Depreciation and Tax

Straight line method (7 questions)

The straight line (SL) method “estimates the value of the asset” by assuming that the asset drops by a fixed amount each year across its life. We shall refer to the estimated value of the asset as its book value. It is noted that, in practice, the true value of the asset (i.e., market value) can differ from its book value. 

Let us consider the SL method using the following simple example: A laser surgical tool costs $200,000. This equipment is estimated to be valued at $10,000 at the end of five years.

Declining balance method (13 questions)

The declining balance (DB) method “estimates the value of the asset” by assuming that the asset drops by the same proportion R each year across N years, where:

Let us consider the DB method using the simple example of a laser surgical tool that costs $200,000. 

DB with switchover to SL (20 questions)

The DB method with switchover to SL determines depreciation based on the SL and DB method, by selecting the higher depreciation amount.

Let us consider the DB method with switchover to SL method using the following simple example: A laser surgical tool costs $200,000. This equipment is estimated to be valued at $10,000 at the end of five years.

Units-of-production method (4 questions)

The units-of-production method “estimates the value of the asset” by assuming that asset value drops by a fixed amount for each production unit of the asset. This approach is suitable for assets whose value is more dependent on usage (e.g., wear and tear) rather than age.

Let us consider the units-of-production using the following simple example: A laser surgical tool costs $200,000. It is estimated that this tool will have to be replaced after 40,000 hours of use with a salvage value of $10,000.

Half year convention (13 questions)

Depreciation is used in the computation of taxes. Taxes are typically charged at a fixed time of the year, which may not coincide with the purchase of assets. Hence, assets may not be exactly N years old at the point of tax computation. To simplify the task of computing depreciation for tax purposes, some governments assume that the asset is half year old in the first year, regardless of the actual purchase date. Hence, the depreciation amount is halved in the first year. Furthermore, the depreciation amount in the final year (i.e., year N+1 or year asset is sold, whichever comes first) is also halved.

Consider a $100,000 equipment with a three year depreciable life and zero salvage value. 

Income tax (4 questions)

Income tax is generally computed as a percentage of taxable income.

Taxable income and after-tax cash flow (6 questions)

Suppose that a company receives $10,000,000 in sales receipt. In addition, it paid out $2,000,000 in operating expenses (e.g., labour, rental). In addition, the company made a capital investment by purchasing a van for $120,000 at the start of the year. The van is to be depreciated over 3 years under the SL method with zero salvage value.