CHAPTER 3 Cash Flow and Financial Planning 99recovery period
The appropriate depreciable life
of a particular asset as
determined by MACRS.
- An exception occurs in the case of assets depreciated under the alternative depreciation system.For convenience,
in this text we ignore the depreciation of assets under this system. - For a review of these depreciation methods as well as other aspects of financial reporting, see any recently pub-
lished financial accounting text.
TABLE 3.1 First Four Property Classes Under MACRSProperty class
(recovery period) Definition3 years Research equipment and certain special tools.
5 years Computers, typewriters, copiers, duplicating equipment, cars, light-
duty trucks, qualified technological equipment, and similar assets.
7 years Office furniture, fixtures, most manufacturing equipment, railroad
track, and single-purpose agricultural and horticultural structures.
10 years Equipment used in petroleum refining or in the manufacture of
tobacco products and certain food products.depreciable life is preferred to a longer one. However, the firm must abide by cer-
tain Internal Revenue Service (IRS) requirements for determining depreciable life.
These MACRS standards, which apply to both new and used assets, require the
taxpayer to use as an asset’s depreciable life the appropriate MACRSrecovery
period.^2 There are six MACRS recovery periods—3, 5, 7, 10, 15, and 20 years—
excluding real estate. It is customary to refer to the property classes, in accordance
with their recovery periods, as 3-, 5-, 7-, 10-, 15-, and 20-year property. The first
four property classes—those routinely used by business—are defined in Table 3.1.Depreciation Methods
For financial reporting purposes,a variety of depreciation methods (straight-line,
double-declining balance, and sum-of-the-years’-digits^3 ) can be used. For tax pur-
poses,using MACRS recovery periods, assets in the first four property classes are
depreciated by the double-declining balance (200 percent) method, using the half-
year convention and switching to straight-line when advantageous. Although
tables of depreciation percentages are not provided by law, the approximate per-
centages(rounded to the nearest whole percent) written off each year for the first
four property classes are shown in Table 3.2. Rather than using the percentages
in the table, the firm can either use straight-line depreciation over the asset’s
recovery period with the half-year convention or use the alternative depreciation
system. For purposes of this text, we will use the MACRS depreciation percent-
ages, because they generally provide for the fastest write-off and therefore the
best cash flow effects for the profitable firm.
Because MACRS requires use of the half-year convention, assets are assumed
to be acquired in the middle of the year, and therefore only one-half of the first
year’s depreciation is recovered in the first year. As a result, the final half-year of
depreciation is recovered in the year immediately following the asset’s stated
recovery period. In Table 3.2, the depreciation percentages for an n-year class
asset are given for n1 years. For example, a 5-year asset is depreciated over 6
recovery years. The application of the tax depreciation percentages given in Table
3.2 can be demonstrated by a simple example.