Chapter Six

Depreciations and Corporate Taxes

 Depreciation can be defined as a gradual decrease in
the utility of fixed assets with use and time.
 Economic depreciation refers The gradual decrease in

utility in an asset with use and time. While Accounting

depreciation The systematic allocation of an asset’s
value in portions over its depreciable life — often used
in engineering economic analysis
Economic Depreciation
 We can classify depreciation into the categories of
physical or functional depreciation. Physical
depreciation can be defined as a reduction in an asset’s
capacity to perform its intended service due to physical
impairment. Physical depreciation leads to a decline in
performance and high maintenance costs.
 Functional depreciation occurs as a result of changes in
the organization or in technology that decrease or
eliminate the need for an asset. Examples of functional
depreciation include obsolescence attributable to
advances in technology, a declining need for the
services performed by an asset, and the inability to
meet increased quantity or quality demands.
 Economic depreciation = Purchase price - market value.
 Physical and functional depreciation are categories of
economic depreciation. The measurement of economic
depreciation does not require that an asset be sold: The market
value of the asset can be closely estimated without actually
testing it in the marketplace.
Accounting Depreciation
 Accounting depreciation: Amount allocated during the
period to amortize the cost of acquiring long term
assets over the useful life of the assets. In engineering
economic analysis, we use the concept of accounting
depreciation exclusively.
Factors Inherent in Asset Depreciation
 The process of depreciating an asset requires that we
make several preliminary determinations:(1) What is
the cost of the asset? (2) What is the asset’s value at the
end of its useful life? (3) What is the depreciable life of
the asset? and, finally, (4) What method of depreciation
do we choose?
Characteristics Depreciable Asset
 1. It must be used in business or must be held for the
production of income.
 2. It must have a definite service life, and that life must

be longer than 1 year.

 3. It must be something that wears out, decays, gets

used up, becomes obsolete, or loses value from natural

causes.
 Depreciable property includes buildings, machinery,
equipment, and vehicles. Inventories are not
depreciable property, because they are held primarily
for sale to customers in the ordinary course of business.
If an asset has no definite service life, the asset cannot
be depreciated. For example, you can never depreciate
land.
Apply depreciation methods to the Fixed assets.

Depreciation
Process of allocating to expense the cost of a plant asset
over its useful (service) life in a rational and systematic
manner.
 Process of cost allocation, not asset valuation.
 Applies to land improvements, buildings, and equipment,
not land.
 Depreciable because the revenue-producing ability of
asset will decline over the asset’s useful life.

LO 2
 Factors in Computing Depreciation

Illustration 10-6
Three factors in computing
Helpful
Helpful Hint
Hint
depreciation
Depreciation
Depreciation expense
expense isis reported
reported on
on
the income statement. Accumulated
the income statement. Accumulated
depreciation
depreciation isis reported
reported on
on the
the balance
balance
Alternative
Alternative Terminology
Terminology sheet
sheet as
as aa deduction
deduction from
from plant
plant assets.
assets.
Another
Another term
term sometimes
sometimes used
used for
for
salvage
salvage value
value is
is residual
residual value.
value.

LO 2
Depreciation Methods

Management selects the method it believes best measures

an asset’s contribution to revenue over its useful life.

Examples include:
1. Straight-line method
2. Units-of-activity method
3. Declining-balance method
4. Number of digits method

Illustration 10-8
Use of depreciation methods
in major U.S. companies

LO 2
 Straight-line depreciation: An equal dollar amount of
depreciation in each accounting period.
 Double declining balance method: A depreciation

method, in which double the straight-line depreciation

amount is taken the first year, and then that same
percentage is applied to the un depreciated amount in
subsequent years.
Depreciation Methods

Illustration: Barb’s Florists purchased a small delivery truck on

January 1, 2017.
Illustration 10-7
Delivery truck data
Cost $13,000
Expected salvage value $1,000
Estimated useful life in years 5
Estimated useful life in miles 100,000

Required: Compute depreciation using the following.

(a) Straight-Line (b) Units-of-Activity (c) Declining Balance

LO 2
Depreciation Methods

STRAIGHT-LINE METHOD
 Expense is same amount for each year.
 Depreciable cost = Cost less salvage value.

Illustration 10-9
Formula for straight-line
method

LO 2
 Depreciation Methods

Illustration: (Straight-Line)
Illustration 10-10
Annual
Depreciable Depreciation Accumulated Book
Year Cost x Rate = Expense Depreciation Value

2017 $ 12,000 20% $ 2,400 $ 2,400 $ 10,600 *

2018 12,000 20 2,400 4,800 8,200
2019 12,000 20 2,400 7,200 5,800
2020 12,000 20 2,400 9,600 3,400
2021 12,000 20 2,400 12,000 1,000

2017 Depreciation expense 2,400

Journal Accumulated depreciation 2,400
Entry

* Book value = Cost - Accumulated depreciation = ($13,000 - $2,400). LO 2

 Depreciation Methods Partial
Year
Illustration: (Straight-Line)
Assume the delivery truck was purchased on April 1, 2017.
Annual Current
Depreciable Depreciation Partial Year Accumulated
Year Cost Rate Expense Year Expense Depreciation
2017 $ 12,000 x 20% = $ 2,400 x 9/12 = $ 1,800 $ 1,800
2018 12,000 x 20% = 2,400 2,400 4,200
2019 12,000 x 20% = 2,400 2,400 6,600
2020 12,000 x 20% = 2,400 2,400 9,000
2021 12,000 x 20% = 2,400 2,400 11,400
2022 12,000 x 20% = 2,400 x 3/12 = 600 12,000
$ 12,000
Journal entry:
2017 Depreciation expense 1,800
Accumulated depreciation 1,800
LO 2
Depreciation Methods

UNITS-OF-ACTIVITY METHOD
 Companies estimate total units of activity to calculate
depreciation cost per unit.
 Expense varies based on units of activity.
 Depreciable cost is cost less salvage value.

Alternative
Alternative Terminology
Terminology
Another
Another term
term often
often used
used
is
is the
the units-of-production
units-of-production
method.
method.

LO 2
 Depreciation Methods

UNITS-OF-ACTIVITY METHOD

Illustration 10-11
Formula for units-of-activity method

LO 2
 Depreciation Methods

Illustration: (Units-of-Activity)
Illustration 10-12
Cost Annual
Miles per Depreciation Accumulated Book
Year Driven x Unit = Expense Depreciation Value

2017 15,000 $ 0.12 $ 1,800 $ 1,800 $ 11,200

2018 30,000 0.12 3,600 5,400 7,600
2019 20,000 0.12 2,400 7,800 5,200
2020 25,000 0.12 3,000 10,800 2,200
2021 10,000 0.12 1,200 12,000 1,000

2017 Depreciation expense 1,800

Journal Accumulated depreciation 1,800
Entry
LO 2
Depreciation Methods

DECLINING-BALANCE METHOD
 Accelerated method.
 Decreasing annual depreciation expense over the asset’s
useful life.
 Twice the straight-line rate with Double-Declining-Balance.
 Rate applied to book value.
Illustration 10-13

LO 2
 Depreciation Methods
Illustration: (Declining-Balance)
Illustration 10-14
Declining Annual
Beginning Balance Depreciation Accumulated Book
Year Book value x Rate = Expense Depreciation Value

2017 $13,000 40% $ 5,200 $ 5,200 $ 7,800

2018 7,800 40 3,120 8,320 4,680
2019 4,680 40 1,872 10,192 2,808
2020 2,808 40 1,123 11,315 1,685
2021 1,685 40 685* 12,000 1,000

2017 Depreciation expense 5,200

Journal Accumulated depreciation 5,200
Entry

* Computation of $674 ($1,685 x 40%) is adjusted to $685. LO 2

 Depreciation Methods Partial
Year
Illustration: (Declining-Balance)
Declining Annual Current
Beginning Balance Depreciation Partial Year Accumulated
Year Book Value Rate Expense Year Expense Depreciation
2017 $ 13,000 x 40% = $ 5,200 x 9/12 = $ 3,900 $ 3,900
2018 9,100 x 40% = 3,640 3,640 7,540
2019 5,460 x 40% = 2,184 2,184 9,724
2020 3,276 x 40% = 1,310 1,310 11,034
2021 1,966 x 40% = 786 786 11,820
2022 1,180 x 40% = 472 Plug 180 12,000
$ 12,000
Journal entry:

2017 Depreciation expense 3,900

Accumulated depreciation 3,900

LO 2
Depreciation Methods
Illustration 10-15

COMPARISON
OF METHODS

Illustration 10-16

Helpful Hint
Under any method,
depreciation stops
when the asset’s book
value equals expected
salvage value.

LO 2
 Number of digits method
 Depreciable cost cost –salvage value
=
 Depreciable cost= 13,000-1000= 12,000
 5
+4+3+2+1=15

5/15x12,000= 4000

4/15x12,000=3200

3/15x12,000=2400

2/15x12,000=1600

1/15x12,000=800
 Describe how to account for natural resources and
intangible assets.

Natural resources consist of standing timber and

underground deposits of oil, gas, and minerals.

Distinguishing characteristics:
 Physically extracted in operations.
 Replaceable only by an act of nature.

Cost is the price needed to acquire the resource and prepare it

for its intended use.

LO 4
 Depletion

The allocation of the cost to expense in a rational and

systematic manner over the resource’s useful life.
 Companies generally use units-of-activity method.
 Depletion generally is a function of the units extracted.

Illustration 10-21
Formula to compute depletion expense

LO 4
 Depletion

Illustration: Lane Coal Company invests $5 million in a mine

estimated to have 1 million tons of coal and no salvage value.

Illustration 10-21
Formula to compute depletion expense

LO 4
amortization

Illustration: National Labs purchases a patent at a cost of

$60,000. National estimates the useful life of the patent to be
eight years. Prepare the journal entry to record the annual
amortization expense.

Cost $60,000
Useful life ÷ 8
Annual expense $ 7,500

LO 4
 Corporate Taxes
 Tax is defined as a monetary charge imposed by the
government on persons, entities, transactions or
property to yield public revenue. Or Taxes are the
enforced proportional contributions from persons and
property levied by the State by virtue of its sovereignty
for the support of government and for all public needs
(Thomas. M. Cooley: The Law of Taxation).
 Principles of Taxation
 Principles of taxation are concepts that provide
guidelines towards a good tax system. Since many
view taxation as a necessary evil, it should be
administered in such a way as to create minimum pain
to the payer, just like the honey bee which collects
nectar from the flower without hurting the flower. The
following are the common canons of taxation:
 Principle of Equity/Fairness Tax should be levied fairly
so that: (i) The same amount is paid by persons or
entities that are equal in earnings or wealth (horizontal
equity). (ii) The contribution in tax should increase as
the taxable income increases (vertical equity).
 Convenience Under normal circumstances, a taxpayer
should not undergo undue difficulty to pay tax.
Therefore, the place, medium, mode, manner and time
of payment should not be an extra burden to the
taxpayer
 Certainty A good tax system is one where the taxes are
well understood by the payers and collectors. The time
and reason of payment as well as the amount to be paid
by an individual should be well documented and
certain or known. The tax should be based on laws
passed by parliament.
 Economical The administrative cost of collecting taxes
should be kept as low as possible to both the collecting
agent and the taxpayer. The general principle is that the
cost of collection and administration of taxes to the
collecting agent should not exceed 5% of the tax
revenue. Likewise, the cost of compliance to the
taxpayer should be as low as possible and must not be
seen to hinder voluntary compliance.
 Simplicity : The type of tax and the method of
assessment and collection must be simple enough to be
understood by both the taxpayers and the collectors.
Complicated taxes lead to disputes, delays, corruption,
avoidance and high costs of collection in terms of time
and resources.
 Ability to Pay The tax should not take away so much of
the income being taxed as to discourage the
performance or participation in the tax base.
Types of Taxes
 In complying with the canons of taxation, taxes may be
characterized as proportional, progressive or
regressive.
 Progressive Tax: This tax is structured in such a way

that the tax rate increases as the income increases. Most

income taxes are progressive so that higher incomes are
taxed at a higher rate. A progressive tax is based on the
principle of vertical equity.
 Regressive Tax: This is a tax not based on the ability to
pay. A regressive tax is structured that the effective tax
decreases as the income increases.
 Proportional Tax: This is a tax whose rate remains

fixed regardless of the amount of the tax base. A

proportional tax may be considered regressive despite
its constant rate when it is more burdensome for low
income payers than to high income payers.
Classification of Taxes
 Taxes are classified as either direct or indirect.
 Direct Taxes are imposed on income arising from

business, employment, property and the burden of the

tax is borne by the individual or business entity.
Examples of direct taxes include Corporation tax,
Individual Income Tax, e.g. Pay As You Earn, capital
gains tax and rental tax.
 Indirect Taxes are taxes levied on consumption of
goods and services collected by an Agent (Taxpayer).
Notable indirect taxes include Value Added Taxes
(VAT), excise duty, import duty.
Income Tax Terms
 A Person includes an individual, a partnership, a trust, a
company, a retirement fund, a government, a political
subdivision of government, and a listed institution.
 Chargeable Income is the gross income of a person for

the year less total deductions allowed under the Income

Tax Act
 Gross Income of a person for a year of income is the
total amount of business income, employment income
and property income other than exempt income.
 Example Amount

Sales £550,000

Expenses (£420,000)

Investment Income £5,000

Net Profit ** £135,000

C.T. @ 20% £27,000