ShmoopTube

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

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

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

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

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

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

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bought a robot waffle maker making factory for three hundred million

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dollars. well that factory is expected to last

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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depreciate ten million dollars against your hundred million dollars of profits

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

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

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

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

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

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

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

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

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

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

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

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

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factories depreciate way worse than cars

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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bucks. your real cash profits well you made a

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

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

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

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

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

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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]

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

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

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

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

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