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.

Related or Semi-related Video

Finance: How Does Depreciation Affect Ta...40 Views

00:00

- a la shmoop. how does depreciation affect taxes? okay you're a waffle maker

00:08

maker. ironically named waffle- even though you're not. last year you use [man grins on screen]

00:13

manual labor to make your waffle makers and made a hundred million dollars in

00:18

profits pre-tax you paid 30% in taxes and showed net income of 70 million

00:24

bucks .but then the Union came to town threatened to strike wanting raises for [equation]

00:28

all and for you to hire a lot more people than you need, so ticked off you

00:33

bought a robot waffle maker making factory for three hundred million

00:38

dollars. well that factory is expected to last

00:41

twenty years before you can sell it for scrap for a hundred million dollars. you [equation]

00:45

apply straight-line depreciation. when you think about accounting for the

00:48

decline in value of the factory you've lovingly called the Union replacer, that

00:52

means that each year you will depreciate the same amount of value to the factory

00:58

until you sell it 20 years after you bought it. during that time it will [100 dollar bill]

01:02

depreciate in value two hundred million dollars declining from the three hundred

01:07

you paid for it to the hundred you'll sell it for got--it's that's a decline

01:11

of two hundred dollars over twenty years or a depreciation amount of ten million

01:14

dollars applied over that time each year. you have a decent year next year and

01:18

make the same hundred million dollars in pre-tax profits you did last year only [man gives presentation]

01:22

this time you have ten million dollars of depreciation you can apply to your

01:26

costs or expenses. you paid three hundred million dollars up front for that

01:30

equipment but you don't lose three hundred million dollars in that one year.

01:34

rather you account for a decline in that value one year at a time. so you can [balance sheet]

01:40

depreciate ten million dollars against your hundred million dollars of profits

01:45

and pay taxes on the remaining ninety million of taxable profits. at thirty

01:50

percent you pay twenty seven million dollars in taxes. well the

01:54

depreciation you took that ten million dollars each year saved you three

01:58

million dollars in taxes, or made you an extra three million dollars in earnings. [equation]

02:03

did your cash profits change? well you kept three million more cash dollars

02:09

because you saved that amount in taxes you'd have had to pay otherwise.

02:13

but other than that, nothing changed. except now you have a whole lot fewer [man speaks to robot]

02:16

workers to give you grief about your lousy curried coffee and a shiny new set

02:21

of robots to hang out with and beat you at chess. so the math above is derived by

02:25

applying straight-line depreciation. but in real life if you just paid 300

02:30

million dollars for a new factory and one year later wanted to sell it well [2 smiling men]

02:33

you'd be lucky to get a lot more than half the price you paid for it. and

02:37

factories depreciate way worse than cars

02:39

you know like one hour after you drive that new factory off the lot blammo it's

02:43

worth a lot less. so what if you used more of a market value approach to the [man drives red sports car]

02:48

depreciation you're applying. and in year one you depreciated the value of the

02:53

factory to be eighty million dollars less holding it now at a Book value than

02:58

to be worth only two hundred twenty million dollars after year one. well

03:02

remember that hundred million dollars of pre-tax profits, and we're ignoring the [man speaks to camera]

03:05

depreciation up to this point to get that hundred million. if you depreciated

03:09

80 million dollars against those profits well you'd show only 20 million dollars

03:14

as taxable profits in year one after you bought the factory. and all those union

03:20

people would be crowing. in reality however nothing changed other than the

03:25

way you are accounting for things. you still earn the hundred million dollars

03:29

in cash you still owe taxes but instead of paying taxes of 30 million against a [equation]

03:35

hundred million in pre robot factory day profits. this time in year 1 you show

03:40

only 20 million dollars in taxable profits and you pay 30 percent on that

03:45

number or 6 million dollars in total taxes to show net income of 14 million

03:50

bucks. your real cash profits well you made a

03:53

hundred million dollars in cash profits and you paid 6 million in taxes and Wow

03:58

now you have 94 million dollars in cash profits even though from an accounting [equation]

04:03

perspective you show earnings or net income of just 14 million dollars. the

04:08

downside in depreciating a lot of the factory up front well? you have fewer tax

04:13

deductions from its depreciation in the future but the value of having that cash

04:18

handy dandy today is a lot to most companies so they don't mind having a [robots standing around man in a pile of cash]

04:22

notionally high tax Eric a decade in the future. most of the

04:25

management will be retired by then anyway, and worried a lot more about

04:29

their putting and wedge game and you know staying out of sand traps made with

04:33

old robot waffle maker makers. [golf ball in sand]

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