W5_OAN_Comparison of Depreciation Methods

  1. Problem Definition

As NOC, storage tank is our main asset. We plan to build a 10.000 Kl storage tank, it will cost $ 1.300.000. The asset will be used for 20 years, and the SV at the end of useful life is $ 65.000.

In this week blog posting, Author wants to know the best depreciation method for the company, in order to reduce our income tax.

  1. Development of Feasible Alternatives

Alternatives for depreciation method are:

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

3. Possible Solution

Option 1: SL Method

In this method, we assumes a constant amount is depreciated each year over the useful life of the asset.

Table 1 : SL Method

Option 2: DB Method Using 150% DB Equations

 

DB Method assumes the annual cost of depreciation is fix percentage of the BV at the beginning of the year.

Table 2: DB Method

Option 3: DB with Switchover 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).

Table 3: DB with Switchover to SL

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

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

Table 4: SYD Method

Option 5: MACRS Method

MACRS is unique to the United States Tax Code. Depreciation rates are set by percentages allowed under the U.S. Tax Code.

Based on IRS Publication 946 table B-2, Storage Tank class life is 14 years, and GDS 7 years.

Table 5: MACRS Method

  1. Selection Criteria

Our selection criteria will be the depreciation method that have the biggest impact on reduce taxable income for company.

  1. Analysis and Comparison of the Alternatives

Table 6: Comparison of Depreciation Method

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 others depreciation method.

  1. Selection and Preferred Alternatives

Figure 1: Depreciation Comparison

Depreciation expense will reduce company’s taxable earnings. The larger depreciation expense, the lower taxable income. Those will lower company’s tax payment.

As shown in figure 1, MACRS method generate the biggest depreciation in early years. Therefore, this method will generate the lower taxable income for company.

  1. Performance Monitoring and the Post Evaluation of Result

MACRS method is unique to US Tax code. For Indonesian company, we must exclude MACRS method from our analysis, and use the acceptable depreciation method that follow Tax system in Indonesia.

Refrences

  1. Sullivan, William G., Wicks, Elin M. & Koelling, C. Patrick. (2014). Engineering Economy 16th edition Chapter 7 page 332 – 354, England: Pearson Education Limited.
  2. Module 06-5 Acquiring Equipment for the Project.
    Retrieved from http://www.planningplanet.com/guild/gpccar/acquiring-equipment-for-the-project
  3. Publication 946 : How to Depreciate Property (2016)
    Retrieved from https://www.irs.gov/pub/irs-pdf/p946.pdf
  4. W18_RM_Comparison of Depreciation Methods (2016)
    Retrieved from https://goldenaace2015.wordpress.com/2016/05/13/w18_rm_comparison-of-depreciation-methods/
 

1 thought on “W5_OAN_Comparison of Depreciation Methods”

  1. AWESOME Pak Nunug…..!!! Nice work on this one…. Great case study and you followed our step by step process just perfectly…..

    Just be sure to claim credit for one problem from Chapter 7 and be careful how you allocate your time as it needs to be split between two projects- Blog project and the Questions project…..

    Keep up the good work…..

    BR,
    Dr. PDG, Jakarta

     

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