Okay, so you’re a waffle-maker-maker, ironically named W’Awful, even though you’re not. Last year, you used manual labor to make your waffle makers, and made $100 million in profits, pre tax. You paid 30 percent in taxes and showed net income of $70 million. But then the union came to town, threatened a strike, wanting raises for all, and for you to hire a lot more people than you needed.
So, ticked off, you bought a robot waffle-maker-making factory for $300 million. That factory is expected to last 20 years before you can sell it for scrap for $100 million. You apply straight line depreciation when you think about accounting for the decline in value of the factory you’ve lovingly called The Union Replacer. That means that, each year, you will depreciate the same amount of value to the factory until you sell it 20 years after you bought it. During that time, it will depreciate in value $200 million, declining from the 300 you paid for it to the 100 you’ll sell it for.
So that’s a decline of $200 million over 20 years, or a depreciation amount of $10 million applied over that time period. You have a decent year, and make the same $100 million in pre-tax profits you did last year. Only this time, you have $10 million of depreciation you can apply to your costs. You paid $300 million up front for the equipment, but you don’t “lose” $300 million in that one year. Rather, you account for a decline in that value one year at a time. So you can depreciate $10 million against your $100 million of profits, and pay taxes on the remaining $90 million of taxable profits. At 30%, you pay $27 million in taxes. The depreciation you took...that $10 million each year...saved you $3 million in taxes, or made you an extra $3 million in earnings.
Did your cash profits change? Well, you kept $3 million more cash dollars because you saved taxes. But other than that, nothing changed. Except now you have a whole lot fewer workers to give you grief about your lousy coffee, and a shiny new set of robots to hang out with and beat you at chess.
So the math above is derived by applying straight line depreciation. But, in real life, if you’d just paid $300 million for a new factory, and one year later wanted to sell it…you’d be lucky to get much more than half the price you paid for it. They depreciate worse than cars. Like, one hour after you drive that new factory off the lot, blammo…it's worth a lot less.
So, what if you used more of a ‘market value’ approach to the depreciation you’re applying…
...and, in year one, you depreciated the value of the factory to be $80 million less…
...holding it at book value then to be worth only $220 million after year one?
Well, remember that $100 million of pretax profits - and we’re ignoring the depreciation up to this point to get that $100 million...
If you depreciated $80 million against those profit… ...you’d show only $20 million as taxable profits in year one after you bought the factory…
...and oh those union people would be crowing. In reality, however, nothing changed other than the way you are accounting for things. You still earned the $100 million in cash.
You still owe taxes. But instead of paying taxes of $30 million against the $100 million in the pre-robot-factory days… ...this time in year one, you show only $20 million of profits…
...and pay 30% on that number or $6 million in taxes to show net income of $14 million. Your real cash profits?
You made $100 million in cash profits… ...and you paid $6 million in taxes. So, you have $94 million in cash profits…...even though from an accounting perspective you show EARNINGS or NET INCOME of just $14 million.
The downside in depreciating a LOT of the factory up front? Well, you have fewer tax deductions from its depreciation in the future.
But the value of having that cash handy today is a lot to most companies…
….so they don’t mind having a notional high tax era coming a decade in the future.
Most of the management will be retired by then…
...and worried a lot more about their putting and wedge game…
...and staying out of sand traps made with old robot waffle makers.
Related or Semi-related Video
Finance: What are operating profits, net...59 Views
finance a la shmoop.what are gross profits operating profits and net
profits? well the greatest fishing company that walks the earth or swims
the ocean made a fortune last year from selling nets. catching things like well [fish is caught from the ocean]
me. but that's really a different thing and no Bueno. leave us alone. in an
accounting sense net profits come after operating profits that come after gross
profits .and the net thing is well pretty much taxes. so here's an income statement
yeah yeah revenues and then there's the cost of the stuff you're selling. okay
fine. we'll note the nets only cost a little bit to make and you sell them for
a fortune .way overpriced if you ask me. like whatever happened to line fishing
anyway lazy humans. so you have your revenues then your cost of goods sold.
all right well if you subtract those cogs from the revs you get your gross [income statement pictured]
profits. yeah gross just gross and sad frankly like why not eat more chicken
seriously. anyway .so then you have your costs of operating the business you know
overhead. secretaries and insurance and rent and fish-smell deodorizer. and then
you have operating profits after you subtract. them yep you subtract those
right from gross profits. get operating. so you made some number let's call it 10
million bucks why not .you know how many of my brethren died to give you that
money right? blood money. talk to Leo to see about it.
maybe he'll make a movie . anyway let's say the tax rates 30% well you'd pay 3
million in taxes on that 10 million of operating profit to then have net
profits of seven million dollars. lots of profits .there people. yeah hope you can [equation]
sleep at night.
Up Next
How does depreciation affect taxes? Depreciation accounts for a company’s assets losing their value over time. Companies are able to factor this...
Double declining balance sheet depreciation is a structure of formula under which companies assess the depreciating value of an asset that loses va...
A company has numerous operating expenses, but the primary ones have to do with payroll, sales and marketing, taxes and fees, office supplies, some...