Depreciation

Depreciation is an unusual charge in that it is paid into the corporate

treasury. There are other kinds of intracorporate transfers, such as
material and utility purchases from one division by another. Such
transfers generally have little or no overall impact on the corporate
finances. Depreciation, however, has a significant effect on corporate
cash flow.

Types of Depreciation

The concept of depreciation is based upon the

fact that physical facilities deteriorate and
decline in usefulness with time; thus, the value of
a facility decreases. Physical depreciation is
the term given to the measure of the decrease in
value of a facility due to the changes in the
physical aspects of a property. Wear and tear,
corrosion, accidents, and deterioration due to the
age or the elements are all causes of physical
depreciation. With this type of depreciation, the
serviceability of a property is reduced because of
the physical changes.
Depreciation due to all other causes is known as
functional depreciation. One common type of
functional depreciation is obsolescence, This is
caused by technological advances which make an
existing property obsolete. Other causes of
functional depreciation could be (1) decrease in
demand for the service rendered by the property
(2)
shifts
in
population
(3)
changes
in
requirements of public authority, (4) inadequacy
or insufficient capacity, and (5) abandonment of
the enterprise.

Depreciation and income

Depreciation is aTax
charge to the revenue resulting from an
investment in real property. It is entirely reasonable that
invested principal should be recovered by the investor and
that project revenues be charged to pay that principal. In
the case of other investments, such as savings accounts,
the original investments is available in addition to any
return that has been earned, and thus a recovery of
invested capital is to be expected in plant investment as
well. Depreciation is charged as an expense and then paid
to the corporation. It is added and subtracted on the
corporate books, and because of this, it is sometimes
referred to as an accounting artifact. Depreciations is more
than an artifact, however, because of the effect it has on
the amount of income tax that a corporation must pay. One
definition of depreciation is as follows:

A deduction for depreciation may be claimed each year for

property with a limited useful life thats used in a trade or
business or held for the production of income. This
deduction allows tax- payers to recover their cost for the
property over a period of years.

AMORTIZATION
What Does Amortization Mean?
1) The paying off of debt in regular installments over a
period of time.
2) The deduction of capital expenses over a specific period
of time (usually over the assets life). More specifically,
this method measures the consumption of the value of
intangible assets, such as a patent or a copyright.
Investopedia explains Amortization:
Suppose XYZ Biotech spent $30 million dollars on a piece of
medical equipment and that the patent on the equipment
lasts 15 years, this would mean that $2 million would be
recorded each year as an amortization expense.
While amortization and depreciation are often used
interchangeably, technically this is an incorrect practice
because amortization refers to intangible assets and
depreciation refers to tangible assets.

Depreciable Investments
In general, all property with a limited useful life of more
than 1 year that is used in a trade or business, held for the
production of income, is depreciable. Physical facilities,
including such costs as design and engineering, shipping,
and field erection, are depreciable. Land is not depreciable.
working capital and start-up costs are not depreciable.
Inventories held for sale are not depreciable. In Project
terminology, the fixed-capital investment, not including
land, is depreciable.
Maintenance is necessary for keeping a property in good
condition; repairs connote the mending or replacing of
broken or worn parts of property. The costs of maintenance
and repairs are direct operating expenses and thus are not
depreciable.
The total amount of depreciation that may be charged is
equal to the amount of the original investment in a
property-no more and no less. Depreciation does not inflate
or deflate.

Current Value
The current value of an asset is the value of the
asset in its condition at the time of valuation.
Book value is the difference between the original
cost of a property and all the depreciation
charged up to a time. It is important, because it
is included in the values of all assets of a
corporation.
The
method
of
determining
depreciation may be different for purposes of
obtaining the book value than that which is used
for income tax purpose, depending on corporate
policy. The price that could be obtained for an
asset if it were sold on the open market is
designated the market value. It may be quite
different from the book value and clearly is
important for determining the true asset value
of the company.

Salvage Value
Salvage value is the net amount of money obtainable
form the sale of used property over and above any
charges involved in removal and sale. The term
salvage value implies that the property may be of
further service. If the property is not useful, it can
often be sold for material recovery. Income obtainable
from this type of disposal is known as scrap value. As
of 2002, tax laws do not permit considering salvage
or scrap value in the calculation of depreciation.
Income from the sale of used property, to the extent
that it exceeds the undepreciated value of the
property, is therefore taxed as a capital gain, if the
net sale price is less than the undepreciated value, it
is not taxable but it is included as an income to the
project at the time of the sale.

Recovery Period
The Period over which the use of
property is economically feasible is
known as the service life of the property.
The period over which depreciation is
charged is the recovery period, and this
is established by tax codes. While
originally the recovery period was at
least approximately related to the
service life, the reality now is that there
is little relationship between the two.
Recovery periods for some chemical- and
process- industries-related depreciation
are shown in table 7.8

Table 7.8 Recovery periods for selected chemicalindustry-related asset classes

Types of Assets

Recovery
Period ,years
MACRS

Straight line

Heavy general-purpose trucks

Industrial steam and electric generation and / or distribution

system

15

22

Information system( e.g ,computers)

Manufacture of chemicals and allied products(including

petrochemicals)

9.5

Manufacture of electronic components , products , and system

Manufacture of finished plastic products

11

Manufacture of other(than grain ,sugar, and vegetable oils)

food and kindred products

12

Manufacture of pulp and paper

13

Manufacture of rubber products

14

Manufacture of semiconductor

Petroleum refining

10

16

Pipeline transportation

15

22

Gas utility synthetic natural gas ( SNG)

14

SNG-coal gasification

10

18

Liquefied natural gas plant

15

22

Waste reduction and resource recovery plant

10

Asset Depreciation Range ADR (years)

Assets Used

Lower Limit

Midpoint Life

Upper Limit

Office furniture, fixtures, and equipment

10

12

Information systems (computers)

Airplanes

2.5

3.5

Buses

11

Light trucks

Heavy trucks (concrete ready-mixer)

12

15

18

Vessels, barges, tugs, and water transportation system

14.5

18

21.5

Industrial steam and electrical generation and or

distribution systems

17.5

22

26.5

Manufacturer of electrical and non-electrical machinery

10

12

Manufacturer of electronic components, products, and

systems

Manufacturer of motor vehicles

9.5

12

14.5

Telephone distribution plant

28

35

42

Automobiles, taxis

Railroad cars and locomotives

Tractor units

Book Depreciation
Methods
Four different methods can be used to
calculate the periodic depreciation
allowances for financial reporting.

Types of Depreciation Methods:

Straight-Line Method
Declining/Reducing Balance Method
Modified Accelerated cost Recovery
system
Sum of digits method

Methods for calculating

Depreciation

There are several methods for calculating depreciation; however, because of

the federal income tax rules in effect since 1987, we shall consider here only
four of the methods: straight-line, Reducing/declining balance, the modified
accelerated cost recovery system (MACRS), and sum of digits method.
Depreciation results in a reduction in income tax payable in the years
in which it is charged. The total amount of depreciation that can be charged
is fixed and equal to the investment in depreciable property. Thus, over any
recovery period, the same total amount is depreciated; hence, the same
total amount of tax is paid- assuming that the incremental tax rate is the
same in all those years. However, because money has a time value, it is
economically preferable to receive benefits, including tax savings, sooner
rather than later. Therefore, it is usually in the taxpayers interest to
depreciate property as rapidly as possible. From the federal governments
perspective, however, for the same reason, it is preferable to receive tax
revenues sooner rather than later. Counterbalancing this, form the
governments point of view. Is the desire to encourage business activity and
thus the overall economy. For these reasons, the rate and length of time
during which depreciation can be charged are a matter of government policy.

Straight Line Method

This method may be elected under the federal tax code as an alternative
depreciation system. It depreciates property less rapidly than does MACRS, and
therefore, it would only be chosen for use in tax computations under special
circumstances, for example a new company night wish to conserve depreciation
deductions for use in the future when its incremental tax rate is expected to be
higher. For purposes of economic evaluation of projects, straight-line depreciation is
often used when employing a profitability measure that does not consider the time
value of money, because under these circumstances the rate of depreciation is not
important.
In the straight-line method, the property value is assumed to decrease linearly with
time over the recovery period, no salvage or scrap value may be taken, Thus the
amount of depreciation in each year of the recovery period is
d= v/n
Where d is annual depreciation in dollars per years, V the original investment in the
property at the start of the recovery period, and n the length of the straight-line
recovery period. For tax purposes, the recovery period for straight-line depreciation
is 9.5 years for chemical plants, as shown in table 7-8. For purposes other than tax
calculations, the corporation may select a value for n. if the straight-line
depreciation is being used in conjunction with a profitability measure that does not
take into account the time value of money, then one reasonable recovery period to
use is the length of the evaluation period,. Another reasonable choice is 6 years,
because this gives the same average rate of depreciation as does MACRS.

Straight Line Method

(continue)
Annual depricaition cost d = (V S)/N
Vn the book value of the asset after n years = V
n (V S)/N

Example Straight-Line Method

Annual Depreciation
$10,000

$8,000

D2

$6,000

$4,000

D3
B1

D4
B2
B3

D5
B4

$2,000

Total depreciation at end of life

D1

Book Value

I = $10,000
N = 5 Years
S = $2,000
D = (I - S)/N
n

B5

1
2
3
4
5

Dn
1,600
1,600
1,600
1,600
1,600

Bn
8,400
6,800
5,200
3,600
2,000

Reducing Balance Method of

Depreciation
In this method, the depreciation cost is highest in the first
year and reduces year after year. A constant percentage of
the book value at the beginning of the year is used to
calculate the depreciation cost. The ratio of asset value at
the end of the year to that at the beginning of year, R is
constant throughout the life of the asset. For example if
the initial cost of an asset is Rs. 1000 and the depreciation
rate is 20% of current book value (R= 0.2) then the value of
the asset after 1,2,3,4. Years will be Rs. 800, Rs. 640, Rs.
512 and Rs. 409.6 .. respectively. A general formula for
the value of asset at the end of year n will be:

Vn = V x (1-R)n
This method of depreciation has the advantage that the
depreciation cost is high in the beginning when
maintenance costs are low and decreases when the
maintenance costs increase in the subsequent years.
However, the sum total of the two costs may not be
uniform.

Example Declining Balance Method

Annual
Depreciation
Book Value
I = $10,000

$10,000
Total depreciation at end of life

D1
$8,000
$6,000
D2
$4,000

B1
B2

D3

$2,000
B3

$778

N = 5 years
S = $778
Dn = Bn 1
= I (1 - n 1
Bn I (1 ) n

D4
B4
4

D5
B5
5

n
0
1
2
3
4
5

Dn
$4,000
2,400
1,440
864
518

Bn
$10,00
0
6,000
3,600
2,160
1,296
778

 Example
The initial cost of a plant is Rs.210 million. The value of the plant after 15 years
of economic life is expected to be Rs. 30 million. Determine the book value of
the plant after three years using (a) linear depreciation (b) Reducing balance
depreciation if the depreciation rate is12%. Also calculate year wise
amount of depreciation.
Solution

V,
the cost value of plant
= Rs. 210,000,000

S,
the salvage value of the plant
= Rs. 30,000,000

N,
the economic plant life
= 15 years
Annual cost recovery by linear depreciation,
= Rs.12,000,000 uniform for all
years
Book value of the plant of after 3 years = 210,000,000 -3 x 12,000,000

= Rs. 174,000,000
b) Book value of the plant after 3 years, with reducing balance depreciation V (1 R) 3

210,000,000 (1 0.12)3

210,000,000 (0.88)3 = Rs. 143,109,120

Depreciation in Ist year= 210,000,000 X 0.12

= Rs. 25,200,000
Depreciation in 2nd year
=(210,000,000 - 25,200,000) x0.12
=
184,800,000 X 0.12

= Rs 22,176,000
Depreciation in 3rd year=(184,800,000 -22,176,000) x 0.12

= 162,624,000 x0.12

= Rs.19,514,880

Modified Accelerated cost

Recovery system
MACRS is the depreciation method used for most income
tax purposes and therefore also for most economic
evaluations. The MACRS method is based upon the classical
double-declining balance method, but with no salvage or
scrap value allowed, a switch to straight-line at a point,
and use of the half-year convention. There are also midmonth and mid-quarter conventions, but they rarely occur
in corporate project tax situations.
The double-declining-balance method allows a depreciation
charge in each year of the recovery period that is twice the
average rate of recovery on the remaining undepreciated
balance for the full recovery period. Thus, in the first year
of a 5-year recovery period, the fraction of the original
depreciable investment that can be taken as depreciation
is (2)(1/5), or 40 %. The undepreciated portion is now 60 %
of the original investment; thus, in the second year, the
allowable amount is (2)(0.6/5)

MACRS Table

The percentages shown in the table use

the half year convention, all the assets are placed in service at midyear and will have zero salvage value.

Modified Accelerated cost

Recovery system (Cont)
An intermediate system may be evolved with variable
values of R, established for the particular type of
asset to charge higher value in the beginning and
lesser value of depreciation in the later years. R,
values such as 0.29, 0.15, 0.12,0.09,0.08,0.08 may be
established to calculate depreciation cost in relation
to initial cost of the asset. The depreciation cost of an
asset, with a cost value of Rs.1000, in the 4 th year
with the above values of R, will be 1000X 0.09 =
Rs.90. the total depreciation after 4 years of use will
be 1000(02 +0.15 + 0.12 + 0.09) x 1000 = Rs.440.
different sets of R-values may be established for
different types of assets.

Example MACRS
Depreciation

Asset cost = $10,000

Property class = 5-year recovery period
DB method = Half-year convention, zero salvage value,
200% DB switching to SL
20%

32%

19.20% 11.52% 11.52% 5.76%

$2000 $3200 $1920 $1152 $1152

Full Full
Full
1
2
3
4
Half-year Convention

$576

Full
5

Sum of Digits Method

Insurance
The annual insurance costs for ordinary industrial projects are
approximately

percent

of

the

fixed-capital

investment.

Despite the fact that insurance costs may represent only a small
fraction of total costs. It is necessary to consider insurrance
requirements carefulluy to make certain the economic operation
of a plant is protected against emergencies or unforesseen
developments.
The design engineer can aid in reducing insurance requirements
if all the factors involved in obtaining adequate insurance are
understood. In particular, the engineer should be aware of the
different

types

of

insurance

available

and

the

legal

responsibilities of a corporation with regard to accidents and

other unpredictable emergencies.

Example - Net Income

Calculation
Item

Amount

Gross income (revenue)

$50,000

Expenses
Cost of goods sold
Depreciation
Operating expenses

20,000
4,000
6,000

Taxable income

20,000

Taxes (40%)
Net income

8,000
$12,000

Legal Responsibility
A corporation can be obtain insurance to protect itself against loss of property
due to any of a number of different causes. Protection against unforeseen
emergencies other than direct property loss can also be obtained through
insurance.
For example, injuries to employees or others due to a fire or explosion can be
covered. It is impossible to insure against every possible incidence, but it is
necessary to consider the results of a potential emergency and understand the
legal responsibility for various types of events. The payments required for
settling a case in which legal responsibility has been proved van be much
greater than any costs due to direct property damage.
The design engineer should be familiar with the laws and regulations governing
the type of plant or process involved in a design. In case of an accident, failure
to comply with the laws involved is a major factor in establishing legal
responsibility. Compliance with all existing laws, however, is not a sufficient basis
for disallowance of legal liability. Every known safety feather should be included,
and extraordinary care in the complete operation must be proved before a good
case can be presented for disallowing legal liability.
Liability for Product safety has become a major concern for manufactures in
recent years, due to heightened public awareness of producers liability. Product
testing and hazard warnings are minimal activities to undertake before releasing
a product for distributions

Types of Insurance
Many different types of insurance are available for protection
against property loss or charges based on legal liability.
Despite every precaution there is always the possibility of an
unforeseen even causing a sudden drain on a corporations
finances, and efficient management protects itself against
such potential emergencies by taking out insurance to cover
such risks.

The major insurance requirements for manufacturing concerns

can be classified as follows:

1.

2.

3.

4.
5.
6.
7.
8.
9.

Fire insurance and similar emergency coverage on buildings

equipment and all other owned, used or stored property.
Included in this category would be losses caused by lightning,
wind, hailstorms, floods, automobile accidents, explosions,
earthquakes, and similar occurrences.
Public-liability insurance, including bodily injury and property
loss or damage, on all operations such as those involving
automobiles, elevators, attractive nuisance, aviation products,
or any corporate function carried out at a location away from
the plant premises.
Business-interruption insurance. The loss of income due to a
business interruption caused by fire or other emergency may far
exceed any loss in property. Consequently, insurance against a
business interruption of this type is extremely important.
Power plan, machinery, and special-operations hazards.
Workers compensation insurance.
Marine and transportation insurance for all property in transit.
Comprehensive crime coverage.
Employee-benefit insurance, including life, hospitalization,
accident, health, personal property, and pension plans.
Product liability.

Self Insurance
Because the payout of claims by insurance companies is
perhaps only 55 to 60% for each dollar of premium they
receive, self insurance is sometimes used to minimize the cost
of insurance. The decision whether to purchase or or selfinsure requires balancing the possible savings versus the
chances of large losses. The tax implications must be
considered as well, because insurance premium for standard
insurance are tax-deductible while funds paid into a selfinsurance reserve ordinarily are not. Overall corporate policies
dictate the type and amount of insurance that will be held. It
should be realized., however, that a well-designed insurance
plan needs input from persons who understand all the aspects
of insurance as well as the problems involved in the
manufacturing operation.