Construction Accounting and Financial Management CHAPTER 5

DEPRECIATION

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Purpose

� Financial statements

� Cost allocation of equipment

� Taxes

Depreciation is the loss in value of a piece of equipment or real property

Different depreciation schedules may be used for the preparation of financial statements, the billing of equipment, and the preparation of income taxes, which may result in very different depreciation rates.

Purpose – cont’d

� Straight-line method

� Declining-balance method

� Sum-of-Years method

For the preparation of financial statements and the billing of equipment, there are three commonly used methods of depreciation.

Variables

� P = Purchase price of the asset

� F = Salvage Value of the asset (this is estimated resale value of the asset at some time in the future when it is sold.)

� Zero for tax purposes – For tax purposes, the salvage value is assumed to be zero.

� N = Recovery period (years)

� Set by code for tax purposes

� Rm = Percentage of depreciation taken in year m

� Dm = Depreciation for year m

� BVm = Book value at the end of year m

� Book value equals the purchase price less the depreciation recorded to date

Each of the three commonly used methods to calculate depreciation, use the following variables:

Straight-Line Method

� Depreciates uniformly over the life of the asset

� Annual depreciation

Dm = (P – F)/N

� Book Value

BVm = P – m(Dm)

-or-

BVm = BVm-1 – Dm

� Rate of Depreciation

Rm = 1/N

Straight-Line

m R m

D m

($) BV m

($)

0 110,000

1 1/5 20,000 90,000

2 1/5 20,000 70,000

3 1/5 20,000 50,000

4 1/5 20,000 30,000

5 1/5 20,000 10,000

A dump truck is purchased for $110,000 and has an estimated salvage value of $10,000 at the end of the recovery period. Prepare a depreciation schedule for the dump truck using the straight-line method with a recovery period of 5 years.

Dm = (P – F)/N BVm = BVm-1 – Dm

Sum-of-the-Years (SOY)

� Accelerates depreciation of an asset

� Annual depreciation Dm = (P – F)Rm Rm = (N – m + 1)/SOY SOY = N(N + 1)/2

� Book Value

BVm = BVm-1 – Dm

Sum-of-the-Years (SOY)

m R m

D m

($) BV m

($)

0 0 110,000

1 5/15 33,333 76,667

2 4/15 26,667 50,000

3 3/15 20,000 30,000

4 2/15 13,333 16,667

5 1/15 6,667 10,000

A dump truck is purchased for $110,000 and has an estimated salvage value of $10,000 at the end of the recovery period. Prepare a depreciation schedule for the dump truck using the sum-of-years method with a recovery period of 5 years.

 Step 1 – Calculate SOY. SOY = N(N+1)/2 = 5(5 + 1)/2 = 5(6)/2= 30/2 = 15  Step 2 – Calculate the Rate of Depreciation (Rm )= (N-m+1)/SOY = (5 -1+ 1)/15 = 5/15  Step 3 – Calculate Depreciation = Dm = (P-F) Rm = ($110,000-$10,000)* 5/15 = $33,333  Step 4 – Calculate Book Value = BVm = BVm-1 – Dm == ($110,000-$33,333) = $76,667

Declining-Balance Method � Accelerates depreciation

� Annual depreciation Dm = (BVm-1)Rm

� Rm = 2.00/N for 200% declining-balance

� Rm = 1.50/N for 150% declining-balance

� Book Value

BVm = BVm-1 – Dm

Declining-Balance Method

� Does not automatically reach salvage value

� Must stop depreciation at salvage value when book value goes below salvage value

– or –

� Must switch to straight-line depreciation when the straight-line depreciation for the remaining years is greater than declining-balance depreciation

Declining-Balance Method A dump truck is purchased for $110,000 and has an estimated salvage value of $10,000 at the end of the recovery period. Prepare a depreciation schedule for the dump truck using the 200% declining-balance method with a recovery period of 5 years.

 Step 1a – Calculate the annual depreciation rate for each year under the 200% declining-balance method: Rm = 2.0 /N = 0.40

Using the example D1 = ($110,000)0.40 = $44,000

 Step 1b – Calculate Depreciation using Straight-line method= Dm = (P-F) /N Using the example D1 = ($110,000 – $10,000)/5 = $20,000

– Use the method of depreciation which produces the larger value.

 Step 2 – Calculate the Book Value = BVm = BVm-1 – Dm = (110,000 – $44,000)/5 = $66.000 Continue Step 1a and Step 1b then, use the larger of the depreciation amounts to calculate the Book Value. Switch to the straight-line method when the depreciation calculated exceeds the depreciation calculated using the declining-balance method for the remaining years.

Stopping at Salvage Value ($20,000)

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

0 1 2 3 4 5 Year

Declining Balance

Stopping at the Salvage Value

Switching to Straight Line (SV = 0)

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

0 1 2 3 4 5 Year

Declining Balance

Straight Line

MACRS � Modified accelerated cost recovery system (MACRS)

� The IRS’s rules for depreciation

� Depreciation methods used:

� Double declining balance

� 150% declining balance

� Straight line

� Includes rules for placing and removing assets from service

Placing in Service

� Half-year

� General rule

� Does not apply to real property (real estate)

� Mid-quarter

� Must use when placing 40% or more of assets in service during the last quarter

� Does not apply to real property (real estate)

� Mid-month

� For real estate

For tax purposes, a full year’s depreciation is not allowed by the IRS during the tax year an asset is placed in service or disposed of. In most cases, the IRS assumes that the asset was placed in service or disposed of in the middle of the year and allows taxpayers to take 50% of the annual depreciation for the first and last years of the recovery period. This is known as the half-year convention.

IRS Recovery Periods

� Three-year: Rent-to-own property and tractors

� Five-year: Automobiles, light general propose trucks, calculators, copiers, computer equipment, concrete trucks, heavy general purpose trucks, trailers, and other construction assets

� Seven-year: Office furniture, office equipment, and railroad tracks

� Ten-year: Vessels, barges, tugs, and other water transportation equipment

� Fifteen-year: Retail motor fuel outlets

IRS Recovery Periods � Twenty-year: Farm buildings

� Twenty-five-year: Municipal sewers, water treatment plants, and water distribution lines

� Twenty-seven-and-a-half-year: Residential real estate where more than 80% of the rent is derived from the dwelling units

� Thirty-nine-year: Non-residential real estate

� Fifty-year: Railroad roadbeds, right-of-ways, and tunnels

Use of Depreciation Tables

� Find correct table

� Find correct recovery period for asset across top of table

� Percentages are percentage of asset value depreciated during the year

� not the percent of the previous year’s book value

Use of Depreciation Tables Table 5-6

Depreciation Rates for 200% Declining-Balance Using the Half-Year

Convention

Year 3 years (%) 5 years (%) 7 years (%) 10 years (%)

1 33.33 20.00 14.29 10.00

2 44.45 32.00 24.49 18.00

3 14.81 19.20 17.49 14.40

4 7.41 11.52 12.49 11.52

5 NA 11.52 8.93 9.22

6 NA 5.76 8.92 7.37

7 NA NA 8.93 6.55

8 NA NA 4.46 6.55

9 NA NA NA 6.56

10 NA NA NA 6.55

11 NA NA NA 3.28

IRS, Instructions for Form 4562, 2006, p. 13

Section 179 � Can expense up to $1,000,000 (for 2018) of equipment without

depreciation

{The Tax Cuts and Job Act increases the Section 179 deduction for 2018 allowing taxpayers to deduct up to $1,000,000 in equipment costs without having to depreciate the equipment.}

� If the amount of Section 179 property placed in service exceeds $2,500,000 the allowed write-off is generally reduced by the difference between the amount of Section 179 property and $2,500,000.

� EXAMPLE: If you placed $3,000,000 of Section 179 property in service during the tax year, the allowable Section 179 deduction would be $1,000,000 minus the difference between $3,000,000 and $2,500,000 ($500,000), or $500,000 ($1,000,000 – $500,000). These limits will be adjusted for inflation annually.

QUESTIONS???

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