Nothing in life is certain except death, taxes and the second law of thermodynamics. Seth Lloyd (Nature, 26 Aug. 2004)

Size: px

Start display at page:

Download "Nothing in life is certain except death, taxes and the second law of thermodynamics. Seth Lloyd (Nature, 26 Aug. 2004)"

Sheena Greene
6 years ago
Views:

ENGM 401 & 620 - X1 Fundamentals of Engineering Management Fall 2010 Lecture 8: Depreciation (2) Nothing in life is certain except death, taxes and the second law of thermodynamics.

ca/~mlipsett/engm401_620/engm401_620/htm Depreciation (Review) Depreciation a) Is a cash expense b) Reflects the need to replace assets that wear out c) Understates earnings if the period is too

1 ENGM 401 & X1 Fundamentals of Engineering Management Fall 2010 Lecture 8: Depreciation (2) Nothing in life is certain except death, taxes and the second law of thermodynamics. Seth Lloyd (Nature, 26 Aug. 2004) M.G. Lipsett Dept. of Mechanical Engineering University of Alberta Depreciation (Review) Depreciation a) Is a cash expense b) Reflects the need to replace assets that wear out c) Understates earnings if the period is too long. d) Is the only method for tracking change in asset value. e) All of the above. True or False: Accounting rules require a company to save the depreciation amount to reinvest in new equipment. True or False: A company uses the same depreciation period for all its assets. MG Lipsett,

2 Straight Line Depreciation The simplest depreciation method is straight line depreciation where an asset s value is depreciated at a constant rate over its lifetime The annual depreciation charge is the same in each year Straight line depreciation: d t = depreciation charge in year t B = original value of asset (cost basis) N = depreciable lifetime, in years S = expected salvage value of asset after depreciable lifetime MG Lipsett, Straight Line Depreciation In-Class Problem #1 You purchase a new $900 asset and decide to calculate its depreciation using the straight line method over a period of five (5) years, after which you expect to be able to sell it for $70 Calculate the asset's annual depreciation charge and its remaining value each year Year t d t Σ to end of year t Book Value end of year t MG Lipsett,

3 Straight Line Depreciation In-Class Problem #2 In April, you purchase a patent for $6800 and depreciate its value using the straight line method over 17 years, after which you expect it to have no value. Calculate the patent s annual depreciation charge and remaining book value BV each year MG Lipsett, Declining Balance Depreciation The declining balance depreciation method applies a rate of depreciation relative to the asset s current book value Declining balance depreciation: d t = depreciation charge in year t D = depreciation rate (i.e., percentage of book value per year) B = original value of asset (cost basis) BV t = book value of asset at end of year t MG Lipsett,

4 Declining Balance Depreciation Problem #1 You purchase a new $900 asset and decide to calculate its depreciation using the declining balance method with a depreciation rate of 40% over a period of five (5) years Calculate the asset's annual depreciation charge and its remaining value each year MG Lipsett, Declining Balance vs. Straight Line Depreciation B = $1000, S = $0, N = 10 B = $1000, D = 10% Straight Line Declining Balance t d t BV t d t BV t 1 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 0.00 $ $ MG Lipsett,

5 Declining Balance vs. Straight Line Depreciation $1, $1, Book Value $ $ $ Declining Balance Depreciation $ Straight Line Depreciation $ Year MG Lipsett, Depreciation and Taxes The Canadian Revenue Agency (CRA) permits a business to claim a Capital Cost Allowance (CCA) against its earnings for the period CRA has specific rules regarding the method and rate a business can use to calculate CCA Rates vary by class of asset CCA is not calculated on a per asset basis, but rather all assets of a certain class are pooled together, and the total residual value is called Unclaimed Capital Cost (UCC) for that class MG Lipsett,

6 Depreciation and Taxes (2) Tax depreciation is virtually always higher than book depreciation This means real taxes are initially lower than they would be if book depreciation were used for tax purposes The difference between depreciation for accounting purposes and depreciation for tax purposes is called deferred taxes The difference between taxes paid according to the law and the taxes you would have paid if taxes were based on your actual depreciation Deferred taxes, like depreciation, also appear on the income statement as a charge against income (reduce book income) MG Lipsett, Depreciation and Taxes (3) Capital Cost Allowance (CCA) is the tax equivalent of depreciation CCA uses the declining balance method, at various rates Unclaimed Capital Cost (UCC) is the tax equivalent of book value The value of all assets of a particular class are lumped together into one UCC for each class One complicating factor in depreciation for tax purposes is the 50% rule or half-year convention For most assets, a business can only claim 50% of its normal CCA in the year in which it was acquired The full amount is claimed in all subsequent years MG Lipsett,

7 Acquisitions Affected by 50% Rule The amount by which acquisitions are affected by the 50% rule is further reduced by an disposal of assets made in the same period For instance: if have a UCC of $20,000 at the start of the year, then purchase a $10,000 asset and sell a $2,000 asset through the year, you calculate the CCA on $20k + $10k - $2k 50% x ($10k - $2k) = $24k The result is that when you have a lot of disposal of assets, it offsets any CCA reductions for acquisitions MG Lipsett, Capital Cost Allowance Calculation Transaction tracking: Purchase amount adds to UCC t-1 (UCC carried over from the previous year) (subject to 50% rule) Selling amount subtracts from UCC t-1 Calculation Method: For each class of asset, choose the appropriate rate R For the current year t Find T t, the sum of the transactions in the current year t (purchase is positive, sale is negative) If T t > 0, then T t * = 0.5 T t ; otherwise T t * = T t (50 % rule) Calculate CCA t = R * (UCC t-1 + T t *) Calculate UCC t = UCC t-1 + T t - CCA t MG Lipsett,

8 Depreciation and Taxes Example Your company has six vehicles with current UCC values: 2004 Chevy Van $ Hyundai $ Honda Accord $ Ford Bronco $ Dodge Pick-up $ Total: $ Calculate Class 10 CCA (i.e., 30% rate) if: Sell Accord for $ in year 2 Buy Toyota Land Cruiser for $ in year 3 Sell Bronco for $850 and purchase Mustang for $ in year 5 Sell all remaining vehicles for $9 000 total in year 6 MG Lipsett, Depreciation and Taxes Example (2) Year 1: No transactions UCC 0 =$86,799 CCA 1 =$86,799 x 0.3 = $26,040 UCC 1 =$86,799 - $26,040 = $60,759 Year 2: Sell Accord for $20,000 UCC 1 =$60,759 CCA 2 =($60,759 - $20,000) x 0.3 = $12,228 UCC 2 =$60,759 - $20,000 - $12,228 = $28,532 Year 3: Buy Land Cruiser for $26,000 UCC 2 =$28,532 CCA 3 =($28, x $26,000) x 0.3 = $12,458 UCC 3 =$28,532 + $26,000 - $12,458 = $42,072 MG Lipsett,

9 Depreciation and Taxes Example (3) Year 4: No transactions UCC 3 =$42,072 CCA 4 =$42,072 x 0.3 = $12,622 UCC 4 =$42,072 - $12,622 = $29,450 Year 5: Sell Bronco for $850 and buy Mustang for $25,000 UCC 4 =$29,450 CCA 5 =[$29, x ($25,000 - $850) ] x 0.3 = $12,458 UCC 5 =$29,450 + $25,000 - $850 - $12,458 = $41,142 Year 6: All remaining vehicles for $9,000 UCC 5 =$41,142 CCA 6 =($41,142 - $9,000) x 0.3 = $9,643 UCC 6 =$41,142 - $9,000 - $9,643 = $22,499 MG Lipsett, Summary Depreciation can be calculated in different ways by a company to track how it thinks different assets are declining in value over time Straight-line is simple, and is not always appropriate Declining-balance is the basic method used to calculate capital cost allowance, which is how Canada Revenue Agency allows depreciation for tax purposes Tax is never simple make sure you understand the rules (or seek assistance from a tax accountant) MG Lipsett,

We come into this world head first and go out feet first; in between, it is all a matter of balance.

ENGM 401 & 620 X1 Fundamentals of Engineering Finance Fall 2010 Lecture 10: The Balance Sheet We come into this world head first and go out feet first; in between, it is all a matter of balance. - Paul