Depreciation Concepts and Terminology

Depreciation is the decrease in value of physical

properties with the passage of time and use.

-More specifically, depreciation is an accounting

concept that establishes an annual deduction
against before-tax income such that the effect
of time and use on an asset’s value can be
reflected in a firm’s financial statements.
 In general, property is depreciable if it meets the following
basic requirements:

1. It must be used in business or held to produce income.

2. It must have a determinable useful life and the life

must be longer than one year.

3. It must be something that wears out, decays, gets used up,

becomes obsolete, or loses value from natural causes.

4. It is not inventory, stock in trade, or investment property.

Depreciable property is classified as either tangible or intangible.

Adjusted (cost) basis The original cost basis of the asset,
adjusted by allowable increases or decreases, is used to
compute depreciation deductions.

Basis or cost basis The initial cost of acquiring an asset

(purchase price plus any sales taxes), including
transportation expenses and other normal costs of
making the asset serviceable for its intended use; this
amount is also called the unadjusted cost basis.
Book value (BV) The worth of a depreciable property as
shown on the accounting records of a company. It is the
original cost basis of the property, including any
adjustments, less all allowable depreciation deductions.
Market value (MV) The amount that will be paid by a willing buyer to a willing
seller for a property, where each has equal advantage and is under no compulsion
to buy or sell.

Recovery period The number of years over which the basis of a property is
recovered through the accounting process. For the classical methods of depreciation,
this period is normally the useful life.

Recovery rate A percentage (expressed in decimal form) for each year of the
MACRS recovery period that is utilized to compute an annual depreciation
deduction.

Salvage value (SV) The estimated value of a property at the end of its useful life.∗
It is the expected selling price of a property when the asset can no longer be used
productively by its owner.

Useful life The expected (estimated) period that a property will be used in a trade
or business to produce income. It is not how long the property will last but how
long the owner expects to productively use it.
 The Classical (Historical) Depreciation
Methods
Straight-Line (SL) Method
SL depreciation is the simplest depreciation method. It assumes that a constant
amount is depreciated each year over the depreciable (useful) life of the asset. If
we define

N = depreciable life (recovery period) of the asset in years;

B = cost basis, including allowable adjustments;
dk = annual depreciation deduction in year k(1 ≤ k ≤ N);
BVk = book value at end of year k;
SVN = estimated salvage value at end of year N; and
d∗k = cumulative depreciation through year k,
then dk = (B − SVN)/N,
d∗k = k · dk for 1 ≤ k ≤ N,
BVk = B − d∗k .
A laser surgical tool has a cost basis of $200,000 and a five-year depreciable
life. The estimated SV of the laser is $20,000 at the end of five years.
Determine the annual depreciation amounts using the SL method. Tabulate
the annual depreciation amounts and the book value of the laser at the end
of each year.
 Declining-Balance (DB) Method
-In the DB method, sometimes called the constant-
percentage method or the Matheson formula, it is
assumed that the annual cost of depreciation is a
fixed percentage of the BV at the beginning of the
year.

-In this method, R = 2/Nwhen a 200% DB is being used

(i.e., twice the SL rate of 1/N), and N equals the
depreciable (useful) life of an asset. If the 150% DB
method is specified, then R = 1.5/N.
The following relationships hold true for the DB method:
Solution
Sample calculations for year six are as follows:
DB with Switchover to SL
Because the DB method never reaches a BV of zero, it is permissible to switch
from this method to the SL method so that an asset’s BVN will be zero (or
some other determined amount, such as SVN). Also, this method is used in
calculating the MACRS recovery rates
Units-of-Production Method
When the decrease in value is mostly a function of
use, depreciation may be based on a method not
expressed in terms of years. The units-of production
method is normally used in this case.
 The Modified Accelerated Cost Recovery
System
the MACRS was created by TRA 86 and is now the principal
method for computing depreciation deductions for property
in engineering projects.

MACRS applies to most tangible depreciable property placed in

service after December 31, 1986. Previous depreciation
methods have required estimates of
useful life (N) and SV at the end of useful life (SVN). Under
MACRS, however, SVN is defined to be zero, and useful life
estimates are not used directly in calculating
depreciation amounts.
MACRS consists of two systems for computing depreciation
deductions. The main system is called the General
Depreciation System (GDS), and the second system is
called the Alternative Depreciation System (ADS).
When an asset is depreciated under MACRS, the following
information is needed before depreciation deductions can
be calculated:
1. The cost basis (B)
2. The date the property was placed in service
3. The property class and recovery period
4. The MACRS depreciation method to be used (GDS or
ADS)
5. The time convention that applies.
Property Class and
Recovery Period
Under MACRS, tangible
depreciable property is
categorized (organized)
into asset classes. The
property in each asset
class is then assigned a
class life, GDS recovery
period (and property
class), and ADS
recovery period.
Depreciation Methods, Time Convention,
and Recovery Rates
The primary methods used under MACRS for calculating the depreciation
deductions over the recovery period of an asset are summarized as follows:
1. GDS 3-, 5-, 7-, and 10-year personal property classes: The 200% DB
method, which switches to the SL method when that method provides a
greater deduction.
2. 2. GDS 15- and 20-year personal property classes: The 150% DB method,
which switches to the SL method when that method provides a greater
deduction.
3. GDS nonresidential real and residential rental property classes: The SL
method over the fixed GDS recovery periods.

4. ADS: The SL method for both personal and real property over the fixed
ADS
recovery periods.
The depreciation deduction (dk) for an asset under MACRS (GDS) is computed with
dk = rk·B; 1 ≤ k ≤ N, (7-10)
where rk = recovery rate for year k from Table 7-3.
NB
 Depreciation In the Philippines
• F) Depreciation. -
• (1) General Rule. - There shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear (including reasonable
allowance for obsolescence) of property used in the trade or business.
• (2) Use of Certain Methods and Rates. - The term 'reasonable allowance' as
used in the preceding paragraph shall include, but not limited to, an allowance
computed in accordance with rules and regulations prescribed by the Secretary
of Finance, upon recommendation of the Commissioner, under any of the
following methods:
• (a) The straight-line method;
• (b) Declining-balance method, using a rate not exceeding twice the rate which
would have been used had the annual allowance been computed under the
method described in Subsection (F) (1);
• (c) The sum-of-the-years-digit method; and
• (d) Any other method which may be prescribed by the Secretary of Finance
upon recommendation of the Commissioner.
• (3) Agreement as to Useful Life on Which Depreciation Rate is
Based. - Where under rules and regulations prescribed by the
Secretary of Finance upon recommendation of the Commissioner,
the taxpayer and the Commissioner have entered into an
agreement in writing specifically dealing with the useful life and
rate of depreciation of any property, the rate so agreed upon shall
be binding on both the taxpayer and the national Government in
the absence of facts and circumstances not taken into
consideration during the adoption of such agreement.

• Provided, however, that where the taxpayer has adopted such

useful life and depreciation rate for any depreciable and claimed
the depreciation expenses as deduction from his gross income,
without any written objection on the part of the Commissioner or
his duly authorized representatives, the aforesaid useful life and
depreciation rate so adopted by the taxpayer for the aforesaid
depreciable asset shall be considered binding for purposes of this
Subsection.
• (4) Depreciation of Properties Used in Petroleum Operations. - An
allowance for depreciation in respect of all properties directly
related to production of petroleum initially placed in service in a
taxable year shall be allowed under the straight-line or declining-
balance method of depreciation at the option of the service
contractor.

• However, if the service contractor initially elects the declining-

balance method, it may at any subsequent date, shift to the straight-
line method.

• The useful life of properties used in or related to production of

petroleum shall be ten (10) years of such shorter life as may be
permitted by the Commissioner.

• Properties not used directly in the production of petroleum shall be

depreciated under the straight-line method on the basis of an
estimated useful life of five (5) years.
(5) Depreciation of Properties Used in Mining Operations. –
an allowance for depreciation in respect of all properties
used in mining operations other than petroleum operations,
shall be computed as follows:
(a) At the normal rate of depreciation if the expected life is ten
(10) years or less; or
(b) Depreciated over any number of years between five(5)
years and the expected life if the latter is more than ten (10)
years, and the depreciation thereon allowed as deduction
from taxable income: Provided, That the contractor notifies
the Commissioner at the beginning of the depreciation
period which depreciation rate allowed by this Section will
be used.
 Different Kinds of Taxes in the Philippines

• National Taxes in the Philippines

Capital Gains Tax – Philippines
Capital Gains Tax is a tax imposed on the gains presumed to
have been realized by the seller from the sale, exchange, or
other disposition of capital assets located in the Philippines.

Documentary Stamp Tax – Philippines

Documentary Stamp Tax is a tax on documents, instruments,
loan agreements, and papers evidencing the acceptance,
assignment, sale, or transfer of an obligation, rights, or
property incident thereto.
 Donor’s Tax – Philipppines
Donor’s Tax is a tax on a donation or gift, and is imposed on the
gratuitous transfer of property between two or more persons
who are living at the time of the transfer.
Estate Tax – Philippines
Estate Tax is a tax on the right of the deceased person to
transmit his/her estate to his/her lawful heirs and
beneficiaries at the time of death and on certain transfers
which are made by law as equivalent to testamentary
disposition.
• Income Tax – Philippines
Income Tax is a tax on all yearly profits arising
from property, profession, trades or offices, or
as a tax on a person’s income, emoluments,
profits, and the like.
• Value Added Tax (VAT) – Philippines
Value Added Tax (VAT) is a business tax imposed and collected
from the seller in the course of trade or business on every sale
of properties (real or personal), lease of goods or properties
(real or personal), or vendors of services. It is an indirect tax,
thus, it can be passed on to the buyer.

SEC. 105. Persons Liable. - Any person who, in the course of

trade or business, sells barters, exchanges, leases goods or
properties, renders services, and any person who imports
goods shall be subject to the value-added tax (VAT) imposed
in Sections 106 to 108 of this Code.

• .
• Withholding Tax on Compensation –
Philippines
Withholding Tax on Compensation is the tax
withheld from individuals receiving purely
compensation income.
• Percentage Tax – Philippines
Percentage Tax is a business tax imposed on persons or
entities who sell or lease goods, properties, or services in the
course of trade or business whose gross annual sales or
receipts do not exceed P550,000 and are not VAT-registered.

• SEC. 116. Tax on Persons Exempt from Value-Added Tax

(VAT). - Any person whose sales or receipts are exempt
under Section 109(V) of this Code from the payment of
value-added tax and who is not a VAT-registered person shall
pay a tax equivalent to three percent (3%) of his gross
quarterly sales or receipts: Provided, That cooperatives shall
be exempt from the three percent (3%) gross receipts tax
herein imposed
• Withholding Tax on Government Money
Payments – Philippines
Withholding Tax on Government Money
Payments is the withholding tax withheld by
government offices and instrumentalities,
including government-owned or controlled
corporations and local government units,
before making any payments to resident
suppliers of goods and services.
• EXCISE TAXES; SEC.129. Goods subject to
Excise Taxes. - Excise taxes apply to goods
manufactured or produced in the Philippines
for domestic sales or consumption or for any
other disposition and to things imported. The
excise tax imposed herein shall be in addition
to the value-added tax imposed under Title IV.
 Local Taxes in the Philippines
• Tax on Transfer of Real Property Ownership –
tax imposed on the sale, donation, barter, or on
any other mode of transferring ownership or
title of real property.

• Tax on Business of Printing and Publication –

tax on the business of persons engaged in the
printing and/or publication of books, cards,
posters, leaflets, handbills, certificates, receipts,
pamphlets, and others of similar nature.
• Franchise Tax – tax on businesses enjoying a
franchise, at the rate not exceeding fifty
percent (50%) of one percent (1%) of the gross
annual receipts for the preceding calendar
year based on the incoming receipt, or
realized, within its territorial jurisdiction.
• Tax on Sand, Gravel and Other Quarry Resources –
tax imposed on ordinary stones, sand, gravel, earth,
and other quarry resources, as defined under the
National Internal Revenue Code, as amended,
extracted from public lands or from the beds of
seas, lakes, rivers, streams, creeks, and other public
waters within its territorial jurisdiction.

• Professional Tax – an annual professional tax on

each person engaged in the exercise or practice of
his profession requiring government examination.
• Amusement Tax – tax collected from the
proprietors, lessees, or operators of theaters,
cinemas, concert halls, circuses, boxing stadia, and
other places of amusement.
• Tax on Business – taxes imposed by cities,
municipalities on businesses before they will be
issued a business license or permit to start
operations based on the schedule of rates
prescribed by the local government code, as
amended. Take note that the rates may vary among
cities and municipalities. This is usually what
businesses pay to get their Business Mayor’s Permit.
• Annual Fixed Tax For Every Delivery Truck or
Van of Manufacturers or Producers,
Wholesalers of, Dealers, or Retailers in, Certain
Products – an annual fixed tax for every truck,
van or any vehicle used by manufacturers,
producers, wholesalers, dealers or retailers in
the delivery or distribution of distilled spirits,
fermented liquors, soft drinks, cigars and
cigarettes, and other products as may be
determined by the sangguniang panlalawigan,
to sales outlets, or consumers, whether directly
or indirectly, within the province.
• Fees for Sealing and Licensing of Weights and
Measures – fees for the sealing and licensing of
weights and measures at such reasonable rates as
shall be prescribed by the sangguniang bayan of the
municipality or city.

• Fishery Rentals, Fees and Charges – rentals, fees or

charges imposed by the municipality/city to grantees
of fishery privileges in the municipal/city waters, e.g.,
fishery privileges to erect fish corrals, oysters,
mussels or other aquatic beds or bangus fry areas
and others as mentioned in the local government
code, as amended.
• Community Tax – tax levied by cities or
municipalities to every inhabitant of the Philippines
eighteen (18) years of age or over who has been
regularly employed on a wage or salary basis for at
least thirty (30) consecutive working days during any
calendar year, or who is engaged in business or
occupation, or who owns real property with an
aggregate assessed value of One thousand pesos
(P1,000.00) or more, or who is required by law to file
an income tax return. Community tax is also imposed
on every corporation no matter how created or
organized, whether domestic or resident foreign,
engaged in or doing business in the Philippines.
• Taxes that may be levied by the barangays on stores
or retailers with fixed business establishments with
gross sales of receipts of the preceding calendar year
of Fifty thousand pesos (P50,000.00) or less, in the
case of cities and Thirty thousand pesos (P30,000.00)
or less, in the case of municipalities, at a rate not
exceeding one percent (1%) on such gross sales or
receipts.

• Service Fees or Charges – fees or charges that may be

collected by the barangays for services rendered in
connection with the regulations or the use of
barangay-owned properties or service facilities, such
as palay, copra, or tobacco dryers.
• Barangay Clearance – a reasonable fee
collected by barangays upon issuance of
barangay clearance – a document required for
many government transactions, such as when
applying for business permit with the city or
municipality.
The Before-Tax and After-Tax Minimum Attractive
Rates of Return
The Effective (Marginal) Corporate
Income Tax Rate
 Gain (Loss) on the Disposal of an Asset

When a capital asset is sold or exchanged, the gain

(loss) is referred to as a capital gain (loss).
 Tax Consequences of Selling an Asset
A corporation sold a piece of equipment during the
current tax year for $78,600. The accounting records
show that its cost basis, B, is $190,000 and the
accumulated depreciation is $139,200. Assume that
the effective income tax rate as a decimal is 0.40 (40%).
Based on this information, what is
(a) the gain (loss) on disposal,
(b) the tax liability (or credit) resulting from this sale,
(c) the tax liability (or credit) if the accumulated
depreciation was $92,400 instead of $139,200?
General Procedure for Making
After-Tax Economic Analysis