Last time, we learned how to calculate the annual depreciation expense using the straight line and declining balance methods. In this session, we'll focus on the MACRS approach or modified accelerated cost recovery system of depreciation, which turns out to be a combination of the straight line and the declining balance approaches. Fortunately, the mcas method takes a lot of the guesswork out of things for us. Let's get started. Recall the modified accelerated cost recovery system was part of the US Congress's 1986 Tax Reform Act, which spelled out the MACRS depreciation process that was then implemented by the US Internal Revenue Service. And once again, because depreciation and amortization for that matter affects a company's income taxes, the IRS is very specific about how to calculate it. If you really want the details, they can be found in IRS Publication 946. We'll cover some of the important highlights from this document to show you how the process works, and you can get the latest update on MACRS at the link shown here. To begin with, the 1986 Tax Reform Act defined a very prescriptive but simplified method to calculate depreciation. For instance, it created something called asset classes for all sorts of equipment and activities. For each asset class, it defined a very specific recovery period, thereby doing away with the somewhat arbitrary estimates of useful life. This helped to standardize how different companies accounted for asset depreciation. MACRS also assumes salvage values are zero, and that takes care of the uncertainty around how companies would estimate the salvage value. The IRS then created depreciation rates or schedules for each year of the recovery period, and it adopted something known as a half year convention, which sort of makes sense when you see it. So hold on to any questions about that for the time being. Overall, the big advantage of the MACRS method is the IRS tells us exactly how to depreciate any type of asset, we just have to follow their instructions. Here is a list of some of the asset classes taken directly from IRS Publication 946, so you know what they look like and their specified recovery periods. For instance, Asset Class 00.11 is for office furniture and for office fixtures. And the IRS stipulates a seven year recovery period. Asset Class 00.24 is for light trucks used in a business like the pickup truck we described when we first started this module. Light Trucks are depreciated using a 5-year recovery period. If you're in the window glass, manufacturing business, equipment is part of Asset Class 320.1, and it has a recovery period of seven years. The IRS defines asset classes for almost any piece of equipment. All found in the appendix of Publication 946. Recovery periods have a rather wide range from three years to 39 years. Three years is fairly short, and limited to some special tools that might be used in a manufacturing process, assets such as computers, automobiles, trucks and equipment used for research and development, all have a five year recovery period. Quite a lot of manufacturing equipment falls into the seven year recovery period category, as does office furniture. The larger and more long live the asset, the longer the recovery period, for example, wastewater treatment plants are depreciated over 15 years and residential rental property such as apartment complexes and the like have a recovery period of 27.5 years, 27.5 years. Why such an odd number? Good question. Maybe something we should ask the IRS. Calculating the annual depreciation expense under MACRS is actually quite straightforward. First, determine the asset class for what you're depreciating, knowing that will also determine the recovery period to use. Then, you need to know the cost basis which is the initial cost, but often all the costs necessary to get things operational such as shipping and installation costs. All that's left is to use the IRS tables to determine the depreciation rate for each year of the recovery period. That's it. How hard can that be? What is interesting is that MACRS starts with the declining balance method using either 150% or 200%. Then, switches over to the straight line method to ensure the book value is zero at the end of the recovery period, the way that it does, that is exactly how he did it in the last lesson only. Now, the IRS has made the process a whole lot easier. Here's a table taken directly from the IRS Publication 946 showing the depreciation rate schedules for 3-20 year recovery periods. We'll use these in an example, but a few important things to highlight to obtain our annual depreciation expense. We multiply the numbers in the table by the cost basis, and that's all there is to it. Little different from the declining balance method, but even easier to remember. But here's an interesting one. Look at the 3 year depreciation rate figures. Over how many years is the asset actually depreciated? If you said four, and said it with a question, look on your face, you would be right. Why four years for a three year recovery period? Because of this thing called the half year convention. Let's take a look at the half year convention. Consider the MACRS. Five year depreciation rate schedule shown here. The depreciation rates were converted from percentages in the IRS table to decimal form to make our calculations easier. As you can see, a five year recovery period actually has six years of depreciation all as a result of the half year convention idea for year one. The depreciation rate is 0.2, which means 20% of the assets cost basis. No, this is a lot less than the rate in year two, which is 0.32 or 32% of the assets cost basis in our declining balance method, the first year always would have the highest appreciation expense. So what's going on here according to how the IRS wants us to do this, the first year only fets 1/2 the normal depreciation. Thus the term half year convention. Then in year six we pick up the other half. That's why there are six years of depreciation for a five year recovery period. The same idea would apply to three years, seven years and in fact, any recovery period, there is always one more year of depreciation as a result of the half year convention. And why would the IRS do this? The rationale, as far as I can tell goes something like this. If you purchased a major piece of equipment in january, you may not get it fully operational until the middle of the year. That means it's creating value for the company for only half the year. So you take only half the depreciation. The other half has to come from somewhere. And that's at the back end where you operate the equipment for half the year and then spend the rest of the time decommissioning it. Is that actually what the IRS had in mind? I'm not entirely sure. But that reasoning makes sense to me and I hope it does for you too. Our goal is to just know how to calculate everything going back to our example of having an asset that Costs $80,000. A salvage value of 10,000 dollars and a recovery period of five years, let's see what depreciation looks like using smackers. The table here shows the six years of depreciation with depreciation rates for each year. The depreciation expense is just the Massacres rate multiplied by the cost basis for each year. In this way, the I. R. S. Has made it super easy for us to figure it all out For the first year. The rate of 0.2 is multiplied by $80,000 To get 16,000 dollars. The first year depreciation expense subtract that from the initial book value and the Book value at the end of year one is $64,000 in year two. The rate is 0.32. And we multiply that by $80,000 to get 25,000 $600. And subtracting that from the book value of $64,000 results in the book value at the end of year Two of $38,400. We do exactly the same thing for the remaining years. And at year six we End up with the depreciation expense of $4,608. When we subtract that from The book value at the end of your five, We get a final book value of zero just what we're supposed to get, What happened to the $10,000 salvage value. Nothing because the massacres approach doesn't take salvage value into account. So even if the company thinks it's worth something after six years, the IRS doesn't, and the IRS always wins in that debate. Here is what the spreadsheet might look like The same. four columns for the year, smackers depreciation rate, the annual depreciation expense and finally the book value, the plot of book value versus the year is also shown and you can see that it looks like the declining balance method during the first few years and then switches over to the straight line method towards the end. In fact, the Switch over takes place in year four. The depreciation expense in year four and year five is the same and the value in year six is just half of that entirely due to the final half year depreciation. See if you can replicate this spreadsheet and then you'll be ready for anything. The I. R. S. Throws at you. Here's an interesting plot that shows how depreciation occurs with all three techniques. The straight line and declining balance still have the $10,000 final book value associated with the salvage value, whereas the mcas method Takes the book value to zero but not until year six. You can also see the book value from Akers is more or less in between the straight line and declining balance methods. And That means the tax deductions each year are in between two. The advantage of mockers being that you get to write off the financial term for depreciation, the full amount of the asset, regardless of whether it has any salvage value or not. And speaking of taxes, what happens if you sold the asset? For whatever reason, there is a term called depreciation recapture, which refers to what happens if the asset is sold at a price or market value that is higher than the book value from the IRS perspective that generates a capital gain which are treated like profits from the IRS point of view and that means it's taxed like any other business income. The example here illustrates the point if a piece of equipment is purchased and installed for a total cost of $10,000, that's its cost basis. A few years later, the book Value might be $5,000. But if it's sold for 7000 dollars Then that is $2,000 in profit for the company, officially called. $2,000 in depreciation recapture And that $2,000 would be taxed at the prevailing tax rate, Which as of 2022 is 21%. What happens when things go the other direction when the sales price is less than the book value for all practical purposes? The IRS looks at that as a financial loss, thereby reducing the company's profit before tax and such a loss would be tax deductible. In our example, the market value or sales price Is $2,000. But the book value is $5,000 And that represents a $3,000 loss for the company, reducing their Tax burden by $630 using the 21% tax rate. Now, you know everything there is to know about depreciation, okay, Maybe not everything there is to know. But everything we, as technical managers need to know to understand how asset valuation impacts a financial cash flow analysis. So let's wrap up this discussion with a few and perhaps more refined takeaways. Again, depreciation is the process of calculating the value of an asset over its recovery period where the recovery period is now defined by the asset class. The process involves calculating the loss and value each year of the recovery period. We've seen several techniques that work here, the straight line approach, the declining balance approach and the more recent massacres approach, which is more of a prescriptive form of the first two. We also mentioned bonus depreciation, whereby the asset value is fully depreciated or written off all in year one, Once again, the annual loss in value shows up on the income statement as depreciation expense and the total loss in value shows up on the balance sheet as accumulated depreciation and the assets book value at the end of any year is just the cost basis minus the accumulated depreciation up to that point. The other thing to remember and a point we've made several times so far is depreciation is a non cash expense and that fact impacts a project's cash flows, something will see far more clearly in the next module for now though, just recognize that we need to account for it in any project valuation analysis and that's why we have gone into such detail in this lesson. One last comment, all these wonky details can make our heads spin sometimes, yet getting depreciation right is essential to getting your company's taxes right and keeping your company out of trouble with the IRS. And while we as technical managers are now knowledgeable enough to use depreciation in our project financial analysis, the real expertise exists with our accounting colleagues down the hall. So let them know how much you appreciate them and their willingness to help you out when you need it. That's a wrap on depreciation for our next lesson. We're going to dive into corporate taxes not to make us think that we would ever be responsible for taxes. That too is a job for our accounting colleagues. We need to see how taxes impact projects, cash flows and as it turns out taxes these days aren't all that complicated. And that's a good thing because if we're going to determine critical parameters such as the project's NPV internal rates of return and payback periods, then we need to take taxes into account to get the right cash flows. So stay tuned. There's a lot more to come. I'm Michael Reedy and I'll see you next time
