequent years. More realistic reflection of an asset's
actual expected benefit from the use of the asset.

Declining Balance (DB) is also called fixed percentage or

uniform percentage method.

Annual depreciation Dt equals book value BVt-1 at beginning

of year t (which is same as end of year t-1) times fixed rate d
Dt = BVt-1 d

Declining Balance (DB)

Values of d are related to Straight Line depreciation rate
Straight Line (SL) Rate:
d=1/n
Maximum Rate of DB Depreciation:
dmax = 2 / n
Known as double declining balance (DDB)
If recovery period n = 5 years, dmax = 2 / n = 0.4
40% of book value is removed each year
150% of SL rate:
d = 1.5 / n

Declining Balance (DB)

Annual depreciation BVt = BVt-1 - Dt

BV0 = B
BV1 = BV0 D1 = BV0 BV0d= BV0 (1-d)
D1 = BV0d
(1-d)2
D2 = BV1d = BV0 (1-d) d

BV2 = BV1 D2 = BV1 BV1d= BV0

.

BVt = BVt-1 Dt = BVt-1 BVt-1d= BV0 (1-d)t

= BV0 d (1 - d )t-1

Dt

Declining Balance (DB)

Annual depreciation rate for each year t, relative to first
cost B, is
dt = d (1 - d )t-1
then,
D t = dt B
Implied Salvage value
Implied S = BVn = B (1 d)n >0
BV

BV
Estimated S

Implied S
Estimated S

Implied S
n

k-1

Declining Balance (DB)

Book value plots of SL, DB and DDB
SL depreciation
DB depreciation
at 150% SL rate

DDB depreciation

Declining Balance (DB)

Example 8.2:
First cost, B = $80,000
Salvage value, S = $10,000
depreciable life, n = 5 years
Compare the book values for two methods:
(1) DB at 150% SL rate
(2) DDB

DB rate at 150% SL rate is: d=1.5/5 = 0.3

DDB rate is: dmax = 2/5 = 0.4
BVt = B (1 - d )t
Dt = d BVt-1

Declining Balance (DB)

Example 8.2 (cont): B = $80,000, S = $10,000, n = 5 years
DB rate at 150% SL rate is: d = 0.3
BVt = B(1 - d )t
Dt = d BVt-1

Declining Balance (DB)

Example 8.2 (cont): B = $80,000, S = $10,000, n = 5 years
DDB rate is: dmax = 0.4
BVt = B(1 - d )t
Dt = d BVt-1
BV5

= B(1-d)5
= 80,000 (1-0.4)5
= 6,220.8 < 10,000

So, BV5 = 10,000

and D5 = 368.