Depreciation

To lose value over time.

Like...let's say 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 a lot more than half the price you paid for it.

They depreciate worse than cars. Like, one hour after you drive that new car 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 milion). 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.