Engineering Economic Analysis

(Chris Devlin) #1

  • --... -._-


Sum-of-Years'-Digits Depreciation

r
Equation 11-1 shows that year-to-year depreciation charges reduce an asset's book
value over its life. The following section describes methods that are or have been allowed
under federal tax law for quantifying these yearly depreciation deductions.

Historical Depreciation Methods

Allowing businesses to deduct the cost for capital expenditures over time (that i$, to de-
preciate business assets) has long been part of the tax code. However, over time several
versions of various depreciation methods have been used to calculate these deductions. In
general, accounting depreciation methods can be categorized as follows.

Pre-1981 historical methods:These methods include thestraight-line, sum-oj-the-
years' -digits,anddeclining balancemethods. Each method required estimates.of
an asset's useful life and salvage value. Firms could elect to use any of these meth-
ods for assets, and thus there was little uniformity in how depreciation expenses
were reported.

1981-1986 method:With the Economic RecoveryTax Act (ERTA)of 1981,Congress
created the accelerated cost recovery system (ACRS). The ACRS method had
three key features: (1) property class lives were created and all depreciated assets
assigned to one particular category, (2) the need to estimate salvage values was
eliminated because all assets werefully depreciated over their recovery period,
and (3) shorter recovery periods were used to calculate annual depreciation, which
acceleratedthe write-off of capital costs more quickly than did the historical
methods-thus the name.

1986 to present:The modified accelerated cost recovery system (MACRS) has been
in effect since the Tax Reform Act of 1986 (TRA-86). The MACRS method is
similar to the ACRS system except that (1) the number of property classes was
expanded and (2) the annual depreciation percentages were modified to include a
half-year convention for the first and final years.

In this chapter, our primary focus is to describe the MACRS depreciation method.
However,it is useful to first describe three historical depreciation methods. These methods
are used in some countries, and MACRS is based on two of them.

Straight-Line Depreciation
The simplest and best known depreciation method isstraight-line depreciation.To calcu-
late the constantannual depreciation charge,the total'amount to be depreciated,B- S,
is divided by the depreciable life, in years,N: 1

B-S


Annual depreciation charge=dt = - N (11-2)


1 Nis used for the depreciation period because it may be shorter thann,the horizon.

-- - ----
Free download pdf