11. Depreciation Flashcards
What is depreciation?
Depreciation is the gradual decrease in utility and value of fixed assets with use and time.
Whats the difference between economic depreciation and accounting depreciation?
Economic depreciation is the gradual decrease of the value of an asset over time (what really happens)
- includes physical and functional depreciation
Accounting depreciation is the systematic allocation of an asset’s value in portions over its depreciable life (used in economic analysis)
- includes book depreciation and tax depreciation
What qualifies as a depreciable asset?
- used in business for production of income
- has life longer than one year
- Must wear out, become obselete or lose value
Are inventories and land depreciable?
No! inventories will have no wear and tear and land does not have finite useful life
How to calculate economic depreciation?
= Purchase price - Market value
*if over time, the market value actually becomes larger than the purchase price, this results in a capital gain (count as income and pay more taxes)
What’s the difference between book depreciation and tax depreciation?
These are two types of economic depreciation, where a fraction of the cost of an asset is charged as an expense over each accounting period.
Book depreciation: Used to calculate how much an asset is worth. used in reporting net income to investors/stockholders.
Tax depreciation: reported in income taxes, helps recover some of the cost of buying an asset through claiming tax deductions
What do you need to know about an asset to calculate the book depreciation?
- Cost basis: The total cost over the asset’s life (initial cost, installation, transport)
- Useful life: duration over which asset fulfills intended duty. may be based on the physical longevity/ functionality
- Salvage value: The asset’s value at the end of its life
- Method of depreciation
What are the methods of calculating depreciation?
a) straight line method
b) accelerated methods
- declining balance method
- sum of years digits method
c) Units of production method
What method does the CRA use to calculate depreciation?
Declining balance method (mostly)
Specifies a percentage rate for each declining balance class.
Otherwise, provides guidelines on how to calculate depreciation using straight line method.
What is the book value of an asset?
Book value is the current net value of an asset, shown on their balance sheets
Book value = initial cost of asset - depreciation
What method of depreciation is this? Explain intuitively how to find the depreciation and book values every year.
Straight line method. Depreciation starts in year 1.
The $ amount of depreciation of each year is calculated by taking the initial value of the asset and subtracting the salvage value at end of useful life, then dividing by the number of years (useful life)
The book value for each year is found by subtracting the total amount of depreciation incurred at a certain year from the initial cost.
ex: yr 5: BV = initial cost - (# yrs · $depreciated/yr)
What method is this? Explain intuitively how you find depreciation and book value each year.
Declining balance method.
It calculated depreciation as a fixed fraction.
The fraction (d) is a constant and is obtained by d = (1/N) where N is useful life
(we can see that if N is larger, d is smaller)
Depreciation:
D = d· initial cost · (1-d)^(n-1)
Book value: BV = C·(1-d)^n
- book value can also be found by subtracting the total depreciation from the initial cost
What method is this? How do you solve for depreciation and book value?
Sum of years digits (SOYD) method: larger depreciation during early years.
SOYD is the sum of years: 1+2+3…+N
Depreciation is [(N-n+1)/SOYD]·[C-S]
C-S represents the total depreciated amount, and the multiplier represents the fraction that gets smaller as current year increases.
What method is this? How do you solve for depreciation and book value?
Sum of years digits (SOYD) method: larger depreciation during early years.
SOYD is the sum of years: 1+2+3…+N
Depreciation is [(N-n+1)/SOYD]·[C-S]
C-S represents the total depreciated amount, and the multiplier represents the fraction that gets smaller as current year increases.
Which depreciation method is used for each line?
y-axis is depreciation amount, x-axis is years
Green: SOYD
Blue: straight line
Red: Declining balance
- SOYD has largest discrepancy between first year and last year
How do you calculate depreciation for Units of Production (UP) method?
Depreciation for every year is (service units consumed/total service units) · [C·S]
ex: use case is for airplanes
Whats the difference between recaptured CCA and Capital gains?
Recaptured CAA occurs when asset is sold at a price higher than the book value (or UCC - undepreciated capital cost). The max you can recapture is initial-book value before it becomes capital gains
Capital Gains are any additional gains that surpass the initial cost
Explain what’s happening in each case.
- UCC < Sale Price < Cost base: There is CAA recapture since the asset was sold at a price higher than book value. This recapture is taxed
- UCC = Sale price: no additional taxes applied
- UCC > Sale price: There is a loss, but you can deduct this loss from your income, and save on taxes
- Sale price > Cost base: There is CAA recapture and capital gains. CAA recapture is added to income and 50% of capital gain is added to income to be taxed.
