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 ContentsPLOT OUTLINE........................................................................................................................2

WHAT IS DEPRECIATION?.....................................................................................................3

WHICH ASSETS ARE DEPRECIATED?..................................................................................3

CAUSES OF DEPRECIATION.................................................................................................5

1. PHYSICAL DETERIORATION..........................................................................................5

2. FUNCTIONAL OBSOLESCENCE.....................................................................................5

3.ECONOMIC OBSOLESCENCE.........................................................................................6

MEASURING DEPRECIATION................................................................................................6

COST....................................................................................................................................7

ESTIMATED USEFUL LIFE................................................................................................10

ESTIMATED RESIDUAL VALUE........................................................................................13

METHODS & USAGE OF DEPRECIATION...........................................................................13

STRAIGHT-LINE METHOD................................................................................................14

DECLINING-BALANCE METHOD......................................................................................15

UNITS OF PRODUCTION METHOD..................................................................................19

COMPARING DEPRECIATION METHODS...........................................................................21

DEPRECIATION AND INCOME TAXES...............................................................................25

MODIFIED ACCELERATED COST RECOVERY SYSTEM...............................................25

ACRS..................................................................................................................................25

MACRS...............................................................................................................................26

WHAT IS ECONOMIC VALUE ADDED (EVA)?.....................................................................28

Stern Stewart & Company...................................................................................................28

EVA Basic Premise.................................................................................................................28

EVA Simplified Calculation.....................................................................................................31

EVA in Comparison with Other Economic Measurements..................................................33

Why is EVA also useful for small companies? (even with less than 100 employees).......33

WHAT’S NEEDED TO CALCULATE COMPANY’S ECONOMIC VALUE ADDED?(EVA).....34

EVA Implementation by a Small Company.............................................................................34

CONCLUSION........................................................................................................................35

TERMINOLOGY.....................................................................................................................36

BIBLIOGRAPHY.....................................................................................................................38

PLOT OUTLINE

Depreciation What is Depreciation? Which Assets will be Depreciated? Causes of Depreciation

o Physical Depreciationo Functional Depreciationo Technological Depreciationo Depletiono Monetary Depreciation

Functions of Depreciationo In Economyo In Financeo In Accountingo In Cost Determination

Measuring Depreciationo Costo Estimated Useful Lifeo Estimated Residual Value

Depreciation Methods Straight-Line (SL) Method Declining Balance (DB) Method Units-of-Production (UOP) Method Comparing Depreciation Methods

Depreciation and 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.

1. 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.

2. Depreciation does not mean that the business sets aside cash to

replace an asset when it 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:

1. Land, such as a bulding site.

2. Land improvements, such as driveways, parking lots, fences, and

underground sprinkler systems.

3. Buildings, such as stores, offices, factories, and warehouses.

4. 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;

b.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 accounting estimate. 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.

Let’s try to understand this method in an example:

Imagine a truck bought on 01.01.2001 at an amount $41,000 and a usefuful

life of 5 years or 100,000 miles can be driven.And also salvage value of the truck is

$1,000.The depreciation amount and the depreciation method is likely to be:

Data Item Amount

Cost Of Truck...................................................................................................$41000

Less:Salvage Value.........................................................................................($1,000)

Depreciable Cost.............................................................................................$40,000

Estimeted Useful Life:

Years...........................................................................................................5 Years

Units Of Production.........................................................................100,000 Miles

Straight-Line Depreciation: (Cost-Salvage Value)/Useful Life,In Years =($41,000-$1,000)/5= $8,000 per year

Depreciation For The YearDate Asset

Cost

Depreciation Rate

Depreciable Cost

Depreciation Expense

Accumulated Depreciation

Book Value

01.01.2001

$41,000

$41,000

12.31.2001

0.20* x $40,000 $8,000 $8,000 $33,000

12.31.2002

0.20 x $40,000 $8,000 $16,000 $25,000

12.31.2003

0.20 x $40,000 $8,000 $24,000 $17,000

12.31.2004

0.20 x $40,000 $8,000 $32,000 $9,000

12.31.2005

0.20 x $40,000 $8,000 $40,000 $1,000

*1/5 year=0.20 per year

DECLINING-BALANCE METHOD:Declaning-balance method also known as

reducing-balance method , is a type of accelerated depreciation because it

recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a

more realistic reflection of an asset's actual resale value, as well as the expected

benefit from the use of the asset: many assets are most useful when they are

new.Also there’s an accerelated method for declining-balance method which is

called double-declining-balance(DDB).It writes off more depreciation near the start

of an asset’s life than the straight-line does.In DDB the asset’s decreasing book

value is multiplied by a constant percentage that is 2 times bigger than DB.This

method is used just for financial reasons.But the main reason why accountants or

manegars prefer to use DB or DDB, is to postpone the tax payments.And this occurs

just because, the early profits of the organization would be less than if the

organization chooses to use any other depreciation method .

Now we’ll examine DB by the given example above:

Depreciation For The YearDate Asset

CostDB

Rate

Book Value

Depreciation Expense

Accumulated Depreciation

Book Value

01.01.2001 $41,000 $41,00012.31.2001 0.20 x $41,000 = $8,200 $8,200 $32,800

12.31.2002 0.20 x $32,800 = $6,560 $14,760 $26,240

12.31.2003 0.20 x $26,240 = $5,248 $20,008 $20,992

12.31.2004 0.20 x $20,992 = $4,198.4 $24,206.4 $16,793.6

12.31.2005 $15,793.6* $40,000 $1,000*Last Year depreciation is the amount needed to reduce book value to the residual amount($16,793.6-$1000=$15,793.6)

1 2 3 4 50

2000400060008000

1000012000140001600018000

82006560

5248 4198.4

15793.6

Declining-Balance

Series1

1 2 3 4 50

50001000015000200002500030000350004000045000

820014760

2000824206.4

40000

Declining-Balance,Accumulated Depreciation

Series1

As we can see the results above;the depreciation amount per yer is dropped

fairly till last year but the last year’s depreciation amount exceeds other four

years’.Actually,the aim of second depreciation technique is to allocate the

depreciable amount greater in the first years and then this amount is decreased until

the good’s book value equals to its residual amount.But as you see, using declining-balance method in this example the fifth year’s depreciation amount exceeds greatly

than others and this is meaningless for accountants to use this method.So Double-Declining-Balance Method is much more preferable.The declining balance method is explained here just to give sight about the method and its application.

If we use DDB;the results will be then:

Depreciation For The YearDate Asset

CostDB

Rate

Book Value

Depreciation Expense

Accumulated Depreciation

Book Value

01.01.2001 $41,000 $41,00012.31.2001 0.40 x $41,000 = $16,400 $16,400 $24,60012.31.2002 0.40 x $24,600 = $9,840 $26,240 $14,76012.31.2003 0.40 x $14,700 = $5,904 $32,140 $8,85612.31.2004 0.40 x $8,856 = $3,542 $35,686 $5,31412.31.2005 $4,314* $40,000 $1,000*Last Year depreciation is the amount needed to reduce book value to the residual amount($5,314-$1000=$4,314)

Fistly we compute the depreciation rate per year.A 5-year asset has a straight-

line rate of 1/5, or 20% per year.A 10-year asset also has 1/10, or 10% and so on.In

double-declining balance method,we multiply the depreciation rate by 2.

DDB Rate = [1/(useful life of the asset,in year)] x 2

Then we’re going to find every year’s the depreciation amount:

DDB For The 1st Year: $41,000 x 0.40 = $16,400

DDB For The 2nd Year: ($41,000-16,400) x 0.40 = $9,840

DDB For The 3rd Year: ($41,000-$16,400-$9,840) x 0.40 = $5,904

DDB For The 4th Year: ($41,000-$16,400-$9,840-$5,904) x 0.40 = $3,542

DDB For The 5th Year: ($41,000-$16,400-$9,840-$5,904-$3,542) - $1,000

=$4,314 (Final Depreciation Year)

Finally be confirmed that DDB differs from the other methods in two ways:

Residual Value (Salvage Value) is ignored at the start.In the first

year,depreciation is computed on the asset’s full cost.

Final-year depreciation is the amount needed to bring the asset to residual

value.Final-year depreciation is a “plug” figure.

1 2 3 4 50

2000400060008000

1000012000140001600018000

16400

9840

5904

3542 4314

Double-Declining Balance

Series1

1 2 3 4 50

50001000015000200002500030000350004000045000

16400

26240

3214035686

40000

Double-Declining BalanceAccumulated Depreciation

Series1

UNITS OF PRODUCTION METHOD

The units-of-production method determines depreciation expense based on

the amount of asset is used. The length of life of an asset is expressed in a form of

productive capacity. The initial cost less any residual value is divided by productive

capacity to determine a rate of unit-of-production depreciation per units of usage.

Units of usage can be expressed in quantity of goods produced, hours used, number

of cuttings, miles driven or tons hauled, for instance. The depreciation expense of a

period is determined by multiplying usage by a fixed unit-of-production rate of usage.

This depreciation method is commonly used when asset usage varies from year-to-

year.

In other words, in the units of production (UOP) method, a fixed amount of

depreciation goes with unit of output produced by the asset. Depreciable cost is

divided by useful life, in units of production. This per-unit expense is then multiplied

by the number of units produced each period to compute depreciation for that period.

The UOP depreciation equation is :

UOP Depreciation per unit of output=(Cost-Residual Value)/Useful Life In

Units Of Production

Why use this method?

The units of production (UOP) method allocates depreciation expenses

according to actual physical usage. Assets with an indefinite useful life but a limited

productive capacity are good candidates for this method. The UOP method is

particularly appropriate when the usage of a fixed asset varies greatly from year to

year.

For example, the blade of an industrial circular saw might be good for 10,000

hours of use, but it could take seven years, ten, or even fifteen to use up those

10,000 hours. In this case, the useful life is not clear, but the total productive capacity

is. Or, the saw might be used for 5,000 hours in the first two years, and only

sporadically for the next three. The UOP method helps solve these problems by

allocating the cost of the saw blade to the accounting periods in which it is actually

used. 

Units of production relies on an estimate of the productive capacity of the fixed

asset. GAAP requires a "systematic and rational" estimate of the number of units - be

they hours, products, miles, or another measure - that the property will produce. 

To find the depreciation expense for a year, a quarter, or a month, multiply the

number of units produced during that period by the UOP rate.  

This is how it works:

Let’s go back to our previous exapmle.Our truck has an useful life of 100,000

miles.And assume that this truck is likely to be driven 20,000 miles the first year

30,000 the second,25,000 the third,15,000 the fourth, and 10,000 during the fifth.The

amount of UOP depreciation each period varies with the number of units the asset

produces.This procedure is shown at the diagram below.

UOP Depreciation Per Unit Of Output:

(Cost-Residual Value)/Useful Life In Units Of Production= ($41,000-$1,000)/100,000 miles

=$0,40 per mile

Depreciation For The YearDate Asset

CostDepreciation

Per UnitNumber Of Units

Depreciation Expense

Accumulated Depreciation

Book Value

01.01.2001

$41,000 $41,000

12.31.2001

$0,40 X 20,000 = $8,000 $8,000 $33,000

12.31.2002

$0,40 X 30,000 = $12,000 $20,000 $21,000

12.31.2003

$0,40 X 25,000 = $10,000 $30,000 $11,000

12.31.2004

$0,40 X 15,000 = $6,000 $36,000 $5,000

12.31.2005

$0,40 X 10,000 = $4,000 $40,000 $1,000

Units of time depreciation

Units of Time Depreciation is similar to units of production, and is used for

depreciation equipment used in mine or natural resource exploration, or cases where

the amount the asset is used is not linear year to year.

COMPARING DEPRECIATION METHODS

Just to reinforce what we’ve learnt thus far, here’s a look at what the depreciation charges for the same , $41,000 truck, would look like, depending upon the methods used.

Year

s Depreciation MethodsStraight-Line Declining-Balance Double-Declining

BalanceUnits-Of-Production

Dep.Exp. Acc.Dep. Dep.Exp. Acc.Dep. Dep.Exp. Acc.Dep. Dep.Exp. Acc.Dep.1st $8,000 $8,000 $8,200 $8,200 $16,400 $16,400 $8,000 $8,0002nd $8,000 $16,000 $6,560 $14,760 $9,840 $26,240 $12,000 $20,0003rd $8,000 $24,000 $5,248 $20,008 $5,904 $32,144 $10,000 $30,0004th $8,000 $32,000 $4,198.4 $24,206.4 $3,542 $35,686 $6,000 $36,0005th $8,000 $40,000 $15,793.6 $40,000 $4,314 $40,000 $4,000 $40,000

1 2 3 4 50

5000

10000

15000

20000

25000

30000

35000

40000

45000

Straight Line Method

Depr

ecia

tion

Amou

nt

1 2 3 4 50

5000

10000

15000

20000

25000

30000

35000

40000

45000

Declining Balance

Depr

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Amou

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1 2 3 4 50

5000

10000

15000

20000

25000

30000

35000

40000

45000

Double-Declining Balance

Depr

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1 2 3 4 50

5000

10000

15000

20000

25000

30000

35000

40000

45000

Units-Of-Production

Depr

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Obviously, depending upon which method is used by management, the

bottom-line of a company can be seriously affected. The level of attention an investor

must give depreciation depends upon the asset intensity of the business he or she is

studying. The more asset-intensive an enterprise, the more attention depreciation

should be given.

If you have two asset intensive businesses, and they are using different

depreciation methods, and / or useful lives, you must adjust them so they are on a

comparable basis in order to get an accurate picture of how they stack up against

each other in terms of profit.

Some managements will report depreciation expense broken out as a

separate line on the income statement, while others will be more clandestine about it,

including it indirectly through SG&A expenses [for the deprecation costs of desks, for

instance]. Either way, you should be able to garner the information either through the

income statement itself or going through the annual report or 10k.

In Security Analysis [the classic 1934 edition], Benjamin Graham

recommended the investor answer three questions when dealing with the effects of

deprecation on a business [paraphrased]:

1. Is depreciation reflected in the earnings statement?2. Is management using conservative and [as much as possible] accurate depreciation rates? Accounting rules allow assets to be written off

over a considerable time period. Buildings, for example, can be depreciated

anywhere from ten to thirty years, resulting in large differences in charges

depending upon the time frame a particular business uses. A company’s 10k

filing should contain information on the rates employed by the company.

3. Are the cost or base to which the depreciation rates applied reasonable accurate? A company may set unrealistic salvage values on its

assets, thus reducing the amount of depreciation charges it must take every

year.

In conclusion, different depreciation methods produce different results,

and in some circumstances the use of a particular depreciation method is

recommended. When the use of an asset fluctuates from period to period, the units-

of-production method is recommended. For assets that decline in usefulness early,

and are subject to high maintenance costs as they age, a form of accelerated

depreciation should be used, i.e. declining-balance and the sum-of-the-years-

digits methods. And also for some tax purposes, the straight-line, declining-balance,

sum-of-the-years-digits, and units-of-production methods of depreciation were

allowed prior to 1981. Between 1980 and 1987, either the straight-line method or the

Accelerated Cost Recovery System (ACRS) could be used. The Tax Reform Act of

1986 revised the ACRS by providing a depreciation rate schedule for eight classes of

plant assets. The use of an accelerated depreciation method reduces tax liabilities

and increases cash flows.

DEPRECIATION AND INCOME TAXES

MODIFIED ACCELERATED COST RECOVERY SYSTEM

As mentioned earlier, depreciation is the systematic allocation of the

cost of a capital asset over a period of time for financial reporting purposes, tax

purposes or both. It’s a non-cash expense and thus does not affect cash from

operations. But depreciation is a tax deductable expense. The higher the

depreciation the lower income and the lower tax payment.

There are a number of alternative procedures that may be used to depreciate

capital assets. These include straight-line method and various accelerated

depreciation methods. Most profitable firms prefer to use an accelerated depreciation

method for tax purposes-one that allows for a more rapid write off and therefore, a

lower tax bill.

Except modified accelerated cost recovery system (MACRS) other

depreciation methods are mentioned above. We’ll tell accelerated cost recovery

system (ACRS) shortly; and we’ll begin to speak about MACRS.

ACRS

Prior to the Accelerated Cost Recovery System (ACRS), most capital

purchases were depreciated using a straight line technique, that allowed for the

depreciation of the asset over its useful life. ACRS was unique in three ways:

property class lives were established, calculations were based on an estimated

salvage value of zero, and shorter recovery periods were used to calculate annual

depreciation. This resulted in an accelerated write off of capital costs (in comparison

to that available using straight line depreciation) and was the source of the name.

Depreciation under ACRS = 2 x Straight Line Depreciation

MACRS

in the United States in 1986 with the passing of the Tax Reform Act (TRA-86),

as the depreciation method condoned by the IRS and is in force today.

MACRS that is replaced ACRS is a specified depreciation method that is used

only for income tax purposes. The cost of an asset, including any other capitalized

expenditure such as shipping and installation. Under MACRS the asset’s depreciable

basis is not reduced by the estimated salvage value of the asset.

Under MACRS, assets are segmented into classes by asset life.

MACRS GDS Property Classes Table

Property Class Personal Property (all property except real-estate)

3-year property

Special handling devices for food and beverage manufacture.

Special tools for the manufacture of finished plastic products, fabricated metal

products, and motor vehicles

Property with ADR class life of 4 years or less

5-year property Information Systems; Computers / Peripherals

Aircraft (of non-air-transport companies)

Computers

Petroleum drilling equipment

Property with ADR class life of more than 4 years and less than 10 years

7-year property

All other property not assigned to another class

Office furniture, fixtures, and equipment

Property with ADR class life of more than 10 years and less than 16 years

10-year property

Assets used in petroleum refining and certain food products

Vessels and water transportation equipment

Property with ADR class life of 16 years or more and less than 20 years

15-year property

Telephone distribution plants

Municipal sewage treatment plants

Property with ADR class life of 20 years or more and less than 25 years

20-year property Municipal sewers

Property with ADR class life of 25 years or more

Property Class Real Property (real estate)

27.5-year property Residential rental property (does not include hotels and motels)

39-year property Non-residential real property

Class Identified

by Asset Life (Years)

Depreciation Method

3 DDB

5 DDB

10 DDB

20 150% DB

27,5 SL

39 SL

Depreciation for the first classesis computed by the double declining balance

method (DDB). Depreciation for 20 year assets is computed by the %150 declining

balance method. Under 150% declining balance method the annual depreciation rate

is computed by multiplying the straight line rate by 1,50.For a 20-year asset, the

straight line rate is 0,05 x(1/20=0,5), so annual MACRS depreciation rate is 0,075

(0,05 x 1,50)..

WHAT IS ECONOMIC VALUE ADDED (EVA)?

EVA is a value-based financial performance measure reflecting the absolute

amount of shareholder value created or destroyed during each year. It is an estimate

of true economic profit after making corrective adjustments to GAAP accounting,

including deducting the opportunity cost of equity capital.

EVA is a useful tool in order to obtain effective protection against shareholder

value destruction, suitable to control operations of a firm by choosing the most

promising financial investments

EVA can be measured as Net Operating Profit After Taxes(or NOPAT)less the

cost of capital, equity as well as debt. The concept of Economic Profit is closely

linked to EVA. However, Economic Profit is not adjusted.

The underlying concept was first introduced by Eugen Schmalenbach, and the

current theory was formulated by Bennett Stewart and Joel M. Stern.

Stern Stewart & Company

Stern Stewart & Company owns a registered trademark for EVA™ for a brand

of software and financial consulting/training services. The proprietary component of

what Stern Stewart & Co. does is the adjustments. The amortization of goodwill or

capitalization of brand advertising and other similar adjustments are the translations

that occur to Economic Profit to make it EVA.

EVA Basic PremiseManagers are obliged to create value for their investors while investors invest

money in a company because they expect returns. There is a minimum level of

profitability expected from investors, called capital charge. Capital charge is the

average equity return on equity markets; investors can achieve this return easily with

diversified, long-term equity market investment. Thus, creating less return (in the long

run) than the capital charge is economically not acceptable (especially from

shareholders perspective). Investors can also take their money away from the firm

since they have other investment alternatives

Profits the way shareholders count them

The capital charge is the most distinctive and important aspect of EVA. Under

conventional accounting, most companies appear profitable but many in fact are not.

Until a business returns a profit that is greater than its cost of capital, it operates at a

loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still

returns less to the economy than it devours in resources…Until then it does not

create wealth; it destroys it. EVA corrects this error by explicitly recognizing that

when managers employ capital they must pay for it, just as if it were a wage.

By taking all capital costs into account, including the cost of equity, EVA

shows the dollar amount of wealth a business has created or destroyed in each

reporting period. In other words, EVA is profit the way shareholders define it. If the

shareholders expect, say, a 10% return on their investment, they "make money" only

to the extent that their share of after-tax operating profits exceeds 10% of equity

capital. Everything before that is just building up to the minimum acceptable

compensation for investing in a risky enterprise.

Aligning decisions with shareholder wealth

EVA helps managers incorporate two basic principles of finance into their

decision making. The first is that the primary financial objective of any company

should be to maximize the wealth of its shareholders. The second is that the value of

a company depends on the extent to which investors expect future profits to exceed

or fall short of the cost of capital. By definition, a sustained increase in EVA will bring

an increase in the market value of a company. This approach has proved effective in

virtually all types of organizations, from emerging growth companies to turnarounds.

This is because the level of EVA isn't what really matters. Current performance

already is reflected in share prices. It is the continuous improvement in EVA that

brings continuous increases in shareholder wealth.

A financial measure line managers understand

EVA has the advantage of being conceptually simple and easy to explain to

non-financial managers, since it starts with familiar operating profits and simply

deducts a charge for the capital invested in the company as a whole, in a business

unit, or even in a single plant, office or assembly line. By assessing a charge for

using capital, EVA makes managers care about managing assets as well as income,

and helps them properly assess the tradeoffs between the two. This broader, more

complete view of the economics of a business can make dramatic differences.

Ending the confusion of multiple goals

Most companies use a numbing array of measures to express financial goals

and objectives. Strategic plans often are based on growth in revenues or market

share. Companies may evaluate individual products or lines of business on the basis

of gross margins or cash flow. Business units may be evaluated in terms of return on

assets or against a budgeted profit level. Finance departments usually analyze

capital investments in terms of net present value, but weigh prospective acquisitions

against the likely contribution to earnings growth. And bonuses for line managers and

business-unit heads typically are negotiated annually and are based on a profit plan.

The result of the inconsistent standards, goals, and terminology usually is incohesive

planning, operating strategy, and decision making.

EVA Simplified Calculation

EVA = OPBT - TAX - (TCE x COC) = NOPAT - (TCE x COC)

OPBT: Operating Profit Before Tax

TAX: Federal , state, county tax

NPAT = Net Operating Profit Before Tax

TCE: Total Capital Employed

COC: Cost of Capital

EVA Simplified Calculation Example

EVA = OPBT - TAX - (TCE x COC)

= 2,250 - 1,050 - (8,000 x 0.11)

= 320

Positive EVA indicates that this company creates value

A Simple Illustration

Assume that you have a firm with;

IA = 100 In each year 1-5, assume that

ROCA = 15% D I = 10 (Investments are at beginning of each year)

WACCA = 10% ROCNew Projects = 15%

WACC = 10%

Assume that all of these projects will have infinite lives.

After year 5, assume that

Investments will grow at 5% a year forever

ROC on projects will be equal to the cost of capital (10%)

Firm Value using EVA Approach

Capital Invested in Assets in Place = $ 100

EVA from Assets in Place = (0.15 - 0.10) (100)/0.10 = $ 50

+ PV of EVA from New Investments in Year 1 = (0.15 - 0.10)(10)/0.10 = $ 5

+ PV of EVA from New Investments in Year 2 = [(0.15 - 0.10)(10)/0.10]/(1.1)2 = $

4.55

+ PV of EVA from New Investments in Year 3 = [(0.15 - 0.10)(10)/0.10]/(1.1)3 = $ 4.13

+ PV of EVA from New Investments in Year 4 = [(0.15 - 0.10)(10)/0.10]/(1.1)4 = $

3.76

+ PV of EVA from New Investments in Year 5 = [(0.15 - 0.10)(10)/0.10]/(1.1)5 = $

3.42

Value of Firm = $ 170.86

EVA Implementation

Stern Stewart & Co., the trademark owner of EVA, supports approximately 250 large

companies around the world. EVA implementation results are highly correlated with

stock prices. This measure can be maximized. Shareholders of the company will

receive a positive value added when the return from the capital employed in the

business operations is greater than the cost of that capital As a result EVA is an

estimator for company’s true economic value creation, unlike the traditional

measures has focus on shareholder value creation. Also it is a good basis for

management compensation systems to motivate managers to create shareholder

value.

EVA in Comparison with Other Economic Measurements

Economic Value Added is a tool more useful than rate of return (ROI) in

controlling and steering day-to-day operations. EVA has not steering failures like ROI

and EPS (maximizing these measures might lead to not optimal outcome; not max.

shareholder value). At all, it is a concept practically the same as Economic Profit

(EP), Residual Income (RI) and Economic Value Management (EVM)

Why is EVA also useful for small companies? (even with less than 100 employees)

Traditional performance measures used by small companies, such as sales or

profits alone, are unable to describe the company’s true business results and

sometimes lead to wrong business decisions. Whereas EVA calculation is simple and

the EVA concept is easy to understand and easy to use, since only main data

contained in income statement and balance sheet is needed. Because EVA reflects

company’s performance in dollars, positive EVA indicates value creation while

negative EVA indicates value destruction. Series of negative EVA is a signal that

restructuring in a company may be needed

EVA helps to understand the concept of profitability even by persons not

familiar with finance and accounting. In a small company, managers can make the

EVA concept transparent to all employees in a short time and this helps to convert a

small company’s strategy into objectives tangible for all employees.

Moreover, because managers having deeper knowledge about capital and

capital cost are able to make better decisions, the EVA concept integrated in a small

company’s decisions making process improves its business performance. As a result,

EVA is a useful tool for allocation of a small company’s scarce capital resources

WHAT’S NEEDED TO CALCULATE COMPANY’S ECONOMIC VALUE ADDED?(EVA)

Only following the information is needed for a calculation of a company’s EVA:

Company’s Income Statement Company’s Balance Sheet

EVA Implementation by a Small Company

When we consider EVA as not easy to use and too complicated for small

business environments, even if little information is enough to calculate it, some

deficiencies of this implementation can be observed. For example, to transform

traditional income statements into EVA ones, up to 164 adjustments need to be

made

For small businesses EVA recommends inexpensive debts in order to reduce

Cost of Capital (COC) ; which is a very questionable strategy. While it is a passive

accounting tool because it measures past performance and because the business

environment for small companies changes extremely quickly, a frequently financial

evaluation is essential.

The following are the important concepts when implementing EVA in a small

company in order to avoid from its deficiencies:

Management should remember that EVA calculation is just a starting point

Permanent EVA improvement has to be the main objective

EVA has to be calculated periodically (at least every three months)

Changes in EVA have to be analyzed

EVA development is the basis for a company’s financial and business policy

The following are the recommendations for the small companies in order to

improve EVA:

Try to improve returns with no or with only minimal capital investments

Invest new capital only in projects, equipment, machines able to cover capital

cost while avoiding investments with low returns

Identify where capital employment can be reduced

Identify where the returns are below the capital cost; divest those investments

when improvements in returns are not feasible

CONCLUSION

EVA is an appropriate management tool for small business because is easy-

to-calculate. Periodical EVA calculation and analysis can be done with minimal effort

because only few basic data have to be entered in a common spreadsheet. Its

implementation in a small company will result in a better business performance,

because of better understanding the objectives (especially near the floor/operating

activities)

EVA calculation is just a starting point for improvement in financial and

business policy. Scarce capital resources of a small company can be more efficiently

allocated using EVA than using intuition or traditional methods. Since EVA helps the

organization to realize that capital is a costly resource the most immediate effect of

EVA implementation is in most cases dramatic improvement in capital efficiency

(improved capital turnover)

Compared to conventional measures, EVA is an epochal measure since it can

be maximized: it is the better the bigger EVA is. With traditional measures that is not

the case, since ROI can be increased with ignoring below average projects and

EPS/Operating Profit/Net profit can be increased simply investing more money in the

company.

In conclusion, EVA helps enormously the management and employees to see

what should be real objective of the company, since it makes clear to all what

profitability really is.

TERMINOLOGY

Basis: The full cost of placing a fixed asset in service, used to calculate

depreciation expense.

Book value: Basis less accumulated depreciation

Cost: It will include all expenditures incurred by the business to bring the

asset to its required location and to make it ready for use.

Depreciable assets: The assets whose usefulness to the company and

revenue-producing ability will decline over their useful life like land improvements,

buildings, and equipment.

Depreciation: The allocation of the cost of a plant asset to expense over its

useful (service) life in a rational and systematic manner

Deterioration: 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.

Economic obsolescence: “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”.

Earnings Per Share (EPS): The net income of a company divided by the total

number of shares it has outstanding.

Economic Value Management (EVM): A management approach towards

managing the shareholder ‘value’ in an organization.

Economic Value Added (EVA): A value-based financial performance

measure reflecting the absolute amount of shareholder value created or destroyed

during each year.

Estimated residual value - also called scrap value or salvage value: The

expected cash value of an asset at the end of its useful life.

Estimated useful life: The length of the service period expected from the

asset. Useful life may be expressed in years, units of output, miles, or another

measure.

Fixed Asset: Property used in a productive capacity which will benefit the

enterprise for longer than one year

Fully depreciated asset: An asset that has reached the end of its estimated

useful life. No more depreciation is recorded for the asset.

Functional obsolescence: The “loss in value of a property resulting from

changes in tastes, preferences, technical innovations, or market standards”.

Market value: What the property could be sold for today.

Obsolescence: The changes in usefulness of structures in certain

neighborhoods which cause them to become less desirable or less useful.

Physical deterioration: Cause of depreciation is the result of wear and tear

with usage and deterioration with age among others.

Plant assets: 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.

Rate Of Return (ROI): The amount of profit (return) based on the amount of

resources (funds) used to produce it. Also the ability of a given investment to earn a

return for its use.

Residual Income (RI): The amount of profit that a segment has made after

charging a notional amount of interest based on the business’s investment in that

segment.

BIBLIOGRAPHY

Horngren, Charles T.; Harrison Jr., Walter T.; Bamber, Linda Smith; “Accounting”, Prentice Hall, 5th Edition, 2002, page 386-402

Atrill, Peter; Mclaney, Eddie; “Accounting and Finance for Non-Specialists”, Prentice Hall, 2nd Edition, 1997, page 61

Weygandt, Jerry S.; Kieso, Donald E.; Kimmel, Paul D.; “Accounting Principles”, John Wiley & Sons, Inc., 6th Edition, 2002, page 400-405

Hermanson, Roger H.; Edwards, James Don; Salmonson R.F.; “Accounting Principles” Business Publications, Inc., Revised Edition, 1983, page 365-372

Canada, R.S.; Sullivan, W.A.; White, J.A.; Kulonda, D.; “Capital Investment Analysis for Engineering and Management”, Pearson Prentice Hall, …

Levy, Haim; Sarnat, Marshall; “Capital Investment and Financial Decisions”, Prentice Hall International, 3rd Edition, 1986, page 123-140

Horne, James C. Van; Wachowicz John M.; “Fundamentals of Financial Management”, Prentice Hall International, 10th Edition, page 15-21, 309-310

Collins, Stephen J.; Forrester, Robert T.; “Recognition of Depreciation by Not-For-Profit Institutions”, NACUBO, 1988, page 39-58

Peterson, Raymond H.; “Accounting for Fixed Assets”, John Wiley & Sons, Inc., 1994, page 99-103

Monks, Robert A.G.; Minow, Nell; “Corporate Governance” Blackwell Business, 2nd Edition, 2001, page 53-54

Grant, James L., “Foundations of Economic Value Added”, Published by Frank J. Fabozzi Associates,1997

Salmi, Timo; Ilkka, Virtanen; “Economic Value Added: A simulation analysis of the trendy, owner-oriented management tool.” Acta Wasaensia No. 90, 2001, page 33

Internet Resources:

Economic Value Added, its Computation and in Comparison with NPV,DCF Valuation

EVA Introduction to EVA, Overview, Calculating NOPAT and Invested Capital and Conclusion

http://www.fig.net/pub/accra/papers/ts24/ts24_02_gyamfiyeboah_ayitey.pdf

http://www.accesskansas.org/kcaa/reports/mercury.pdf

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html

http://www.investopedia.com/university/EVA/default.asp

http://www.pitt.edu/~roztocki/evasmall/index.htm

http://www.pitt.edu/~roztocki/abceva/index.htm

http://www.sternstewart.com/evaabout/whatis.php

http://en.wikipedia.org/wiki/Economic_Value_Added

http://www.valuatum.com/valuation/valuation_tutorial_tiedostot/frame.htm#slide0132.htm

http://www.ensc.sfu.ca/undergrad/courses/ENSC301/Unit11/lecture11.html

http://beginnersinvest.about.com/cs/investinglessons/l/blcompdeprec.html

http://www.imaginecorp.com/depreciation.htm

http://en.wikipedia.org/wiki/Depreciation

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/eva.html

http://www.investopedia.com/university/EVA/default.asp