W18_RM_Comparison of Depreciation Methods


1. Problem Recognition

A downstream oil & gas  company in the US plan to purchase a centrifugal pump for transferring white oil from storage tank to filling shed. The company purchase the pump for US$ 800.000. The asset will used for 16 years, and the SV at the end of the useful life is expected US$ 16.000.

In this blog posting, the Author wants to know the best depreciation method for the company that could reduce the company’s income taxes in the early years. Then, in the next blog posting, the Author will conduct an analysis related to the relationship of depreciation and income taxes.

2. Identify the Feasible Alternative

Based on the problem, the Author identify that there are five feasible alternatives [1]:

  • Option 1: the Straight Line (SL) Method
  • Option 2: Declining-Balance (DB) Method
  • Option 3: DB with Switchover to SL Depreciation
  • Option 4: Sum of the Year Digits (SYD) Method
  • Option 5: Modified Accelerated Cost Recovery System (MARCS)

 

3. Development of the Outcome for Alternative

Option 1: SL Method

This method assumes that a constant amount is depreciated each year over the useful life of the asset.

dk = (800.000 – 16.000) / 16 Years,  for k = 1 to 16 ;

EOY = End of Year k

d k  = depreciation amount in year k

BV k = Book Value in Year k

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Table 1. Straight Line Method

 

Option 2: DB Method using 200% DB Equations

DB Method assumes that the annual cost of depreciation is a fixed percentage of the BV at the beginning of the year.

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Table 2. Declining Balance Method

 

Option 3: DB with Switch over to SL Depreciation

DB with Switch over to SL Depreciation assumes that the DB Method never reaches a BV of zero; it is permissible to switch from DB to the SL method so that an asset’s BV will be zero (or some other determined amount such as its SV at year k).

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Table 3. DB with Switch Over to SL

 

Option 4: Sum of the Year Digits (SYD) Method

SYD methods assumes that assets are generally more productive when they are new and their productivity decreases as they become old.

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Table 4. SYD Method

 

Option 5: Modified Accelerated Cost Recovery System (MARCS)

MACRS is unique to the United States Tax Code. Depreciation is based on original asset cost, asset class, asset recovery period, and asset placed in service. Asset classes are differentiated depending on asset type. Depreciation rates are set by percentages allowed under the U.S. Tax Code.

Based on the MARCS Class Lives and Recovery Periods from IRS Publication 946, Tables B-1 and B-2 2006, the equipment categorized in asset class 13.3 Petroleum refining, class life 16 years and GDS 10 years.

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Table 5. MARCS Method

4. Selection of Criteria

Since the company is planning to expand its business, the company will choose the depreciation method that could reduce the company’s income taxes in the early years.

5. Analysis and Comparison of the Alternative

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Table 6. Comparison of depreciation Amount each year

Table 6 shows that the MACRS Method results in a larger share of the depreciation being charged during the earlier years of the asset’s life than the Declining Balance Method and the Sum of Years Digit Method. The Straight Line Method is neither accelerated nor decelerated and draws a linear line.

6. Selection of the Preferred Alternative

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Figure 1. BV Comparison for selected method of Depreciation

A company’s depreciation expense reduces the amount of taxable earnings used to calculate taxes and reduces the amount of taxes owed. The larger the depreciation expense, the lower the taxable income and the lower a company’s tax payments owed. [2]

The largest depreciation expense in early years generated from MARCS method, hence this method will generate the lower taxable income for the company in early years.

7. Performance Monitoring and Post-Evaluation Results

MACRS is unique to the United States Tax Code. The application of this method depends on the location of the company itself. If the company’s business located outside of the US, for example in Indonesia, the depreciation method will exclude the MARCS from the analysis and use the acceptable depreciation method based on the tax regulation in Indonesia.

References

  1. Sullivan, W.G., Wicks, E. M., & Koelling, C. P. (2011). Engineering Economy, pp. 289 – 308
  2. Investopedia. (2016). What is the tax impact of calculating depreciation?. Retrieved from: http://www.investopedia.com/ask/answers/031815/what-tax-impact-calculating-depreciation.asp
  3. Nurani, E.D. (2016). W7.0_EDN_Comparison of Depreciation Methods. Retrieved from: https://goldenaace2015.wordpress.com/2016/02/26/w7-0_edn_comparison-of-depreciation-methods-2/

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2 Responses to W18_RM_Comparison of Depreciation Methods

  1. drpdg says:

    Awesome, Pak Rico!!!!

    Just keep on doing what you are doing and you will be in great shape…….

    Not sure what has happened to your team but it is not looking too promising for most of them……

    BR,
    Dr. PDG, Jakarta

    Like

  2. Pingback: W5_OAN_Comparison of Depreciation Methods – EMERALD AACE 2017 – WEEKLY BLOG

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