PLOT OUTLINE - Hacettepe Üniversitesi



Hacettepe University Faculty Of Economics And Aministrative SciencesDepartment Of Business AdministationConsideration Of Depreciation And Income TaxesPapers Created By:?ZPARLAK,Ay?egül 20312383 ?ZG?N,Aysun 20212445EROL,Cem Umut 20311219AYANO?LU,Faik Uras 20211712NAR?N,Mü?erref ?zlem 20211214LECTURER:Dr. ARSLAN,?zgürIn the Division Of Finance-AccountingTable of Contents TOC \o "1-3" \h \z \u PLOT OUTLINE PAGEREF _Toc162254025 \h 2WHAT IS DEPRECIATION? PAGEREF _Toc162254026 \h 3WHICH ASSETS ARE DEPRECIATED? PAGEREF _Toc162254027 \h 3CAUSES OF DEPRECIATION PAGEREF _Toc162254028 \h 51. PHYSICAL DETERIORATION PAGEREF _Toc162254029 \h 52. FUNCTIONAL OBSOLESCENCE PAGEREF _Toc162254030 \h 53.ECONOMIC OBSOLESCENCE PAGEREF _Toc162254031 \h 6MEASURING DEPRECIATION PAGEREF _Toc162254032 \h 6COST PAGEREF _Toc162254033 \h 7ESTIMATED USEFUL LIFE PAGEREF _Toc162254034 \h 10ESTIMATED RESIDUAL VALUE PAGEREF _Toc162254035 \h 13METHODS & USAGE OF DEPRECIATION PAGEREF _Toc162254036 \h 13STRAIGHT-LINE METHOD PAGEREF _Toc162254037 \h 14DECLINING-BALANCE METHOD PAGEREF _Toc162254038 \h 15UNITS OF PRODUCTION METHOD PAGEREF _Toc162254039 \h 19COMPARING DEPRECIATION METHODS PAGEREF _Toc162254040 \h 21DEPRECIATION AND INCOME TAXES PAGEREF _Toc162254041 \h 25MODIFIED ACCELERATED COST RECOVERY SYSTEM PAGEREF _Toc162254042 \h 25ACRS PAGEREF _Toc162254043 \h 25MACRS PAGEREF _Toc162254044 \h 26WHAT IS ECONOMIC VALUE ADDED (EVA)? PAGEREF _Toc162254045 \h 28Stern Stewart & Company PAGEREF _Toc162254046 \h 28EVA Basic Premise PAGEREF _Toc162254047 \h 28EVA Simplified Calculation PAGEREF _Toc162254048 \h 31EVA in Comparison with Other Economic Measurements PAGEREF _Toc162254049 \h 33Why is EVA also useful for small companies? (even with less than 100 employees) PAGEREF _Toc162254050 \h 33WHAT’S NEEDED TO CALCULATE COMPANY’S ECONOMIC VALUE ADDED?(EVA) PAGEREF _Toc162254051 \h 34EVA Implementation by a Small Company PAGEREF _Toc162254052 \h 34CONCLUSION PAGEREF _Toc162254053 \h 35TERMINOLOGY PAGEREF _Toc162254054 \h 36BIBLIOGRAPHY PAGEREF _Toc162254055 \h 38PLOT OUTLINEDepreciationWhat is Depreciation?Which Assets will be Depreciated?Causes of DepreciationPhysical DepreciationFunctional DepreciationTechnological DepreciationDepletionMonetary DepreciationFunctions of DepreciationIn EconomyIn FinanceIn AccountingIn Cost DeterminationMeasuring DepreciationCostEstimated Useful LifeEstimated Residual ValueDepreciation MethodsStraight-Line (SL) MethodDeclining Balance (DB) MethodUnits-of-Production (UOP) MethodComparing Depreciation MethodsDepreciation and Income TaxesModified 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.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.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:Land, such as a bulding site.Land improvements, such as driveways, parking lots, fences, and underground sprinkler systems.Buildings, such as stores, offices, factories, and warehouses.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 DEPRECIATIONBaum (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 DETERIORATIONDeterioration 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 OBSOLESCENCEObsolescence 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;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 OBSOLESCENCEBy 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 DEPRECIATIONIn measuring the amount of depreciation to recognize in a specific period there are three variables:CostEstimated useful lifeEstimated residual valueCOSTThis 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 ImprovementsThe 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.BuildingsAll 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.EquipmentThe 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 325i21,350Delivery charge 80Alloy wheels660Sun roof200Petrol 30Number plates130Road fund licence140 1,24022,590Part exchange-Reliant Robin 1,000Amount outstanding21,590The cost of the new car will be as follows: $ $New BMW 325i21,350Delivery charge 80Alloy wheels660Sun roof200Number plates130 1,07022,420These 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 LIFEEstimated 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 AssetEstimating 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$30,000÷10 years=$,3000Willamette 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 AssetsA 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 VALUEEstimated 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 DEPRECIATIONActually,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...................................................................................................$41000Less:Salvage Value.........................................................................................($1,000)Depreciable Cost.............................................................................................$40,000Estimeted Useful Life: Years...........................................................................................................5 Years Units Of Production.........................................................................100,000 MilesStraight-Line Depreciation: (Cost-Salvage Value)/Useful Life,In Years =($41,000-$1,000)/5= $8,000 per yearDepreciation For The YearDateAssetCostDepreciation RateDepreciable CostDepreciation ExpenseAccumulated DepreciationBook Value01.01.2001$41,000$41,00012.31.20010.20* x$40,000$8,000$8,000$33,00012.31.20020.20 x$40,000$8,000$16,000$25,00012.31.20030.20 x$40,000$8,000$24,000$17,00012.31.20040.20 x$40,000$8,000$32,000$9,00012.31.20050.20 x$40,000$8,000$40,000$1,000*1/5 year=0.20 per yearDECLINING-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 YearDateAsset CostDBRateBook ValueDepreciation ExpenseAccumulated DepreciationBook Value01.01.2001$41,000$41,00012.31.20010.20x$41,000=$8,200$8,200$32,80012.31.20020.20x$32,800=$6,560$14,760$26,24012.31.20030.20x$26,240=$5,248$20,008$20,99212.31.20040.20x$20,992=$4,198.4$24,206.4$16,793.612.31.2005$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)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 YearDateAsset CostDBRateBook ValueDepreciation ExpenseAccumulated DepreciationBook Value01.01.2001$41,000$41,00012.31.20010.40x$41,000=$16,400$16,400$24,60012.31.20020.40x$24,600=$9,840$26,240$14,76012.31.20030.40x$14,700=$5,904$32,140$8,85612.31.20040.40x$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 2Then 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 = $9,840DDB For The 3rd Year: ($41,000-$16,400-$9,840) x 0.40 = $5,904DDB For The 4th Year: ($41,000-$16,400-$9,840-$5,904) x 0.40 = $3,542DDB 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.UNITS OF PRODUCTION METHODThe 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 ProductionWhy 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 mileDepreciation For The YearDateAsset CostDepreciation Per UnitNumber Of UnitsDepreciation ExpenseAccumulated DepreciationBook Value01.01.2001$41,000$41,00012.31.2001$0,40X20,000=$8,000$8,000$33,00012.31.2002$0,40X30,000=$12,000$20,000$21,00012.31.2003$0,40X25,000=$10,000$30,000$11,00012.31.2004$0,40X15,000=$6,000$36,000$5,00012.31.2005$0,40X10,000=$4,000$40,000$1,000Units of time depreciationUnits 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 PARING DEPRECIATION METHODSJust 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.YearsDepreciation MethodsStraight-LineDeclining-BalanceDouble-Declining BalanceUnits-Of-ProductionDep.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$40,000Obviously, 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 SYSTEMAs 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.ACRSPrior 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 DepreciationMACRSin 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 TableProperty Class Personal Property (all property except real-estate)3-year propertySpecial handling devices for food and beverage manufacture.Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehiclesProperty with ADR class life of 4 years or less5-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 years7-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 years10-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 years15-year property Telephone distribution plants Municipal sewage treatment plants Property with ADR class life of 20 years or more and less than 25 years20-year property Municipal sewers Property with ADR class life of 25 years or moreProperty Class Real Property (real estate)27.5-year propertyResidential rental property (does not include hotels and motels)39-year propertyNon-residential real property Class Identified by Asset Life (Years) Depreciation Method3DDB5DDB10DDB20150% DB27,5SL39SLDepreciation 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 & CompanyStern 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 alternativesProfits 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 goalsMost 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 CalculationEVA = 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 CapitalEVA Simplified Calculation ExampleEVA = OPBT - TAX - (TCE x COC) = 2,250 - 1,050 - (8,000 x 0.11) = 320 Positive EVA indicates that this company creates valueA Simple IllustrationAssume that you have a firm with;IA = 100 In each year 1-5, assume thatROCA = 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 thatInvestments will grow at 5% a year forever ROC on projects will be equal to the cost of capital (10%) Firm Value using EVA ApproachCapital Invested in Assets in Place = $ 100EVA 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 = $ 3.42Value of Firm = $ 170.86EVA ImplementationStern 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 MeasurementsEconomic 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 neededEVA 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 SheetEVA Implementation by a Small CompanyWhen 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 policyThe 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 CONCLUSIONEVA 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.TERMINOLOGYBasis: The full cost of placing a fixed asset in service, used to calculate depreciation expense.Book value: Basis less accumulated depreciationCost: 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 mannerDeterioration: 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 yearFully 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.BIBLIOGRAPHYHorngren, Charles T.; Harrison Jr., Walter T.; Bamber, Linda Smith; “Accounting”, Prentice Hall, 5th Edition, 2002, page 386-402Atrill, Peter; Mclaney, Eddie; “Accounting and Finance for Non-Specialists”, Prentice Hall, 2nd Edition, 1997, page 61Weygandt, Jerry S.; Kieso, Donald E.; Kimmel, Paul D.; “Accounting Principles”, John Wiley & Sons, Inc., 6th Edition, 2002, page 400-405Hermanson, Roger H.; Edwards, James Don; Salmonson R.F.; “Accounting Principles” Business Publications, Inc., Revised Edition, 1983, page 365-372Canada, 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 123-140Horne, James C. Van; Wachowicz John M.; “Fundamentals of Financial Management”, Prentice Hall International, 10th Edition, page 15-21, 309-310Collins, Stephen J.; Forrester, Robert T.; “Recognition of Depreciation by Not-For-Profit Institutions”, NACUBO, 1988, page 39-58Peterson, Raymond H.; “Accounting for Fixed Assets”, John Wiley & Sons, Inc., 1994, page 99-103Monks, Robert A.G.; Minow, Nell; “Corporate Governance” Blackwell Business, 2nd Edition, 2001, page 53-54Grant, James L., “Foundations of Economic Value Added”, Published by Frank J. Fabozzi Associates,1997Salmi, Timo; Ilkka, Virtanen; “Economic Value Added: A simulation analysis of the trendy, owner-oriented management tool.” Acta Wasaensia No. 90, 2001, page 33Internet Resources:Economic Value Added, its Computation and in Comparison with NPV,DCF ValuationEVA Introduction to EVA, Overview, Calculating NOPAT and Invested Capital and Conclusion ................
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