Hacettepe University Faculty Of Economics And Aministrative Sciences
Department Of Business Administation
Consideration Of Depreciation And Income Taxes
Papers Created By:
ÖZPARLAK,Ayşegül 20312383
ÖZGÜN,Aysun 20212445
EROL,Cem Umut 20311219
AYANOĞLU,Faik Uras 20211712
NARİN,Müşerref Özlem 20211214
LECTURER:
Dr.ARSLAN,Özgür
In the Division Of Finance-Accounting
Table of Contents
PLOT OUTLINE
WHAT IS DEPRECIATION?
WHICH ASSETS ARE DEPRECIATED?
CAUSES OF DEPRECIATION
1. PHYSICAL DETERIORATION
2. FUNCTIONAL OBSOLESCENCE
3.ECONOMIC OBSOLESCENCE
MEASURING DEPRECIATION
COST
ESTIMATED USEFUL LIFE
ESTIMATED RESIDUAL VALUE
METHODS & USAGE OF DEPRECIATION
STRAIGHT-LINE METHOD
DECLINING-BALANCE METHOD
UNITS OF PRODUCTION METHOD
COMPARING DEPRECIATION METHODS
DEPRECIATION AND INCOME TAXES
MODIFIED ACCELERATED COST RECOVERY SYSTEM
ACRS
MACRS
WHAT IS ECONOMIC VALUE ADDED (EVA)?
Stern Stewart & Company
EVA Basic Premise
EVA Simplified Calculation
EVA in Comparison with Other Economic Measurements
Why is EVA also useful for small companies? (even with less than 100 employees)
WHAT’S NEEDED TO CALCULATE COMPANY’S ECONOMIC VALUE ADDED?(EVA)
EVA Implementation by a Small Company
CONCLUSION
TERMINOLOGY
BIBLIOGRAPHY
PLOT OUTLINE
Depreciation
- What is Depreciation?
- Which Assets will be Depreciated?
- Causes of Depreciation
- Physical Depreciation
- Functional Depreciation
- Technological Depreciation
- Depletion
- Monetary Depreciation
- Functions of Depreciation
- In Economy
- In Finance
- In Accounting
- In Cost Determination
- Measuring Depreciation
- Cost
- Estimated Useful Life
- Estimated Residual Value
Depreciation Methods
- Straight-Line (SL) Method
- Declining Balance (DB) Method
- Units-of-Production (UOP) Method
- Comparing Depreciation Methods
Depreciationand Income Taxes
- Modified Accelerated Cost Recovery System (MACRS)
Economic Value Added (EVA)
EVA = Net Operating Profit – (Capital x The Cost of Capital)
After Tax (NOPAT)
WHAT IS DEPRECIATION?
Depreciation is the allocation of the cost of a plant asset to expense over its useful (service) life in a rational and systematic manner. Depreciation accounting matches the asset’s cost (expense) against the revenue earned by the asset, as the matching principle directs.
If we want to contrast what depreciation accounting is with what it is not.
- Depreciation is not a process of asset valuation. Businesses do not record depreciation based on the market (sales) value of their plant assets at the end of each year. Instead, businesses allocate an asset’s cost to expense during the period of its use.
- Depreciation does not mean that the business sets aside cash to replace an asset whenit is used up. Establishing a cash fund is entirely separate from depreciation, and depreciation does not represent cash.
WHICH ASSETS ARE DEPRECIATED?
Plant assets are tangible resources that are used in the operations of a business and are not intended for sale to customers. They are also called property, plant, and equipment; plant and equipment; or fixed assets. These are generally long-lived. They are expected to provide services to the company for a number of years. Plant assets are often subdivided into four classes:
- Land, such as a bulding site.
- Land improvements, such as driveways, parking lots, fences, and underground sprinkler systems.
- Buildings, such as stores, offices, factories, and warehouses.
- Equipment, such as store check-out counters, cash registers, coolers, Office furniture, factory machinery, and delivery equipment.
Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment. Each asset in these classes is considered to be a depreciable asset. Why? Because the usefulness to the company and revenue-producing ability of each asset will decline over the asset’s useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact over time. In fact, in many cases, the usefulness of land is greater over time because of the scarcity of good land sites. Thus, land is not a depreciable asset.
CAUSES OF DEPRECIATION
Baum (1991) defines depreciation as a loss in the existing value of property and attributes the causes to physical deterioration, functional obsolescence or aesthetic obsolescence. Mansfield (2000) also notes that property-based depreciation is the result of two negatives processes; physical deterioration and obsolescence. Barreca (1999) classifies depreciation into three classes namely physical depreciation, functional depreciation and other economic losses. These three views of depreciation obviously have something in common and that is the fact that depreciation is the result of physical deterioration, functional and economic obsolescence.
1. PHYSICAL DETERIORATION
Deterioration is the decay and disintegration which takes place in structures with the passage of time. Deterioration is caused by natural forces, by the elements, and by use. Deterioration operates to terminate the physical life of a building.
Physical deterioration as a cause of depreciation is the result of wear and tear with usage and deterioration with age among others. For example, physical deterioration wears out the trucks that move merchandise from warehouses to company stores. The stores fixtures used to display merchandise are also subject to physical wear and tear.
2. FUNCTIONAL OBSOLESCENCE
Obsolescence refers to those changes in usefulness of structures in certain neighborhoods which cause them to become less desirable or less useful. It operates to terminate the economic life of a building. Obsolescence does not affect physical life as it does not cause deterioration. It has greater significance in valuation than does deterioration.
Functional obsolescence is defined as the “loss in value of a property resulting from changes in tastes, preferences, technical innovations, or market standards”(IAAO 1997). Functional obsolescence is caused by
a. New inventions and discoveries;
- Changes in the preferences and tastes of the public, with regard to styles of architecture, geographical locations as places of residence, sizes of rooms, heights of ceilings, the extent of mechanical equipment, such as plumbing and heating, etc.
3.ECONOMIC OBSOLESCENCE
By definition, economic obsolescence is “a cause of depreciation that is a loss of value as a result of impairment in utility and desirability caused by factors outside the property’s boundaries” (IAAO 1997). Economic obsolescence is also referred to as external or locational obsolescence.
High maintenance costs may require replacement earlier than anticipated. There may be a better alternative, such as selling aircraft for a greater total return, which is more cost effective than continuing to operate them. A review of market value versus rate of return on production of assets is appropriate periodically. Where the current market value of equipment is greater than the combined future return on production, sale of the asset is a better alternative.
MEASURING DEPRECIATION
In measuring the amount of depreciation to recognize in a specific period there are three variables:
- Cost
- Estimated useful life
- Estimated residual value
COST
This will include all expenditures incurred by the business to bring the asset to its required location and to make it ready for use. Thus, in addition to the costs of acquiring the asset, any delivery costs, installation costs (e.g. plant) and legal costs incurred in the transfer of legal title (e.g. freehold property) will be included as part of the total cost of the asset. Similarly, any costs incurred in improving or altering an asset in order to make it suitable for its intended use within the business will also be included as part of the total cost.
Land Improvements
The cost of land improvements includes all expenditures needed to make the improvements ready for their intended use. For example; the cost of a new company parking lot will include the amount paid for paving, facing and lighting. Thus, these costs are debited to Land Improvements. Because these improvements have limited useful lives and their maintenance and replacement are the responsibility of the company, they are depreciated over their useful lives.
Buildings
All necessary costs related to the purchase or construction of a building are debited to the Buildings account. When a building is purchased, such costs include the purchase price, closing costs (attorney’s fees, title insurance, etc.) and broker’s comission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors electrical wiring, and plumbing.
When a new building is constructed, cost consists of the contract price plus payments for architect’s fees, building permits, and excavation costs. Also, interest costs incurred to finance the project are included when a significant period of time is required to get the building ready for use. These interest costs are considered as necessary as materials and labor. The inclusion of interest costs is limited to the construction period, however. When construction has been completed, subsequent interest payments on funds borrowed to finance the construction are debited to Interest Expense.
Equipment
The cost of equipment, such as Rent-a-Wreck vehicles, consists of the cash purchase price plus certain related costs. These costs include sales taxes, freight charges, and insurance during transit paid by the purchaser. They also iclude expenditures required in assembling, installing, and testing the unit. However, motor vehicle licenses and accident insurance on company trucks and cars are not included in the cost of equipment. They are treated as expenses as they are incurred. They represent annual recurring expenditures and do not benefit future periods.
To illustrate, Dalton Engineering Ltd purchased a new motor car for its marketing director. The invoice received from the motor car supplier revealed the following:
$ / $New BMW 325i / 21,350
Delivery charge / 80
Alloy wheels / 660
Sun roof / 200
Petrol / 30
Number plates / 130
Road fund licence / 140 / 1,240
22,590
Part exchange-Reliant Robin / 1,000
Amount outstanding / 21,590
The cost of the new car will be as follows:
$ / $New BMW 325i / 21,350
Delivery charge / 80
Alloy wheels / 660
Sun roof / 200
Number plates / 130 / 1,070
22,420
These costs include delivery costs and number plates as they are a necessary and integral part of the asset. Improvements (alloy wheels and sun roof) are also regarded as part of the total cost of the motor car. The petrol costs and road fund licence, however, represent a cost of operating the asset rather than a part of the cost of acquiring the asset and making it ready for use, hence these amounts will be charged as an expense in the period incurred (although part of the cost of the licence may be regarded as a prepaid expense in the period incurred).
The part exchange figure shown is part payment of the total amount outstanding and is not relevant to a consideration of the total cost.
ESTIMATED USEFUL LIFE
Estimated useful life is the length of the service period expected from the asset. Useful life may be expressed in years, units of output, miles, or another measure. For example, the useful life of a building is stated in years. The useful life of a bookbinding machine is the number of books the machine can bind-that is, its expected units of output. A delivery truck’s useful life can be measured in miles.
It is necessary to determine the estimated useful life of each piece of property, plant, and equipment as it will be used in the entity involved. However, as a matter of expediency, most organizations establish classes or groups of items and depreciate them over a similar life. For example, furniture may be defined as a class and a single life utilized for it. Because it is necessary to project into the future, this is not a simple task. Useful lives of items may be far beyond what the practical or economic life of an item will be.
Automobiles may have a useful life of ten or twelve years. However, or in a rental car business, the practice may be to replace an automobile each year, or within two years. Because customers expect to drive new automobiles, the economic life in the rental car business would no more than two years. The same automobiles used by administrative employees of the rental company may be replaced every three or four years. Past practice should be reviewed in determining the future useful life of the item.
Determining the estimated useful life has a significant impact on the period expenses. Shortening the life will increase expenses in the periods. An estimated useful life in excess of actual life understates the expenses in those periods and will cause retirement of undepreciated assets. Therefore, careful consideration should be given to ensuring that estimated useful life and actuals are reasonably accurate.
In determining the estimated useful life, consider the lives of similar items used by the company in the past. A well-defined property record will provide that type of information. Review with the users of the items their expected use in the future. Is it increasing or decreasing? Determine what policies may be changed that will affect the actual life of an item in the organization. Companies also make such estimates from industry information and government publications.
Changing the Useful Life of a Depreciable Asset
Estimating the useful life of each plant asset poses an accounting challenge. As the asset is being used, the business may refine its estimate on the basis of experience and new information. The Walt Disney Company made such a change, called a change in accountingestimate. Disney refigured depreciation for the revised useful lives of several theme-park assets. The following note in Disney’s financial statements reprts this change in accounting estimate:
Note 5
…[T]he Company extended the estimated useful lives of certain theme park … assets based upon … engineering studies. The effect of this change was to decrease depreciation by approximately $8 million (an increase in net income of approxiamately $4.2 million … ).
Accounting changes like these are common because no one has perfect foresight. Generally accepted accounting principles require the business to report the nature, reason, and effect of the accounting change on net income, as the Disney example shows. For a change in accounting estimate, the remaining book value of the asset is spread over its remaining useful life. The new useful life may be longer or shorter than the original useful life.
Assume that a Disney World hot dog stand cost $40,000 and that the company originally believed the asset had an eight-year life with no residual value. Using the straight-line method, the company would record depreciation of $5,000 each year ($40,000/8 = $5,000).
Suppose Disney used the asset for two years. Accumulated depreciation reached $10,000, leaving a remaining depreciable book value (cost less accumulated depreciation less residual value) of $30,000 (440,000 - $10,000). Suppose Disney management believes the hot dog stand will remain useful for an additional ten years. The company would revise the annual depreciation amount as follows:
Asset’s remaining (New) Estimated (New) Annual depreciable book value ÷ useful life remaining = depreciation
$30,000÷10 years=$,3000
Willamette Industries, Inc., of Portland, Oregon, said in March 1999 that it would change its accounting estimates relating to depreciation of certain assets, beginning with the first quarter of 1999. The vertically integrated forest products company said the changes were due to advances in technology that have increased the service life on its equipment an extra five years. Willamette expected the accounting changes to increase its 1999 full-year earnings by about $57 million, or $0.52 a share. Its 1998 earnings were $89 million, or $0.80 a share. Imagine a 65 percent improvement in earnings per share from a mere change in the estimated life of equipment!
Using Fully Depreciated Assets
A fully depreciated asset is an asset that has reached the end of its estimated useful life. No more depreciation is recorded for the asset. If the asset is no longer suitable for its purposes, it is disposed of. However, the company may be unable to replace the asset. Or the asset remain useful. In any event, companies sometimes continue using fully depreciated assets. The asset account and its accumulated depreciation remain on the books, even though no additional depreciation is recorded. For example, a fully depreciated asset has a cost of $80,000 and zero residual value. The asset’s accumulated depreciation is $80,000 (same as the asset’s cost). If its residual value is $10,000, the asset’s accumulated depreciation is now $70,000 ($80,000 - $10,000).
ESTIMATED RESIDUAL VALUE
Estimated residual value - also called scrap value or salvage value - is the expected cash value of an asset at the end of its useful life. For example, a machine’s useful life may be seven years. After seven years, the company expects to sell the machine as scrap metal. The cash the business thinks it can sell the machine for is its estimated residual value. Estimated residual value is not depreciated because the business expects to receivethis amount from disposing of the asset. If there is no residual value, then it depreciates the full cost of the asset. Cost minus residual value is called the depreciable cost of the asset.
METHODS & USAGE OF DEPRECIATION
Actually,there are three types of methods that are used in depreciation.Theese are straight-line (SL),declining-balance (DB),the third and the last method is units-of-production(UOP).Here we begin to explain the first and commonly used method,straight-line.
STRAIGHT-LINE METHOD:It is the simplest and most often used technique, in which the company estimates the salvage value of the asset after the length of time over which it will be used to generate revenues (useful life), and will recognize a portion of that original cost in equal increments over that amount of time. The salvage or estimated residual value is an estimate of the value of the asset at the time it will be sold or disposed of; as just it may be zero also.Basicly in this method ,the salvage value is subtracted from the good’s cost at the time of the purchase and then the result is divided to its useful life, in years.The reason that why this method is commonly is used is just because of its simplicity,nothing more.