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Depreciation ENGG 401 X2 Fundamentals of Engineering

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					          ENGG 401 X2
Fundamentals of Engineering Management
              Spring 2008



             Chapter 3 (cont):
              Depreciation


                 Dave Ludwick
        Dept. of Mechanical Engineering
              University of Alberta
          http://members.shaw.ca/dave_ludwick/
                                        ENGG 401 X2 – Fundamentals of Engineering Management



Discussion Question #1
• Think about how many hours per year each of the following
  pieces of equipment operates.
   –   pump in an oil refinery
   –   telephone switch
   –   family automobile
   –   lawnmower


• How many hours in the total life of the piece of equipment?




                                                              Dave Ludwick, Dept. of Mech. Eng.
                                                                                   Depreciation
                                 2                                                Summer 2008
                                        ENGG 401 X2 – Fundamentals of Engineering Management



Discussion Question #2
• Two brothers inherit $1 million each. The conservative
  brother buys a 20 year bond yielding 5.5% and hence
  makes $55,000 per year. The entrepreneurial brother buys
  two oil well service rigs, and makes $70,000 a year in cash
  from the business. 15 years later, over a beer, the
  entrepreneurial brother brags that he made the better
  choice. Assuming the entrepreneurial brother didn’t work in
  the service rig business (i.e., he had another job), was he
  right? Why?




                                                              Dave Ludwick, Dept. of Mech. Eng.
                                                                                   Depreciation
                              3                                                   Summer 2008
                                               ENGG 401 X2 – Fundamentals of Engineering Management



Capital Assets
• Capital Assets – assets used in the operations of a
  company and have a useful life of more than one
  accounting period
• Generally divided into 2 groups
   – Tangible Assets – Property, Plant and Equipment
   – Intangible Assets – patents, copyrights, trademarks (excluding
     goodwill)
• The three major accounting issues to examine are
   – The accounting for initial and subsequent costs
   – Allocating costs of capital assets against revenues
   – Recording the disposal of the capital assets



                                                                     Dave Ludwick, Dept. of Mech. Eng.
                                                                                          Depreciation
                                    4                                                    Summer 2008
                                                ENGG 401 X2 – Fundamentals of Engineering Management



Costs of Capital Assets
• Capital assets are recorded at cost, which includes normal
  and reasonable expenditures to get the asset to a place
  where it can be useful
   – Freight, packing and unpacking costs, installation costs, non-
     refundable taxes
   – These are known as capital expenditures
• Capital Expenditures are costs relating to capital assets that
  provide a benefit beyond the current period.
   – They are added to the capital assets line and depreciated along with
     the capital assets over time.




                                                                      Dave Ludwick, Dept. of Mech. Eng.
                                                                                           Depreciation
                                    5                                                     Summer 2008
                                                  ENGG 401 X2 – Fundamentals of Engineering Management



Land
• Land is a special asset. It can’t be depreciated.
   – But stuff on the land, like buildings, parking lots, etc are depreciated.
• Cost of land will include its price, real estate commissions,
  insurance for titles, legal fees and accrued property taxes
• Costs relating to land preparation for building are also
  added to the cost of the land
• Costs relating to removing old unwanted buildings or scrap
  can also be added to the land. If those are sold for salvage,
  then the salvage amount is subtracted from the land costs




                                                                        Dave Ludwick, Dept. of Mech. Eng.
                                                                                             Depreciation
                                      6                                                     Summer 2008
                                         ENGG 401 X2 – Fundamentals of Engineering Management



Buildings
• Building costs include its purchase price, commissions,
  taxes, legal and title fees. These are all costs needed to
  make the building ready for use.
• Buildings are depreciated over a defined useful life




                                                               Dave Ludwick, Dept. of Mech. Eng.
                                                                                    Depreciation
                               7                                                   Summer 2008
                                                 ENGG 401 X2 – Fundamentals of Engineering Management



Amortization and Depreciation
• Capital Assets wear out over time or decline in usefulness
• Amortization or depreciation is the process of matching or
  allocating the cost of the capital assets over the time that
  the asset is used.
   – In effect, accounting is trying to use the matching principle to match
     the cost of the assets to the revenues they helped create.
• We only start recording asset depreciation once the asset is
  put into use
• We often use the words Depreciation and Amortization
  inter-changeably
   – We usually depreciate fixed assets
   – We usually amortize intangible assets
   – But, it is okay to use them inter-changeably because they mean the
     same thing
                                                                       Dave Ludwick, Dept. of Mech. Eng.
                                                                                            Depreciation
                                     8                                                     Summer 2008
                                                ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation
• Depreciation is a charge against earnings to reflect the
  need to replace wearing out of assets.

• Depreciation is not a cash cost.
   – The business has already spent the cash.
   – It can be thought of as a recovery of previously spent costs (or “pre-
     recovering” future costs).
   – If these costs can not be recovered, then the business isn’t earning
     its cash flow.
• Note that depreciation is a process of cost allocation NOT
  asset valuation.
   – Amortization is not a measure of an assets declining market value




                                                                      Dave Ludwick, Dept. of Mech. Eng.
                                                                                           Depreciation
                                     9                                                    Summer 2008
                                              ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation (2)
• Assets last longer than a single year.
• All assets that wear out flow through the income statement
  as an expense.
• This expense is either
   – Depreciation, normal loss of value, over time, or
   – A writedown, the remaining book value of the asset when it is taken
     out of service.


• Accumulated Depreciation
   – the sum total of all the depreciation taken to date
   – Depreciation Expense, Yr 1 + Depreciation Expense, Yr 2 + …
     Depreciation Expense, Yr N


                                                                    Dave Ludwick, Dept. of Mech. Eng.
                                                                                         Depreciation
                                  10                                                    Summer 2008
                                                ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation (3)
• We should make reasonable efforts to estimate the “correct”
  period for replacement.
   – Too short a period depresses earnings, and makes the business
     look like an underperformer during the depreciation period, with a
     sudden swing up in earnings at the end of the period. Which would a
     buyer believe?
   – Too long a period overstates earnings but requires a writedown of
     residual value at the time of replacement, since the equipment is not
     fully depreciated. Writedowns are a potential problem at time of sale.




                                                                      Dave Ludwick, Dept. of Mech. Eng.
                                                                                           Depreciation
                                    11                                                    Summer 2008
                                                  ENGG 401 X2 – Fundamentals of Engineering Management



Calculating Depreciation – Terms for reference
• Cost – the cost of the capital asset including all reasonable
  costs needed to acquire it and prepare it for use
• Salvage Value – aka Residual Value, is an estimate of the
  amount that the asset could be sold for at the end of its
  useful life
• Useful Life – aka Serviceable Life, the length of time over
  which the asset is productive
   – Different types of assets will have different useful lives


• There are many ways to calculate depreciation which we
  will see in a few minutes


                                                                        Dave Ludwick, Dept. of Mech. Eng.
                                                                                             Depreciation
                                     12                                                     Summer 2008
                                                      ENGG 401 X2 – Fundamentals of Engineering Management



Writedowns
• A writedown is when we reduce the book value of an asset
  by a decision of management (or by circumstances that
  arise).

• If the depreciation period of an asset is longer than its
  actual lifetime, the remaining undepreciated value of the
  asset charged as an expense (a writedown).
   – Operating income is overstated during the depreciation period.
   – Usually listed with the “other income” category as an extraordinary
     one-time expense.
   – Often lists a few words to clarify it as well:
       • “loss on sale of assets”, “disposal of assets”, “liquidation of assets”,…



                                                                            Dave Ludwick, Dept. of Mech. Eng.
                                                                                                 Depreciation
                                        13                                                      Summer 2008
                                                      ENGG 401 X2 – Fundamentals of Engineering Management



Gain on Sale of Assets
• The opposite of a writedown can also occur, and is
  considered to be a gain on the sale of assets.

• If the depreciation period is shorter than the actual life of the
  asset, the market value of the asset is more than the “book
  value”.
   – Operating income is depressed during the depreciation period and
     “bumps up” at the end of the depreciation period.

• If the asset is sold for more than its book value, the gain is
  also listed as “other income” on the income statement.
   – Often lists a few words to clarify it as well:
       • “gain on sale of assets”, “disposal of assets”, “liquidation of assets”,…


                                                                            Dave Ludwick, Dept. of Mech. Eng.
                                                                                                 Depreciation
                                        14                                                      Summer 2008
                                                    ENGG 401 X2 – Fundamentals of Engineering Management



Calculating Depreciation
• There are four different methods of calculating depreciation:
   – Straight line is the most common and the easiest to work with in
     interpreting year over year results.
      • The danger is that in early years, the “book value” may be significantly
        higher than its resale value.
   – Sum-of-the-years digits depreciates more heavily in earlier years.
      • It more accurately reflects resale value.
   – Declining balance depreciation is also more heavily weighted to
     earlier years of an asset’s life.
      • The motive is often economic stimulation.
      • Income tax uses this method.
   – Units-of-production depreciation recovers costs based on the use
     of the asset rather than time (age).



                                                                          Dave Ludwick, Dept. of Mech. Eng.
                                                                                               Depreciation
                                       15                                                     Summer 2008
                                                     ENGG 401 X2 – Fundamentals of Engineering Management



Straight Line Depreciation
• The simplest depreciation method is straight line
  depreciation where an asset’s value is depreciated at a
  constant rate over it’s lifetime.
   – The annual depreciation charge is the same in each year.

• Straight line depreciation:
   – Depreciation Expense =
       • (Total Cost – Salvage Value)/No. useful periods
       • Where, the No. of useful periods is the life of the asset in terms of the
         number of accounting periods (ex: number of quarters if the statements
         are being prepared quarterly)




                                                                           Dave Ludwick, Dept. of Mech. Eng.
                                                                                                Depreciation
                                       16                                                      Summer 2008
                                                  ENGG 401 X2 – Fundamentals of Engineering Management



Straight Line Depreciation Example
• In April, you purchase a patent for $6800 and depreciate its
  value using the straight line method over 17 years, after
  which you expect it to have no value. Calculate the patent’s
  annual depreciation charge and remaining value each year.
   – Depreciation Expense =
      • (Total Cost – Salvage Value)/No. useful periods
      • (6800 – 0) / 17 = 400 per year


• Note: We have special rules for handling the first year of
  depreciation




                                                                        Dave Ludwick, Dept. of Mech. Eng.
                                                                                             Depreciation
                                     17                                                     Summer 2008
                                               ENGG 401 X2 – Fundamentals of Engineering Management



Partial-Year Depreciation
• Assets are not always acquired at the beginning of a period
• To account for this, there are 2 ways to calculate the first
  year’s depreciation expense

• Nearest Whole Month
   – If the asset is purchased in the first part of a month, that whole
     month and all months after it until the end of the period are
     considered the first year
   – Example: A patent is purchased for $6800 on April 8, with a fiscal
     year end of Dec 31 and salvage value of $0 in 17 years
   – First Year Depreciation = [(Cost – Salvage Value)/Estimate useful
     life]* 9/12


                                                                     Dave Ludwick, Dept. of Mech. Eng.
                                                                                          Depreciation
                                   18                                                    Summer 2008
                                                    ENGG 401 X2 – Fundamentals of Engineering Management



Partial-Year Depreciation
• Half-Year Rule
   – The materiality principal may allow a company to simply use the half
     year rule for the first year’s depreciation amount
   – The Half-Year Rule says the regardless of when the asset was
     purchased, only half of the depreciation is allocated in the first year.
   – The process is to calculate what normally would be the first year’s
     depreciation, then multiply it by half.
       • This applies to all the depreciation calculation methods except Units of
         Production


• Each of these rules would be used for all of the depreciation
  methods except Units-of-production



                                                                          Dave Ludwick, Dept. of Mech. Eng.
                                                                                               Depreciation
                                       19                                                     Summer 2008
                                         ENGG 401 X2 – Fundamentals of Engineering Management



Straight Line Depreciation In-Class Problem
• You purchase a new $9000 asset on February 23 and
  decide to calculate its depreciation using the straight line
  method over a period of five (5) years, after which you
  expect to be able to sell it for $700. The company’s fiscal
  year end is December 31.
• Calculate the asset's annual depreciation charge and its
  remaining value each year. For the first year, use the
  nearest whole month rule.




                                                               Dave Ludwick, Dept. of Mech. Eng.
                                                                                    Depreciation
                               20                                                  Summer 2008
                                                 ENGG 401 X2 – Fundamentals of Engineering Management



Sum-of-the-Years’-Digits Depreciation
• The sum-of-the-years’-digits depreciation method is a
  more accurate model for some assets (e.g., car) whose
  value depreciates more in the earlier years of its life.

• Sum-of-the-years’-digits depreciation expense:

                                   N  t 1
                              dt            B  S 
                                   SOYD
   –   t = period number
   –   dt = depreciation expense in year t
   –   B = original value of asset (cost basis)
   –   N = depreciable lifetime, in years
   –   S = expected salvage value of asset after depreciable lifetime
   –   SOYD = sum of the years’ digits = N(N+1)/2
                                                                       Dave Ludwick, Dept. of Mech. Eng.
                                                                                            Depreciation
                                     21                                                    Summer 2008
                                                      ENGG 401 X2 – Fundamentals of Engineering Management



Sum-of-the-Years’-Digits Example
• You purchase a new asset for $5000 and expect to sell it for
  $1000 after 4 years. Calculate the sum-of-the-years’-digits
  depreciation charges and book value for each year.
                   N  t 1
            dt              B  S 
                   SOYD

            4  1 1
   d1                   $5000  $1000   $1600   BV1  $5000  $1600  $3400
          1 2  3  4
           4  2 1
   d2                   $5000  $1000  $1200    BV2  $3400  $1200  $2200
          1 2  3  4
           4  3 1
   d3                   $5000  $1000  $800     BV3  $2200  $800  $1400
          1 2  3  4
           4  4 1
   d1                   $5000  $1000  $400     BV4  $1400  $400  $1000
          1 2  3  4
                                                                            Dave Ludwick, Dept. of Mech. Eng.
                                                                                                 Depreciation
                                          22                                                    Summer 2008
                                         ENGG 401 X2 – Fundamentals of Engineering Management



Sum-of-the-Years’-Digits In-Class Problem #1
• You purchase a new $9000 asset on February 23 and
  decide to calculate its depreciation using the sum-of-the-
  years’ digits method over a period of five (5) years, after
  which you expect to be able to sell it for $700. The
  company’s fiscal year end is December 31.
• Calculate the asset's annual depreciation charge and its
  remaining value each year.




                                                               Dave Ludwick, Dept. of Mech. Eng.
                                                                                    Depreciation
                               23                                                  Summer 2008
                                         ENGG 401 X2 – Fundamentals of Engineering Management



Sum-of-the-Years’-Digits In-Class Problem #2
• You purchase a new $900 asset in April and decide to
  calculate its depreciation using the sum-of-the-years’ digits
  method over a period of five (5) years, after which you
  expect to be able to sell it for $70.
• Calculate the asset's annual depreciation charge and its
  remaining value each year.




                                                               Dave Ludwick, Dept. of Mech. Eng.
                                                                                    Depreciation
                               24                                                  Summer 2008
                                                   ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation Methods
• Declining-balance Method
   – This is an accelerated depreciation method: It allocates
     comparatively more to depreciation expense in early years and
     smaller amounts in later years
      • The rate of the acceleration can be different for each asset (but must be
        consistent over the life of that asset)
      • The amount of depreciation expense applied is based on the book value
        in that period.
   – This methods attempts to more closely approximate the value of the
     asset over its life




                                                                         Dave Ludwick, Dept. of Mech. Eng.
                                                                                              Depreciation
                                      25                                                     Summer 2008
                                                      ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation Methods
• Declining-balance Method
   – Two Step Process
      • Calculate the declining balance rate
      • Calculate the depreciation expense by multiplying the rate by the asset’s
        beginning of period book value.
   – Details
      •   Example using Double-declining balance (where “double” means X=2)
      •   Step 1: Rate = X/Estimated Useful Life = 2/Estimated Useful Life
      •   Step 2: First year Deprec. Exp. = Rate * Beg. Period Book Value
      •   Step 3:
            – Next year Beg. Balance = Previous year beg balance – Deprec. Exp.
      • Notice how the Beg. Period book value is the previous period’s end of
        period book value
      • Triple-declining balance, X=3, quadruple, X=4, etc
      • Your book uses another method which also works

                                                                            Dave Ludwick, Dept. of Mech. Eng.
                                                                                                 Depreciation
                                         26                                                     Summer 2008
                                      ENGG 401 X2 – Fundamentals of Engineering Management



Declining Balance Depreciation Problem #1
• You purchase a new $900 asset and decide to calculate its
  depreciation using the declining balance method with a
  depreciation rate of 40% over a period of five (5) years.
• Calculate the asset's annual depreciation charge and its
  remaining value each year.




                                                            Dave Ludwick, Dept. of Mech. Eng.
                                                                                 Depreciation
                             27                                                 Summer 2008
                                                                 ENGG 401 X2 – Fundamentals of Engineering Management



Declining Balance vs. Straight Line Depreciation

                  $1,200.00


                  $1,000.00


                   $800.00
     Book Value




                                                       Declining Balance Depreciation
                   $600.00


                   $400.00


                   $200.00            Straight Line Depreciation


                      $-
                              0   2             4            6                   8                 10
                                                    Year


                                                                                       Dave Ludwick, Dept. of Mech. Eng.
                                                                                                            Depreciation
                                               28                                                          Summer 2008
                                                ENGG 401 X2 – Fundamentals of Engineering Management



Double Declining Balance Depreciation
• The double declining balance depreciation (DDB)
  method is a special case of declining balance depreciation,
  where the rate of depreciation is double the straight line
  depreciation rate.
   – i.e., straight line depreciation is 1/N of the original value (minus
     salvage value) per year, while the double declining balance rate is
     2/N of the current book value per year.


• Historically, companies most often used either the straight
  line method or the double declining balance method




                                                                      Dave Ludwick, Dept. of Mech. Eng.
                                                                                           Depreciation
                                    29                                                    Summer 2008
                                      ENGG 401 X2 – Fundamentals of Engineering Management



Declining Balance Depreciation Problem #2
• You purchase an asset for $10 000 and decide to calculate
  its depreciation using the double declining balance
  method over a period of ten (10) years, after which you
  expect it to have a salvage value of $1000.
• Calculate the asset's annual depreciation charge and its
  remaining value each year.




                                                            Dave Ludwick, Dept. of Mech. Eng.
                                                                                 Depreciation
                             30                                                 Summer 2008
                                       ENGG 401 X2 – Fundamentals of Engineering Management



Declining Balance Depreciation Problem #3
• A constraint with the declining balance depreciation method
  is that the accumulated depreciation cannot exceed the
  purchase cost less the salvage value (i.e., it’s book value
  cannot drop below it’s salvage value).
• What if the asset in the previous example would have a
  salvage value of $3000 instead of $1000?




                                                             Dave Ludwick, Dept. of Mech. Eng.
                                                                                  Depreciation
                              31                                                 Summer 2008
                                                                     ENGG 401 X2 – Fundamentals of Engineering Management



Double Declining Balance vs. Straight Line (2)

                  $1,200.00


                  $1,000.00


                   $800.00                           Straight Line Depreciation
     Book Value




                   $600.00


                   $400.00


                   $200.00
                                  Double Declining Balance Depreciation
                      $-
                              0          2           4           6                   8                 10
                                                         Year


                                                                                           Dave Ludwick, Dept. of Mech. Eng.
                                                                                                                Depreciation
                                                   32                                                          Summer 2008
                                                          ENGG 401 X2 – Fundamentals of Engineering Management



Units-of-Production Depreciation
• The units-of-production depreciation method is used
  when the value of an asset might depend more on how
  much it’s been used, rather than how old it is.
   – Units of production can refer to such things as tons hauled,
     kilometres driven, hours used, widgets manufactured, etc.

• Units-of-production depreciation:
                                    Pt
                          dt                 B  S 
                                 PLifetime
   –   dt = depreciation expense in year t
   –   B = original value of asset
   –   S = salvage value
   –   Pt = production in year t
   –   PLifetime = total lifetime production of the asset
                                                                                Dave Ludwick, Dept. of Mech. Eng.
                                                                                                     Depreciation
                                             33                                                     Summer 2008
                                          ENGG 401 X2 – Fundamentals of Engineering Management



Units-of-Production Depreciation Problem
• You purchase a new $900 asset to be used in a sand and
  gravel pit that will only be in operation for five years, after
  which you expect to be able to sell it for $70. You decide to
  calculate its depreciation using the units-of-production
  method and expect it to be used different amounts in each
  year, as follows:
              Year          Sand and Gravel Needed
               1                    4000 m3
               2                    8000 m3
               3                   16000 m3
               4                    8000 m3
               5                    4000 m3

• Calculate the asset's annual depreciation charge and its
  remaining value each year.
                                                                Dave Ludwick, Dept. of Mech. Eng.
                                                                                     Depreciation
                                34                                                  Summer 2008
                                                           ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation and Taxes
• The Canadian Revenue Agency (CRA) permits a business
  to claim a Capital Cost Allowance (CCA) against it’s
  earnings for the period.
   – CCA is the tax equivalent of depreciation

• CCA is not calculated on a per asset basis, but rather all
  assets of a certain class are pooled together, and their total
  residual value is called Undepreciated Capital Cost
  (UCC).
   – UCC is the tax equivalent of book value

• CRA has specific rules regarding the method and rate a
  business can use to calculate CCA
   – Declining balance depreciation is used, but the exact rate varies by
     class of asset                                        Dave Ludwick, Dept. of Mech. Eng.
                                                                                Depreciation
                                            35                                                     Summer 2008
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Depreciation and Taxes (2)
• Tax depreciation is virtually always higher than book
  depreciation.
   – This means real taxes are initially lower than they would be if book
     depreciation were used for tax purposes.

• The difference between depreciation for accounting
  purposes and depreciation for tax purposes is called
  deferred taxes.
   – The difference between taxes paid according to the law and the
     taxes you would have paid if taxes were based on your actual
     depreciation
   – Deferred taxes, like depreciation, also appear on the income
     statement as a charge against income (the reduce book income)


                                                                      Dave Ludwick, Dept. of Mech. Eng.
                                                                                           Depreciation
                                    36                                                    Summer 2008
                                                ENGG 401 X2 – Fundamentals of Engineering Management



Depreciation and Taxes (3)
• Capital Cost Allowance (CCA) is the tax equivalent of
  depreciation
   – CCA uses the declining balance method, at various rates.

• Undepreciated Capital Cost (UCC) is the tax equivalent of
  book value
   – The value of all assets of a particular class are lumped together into
     one UCC for each class.

• One complicating factor in depreciation for tax purposes is
  the 50% rule or half-year convention.
   – For most assets, a business can only claim 50% of it’s normal CCA
     in the year in which it was acquired.
   – The full amount is claimed in all subsequent years.
                                                                      Dave Ludwick, Dept. of Mech. Eng.
                                                                                           Depreciation
                                    37                                                    Summer 2008
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Depreciation and Taxes Example
• Your company has six vehicles at UCC values listed:

        1998 Chevy Van          $ 22 465
        2002 Hyundai            $ 31 620
        2000 Honda Accord       $ 18 732
        1980 Ford Bronco        $ 2 419
        1995 Dodge Pick-up      $ 11 563
                       Total:   $ 86 799

• Calculate Class 10 CCA (i.e., 30% rate) if:
   –   Sell Accord for $20 000 in year 2
   –   Buy Toyota Land Cruiser for $26 000 in year 3
   –   Sell Bronco for $850 and purchase computer for $25 000 in year 5
   –   Sell all remaining vehicles for $9 000 total in year 6
                                                                     Dave Ludwick, Dept. of Mech. Eng.
                                                                                          Depreciation
                                    38                                                   Summer 2008
                                               ENGG 401 X2 – Fundamentals of Engineering Management



More on Depreciation
• The book value of any asset is strictly non-increasing.
   – In very rare cases, you can be permitted to change the rate of
     depreciation.

• If inflation or something else drove the market value of an
  asset up above the book value (or even it’s cost basis), you
  still cannot increase its book value.
   – Doesn’t matter if the book value was brought down by depreciation
     or even a writedown at some past point in time




                                                                     Dave Ludwick, Dept. of Mech. Eng.
                                                                                          Depreciation
                                   39                                                    Summer 2008

				
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