Taxes and Depreciation

Learning Outcomes

  • Understand how long-term assets are depreciated and how that affects taxes

Let’s review the custom hat embroidery machine investment analysis from the previous reading:

Capital Investment
Description Amount
Embroidery machine $  40,000

 

Annual Cash Flows
YR 1 YR 2 YR 3 YR 4
Hats (2,500 * $4) $  10,000 $  10,000 $  10,000 $  10,000
Shipping (2,500 * $1)       2,500       2,500       2,500       2,500
  Total cash out Single Line$  12,500Double line Single Line$  12,500Double line Single Line$  12,500Double line Single Line$  12,500Double line
Sales Revenue (2,500 * $10) $  25,000Double line $  25,000Double line $  25,000Double line $  25,000Double line

 

Cash in Cash out Net Cash Flow
Year 1 $  25,000 $  52,500 $(27,500)
Year 2 $  25,000 $  12,500 $  12,500
Year 3 $  25,000 $  12,500 $  12,500
Year 4 $  25,000 $  12,500 $  12,500
Single Line$  10,000Double line

 

Now, let’s look at this from a financial accounting perspective. For financial accounting, the cost of the equipment is “depreciated” over the useful life of the asset, in this case, four years. Tax rules differ from Generally Accepted Accounting Principles, but we will use this “straight-line” method here to compute the tax effect of the investment, sometimes called the “tax shield”. Entire volumes have been written on tax depreciation, so that is a topic for a much more advanced course.

Our $40,000 machine has no residual value, so we will depreciate the entire purchase price by dividing it by 4 years. We could also divide by 10,000 units and depreciate the machine at $4 per unit, but in our example, this will give us the same result because we are assuming production and sales of 2,500 units per year.

Income Statement (accrual basis)
YR 1 YR 2 YR 3 YR 4
Sales Revenue $  25,000 $  25,000 $  25,000 $  25,000
Cost of Goods Sold 10,000 10,000 10,000 10,000
Gross Profit Single Line15,000 Single Line15,000 Single Line15,000 Single Line15,000
Subcategory, Expenses Single Line Single Line Single Line Single Line
    Depreciation 10,000 10,000 10,000 10,000
    Shipping       2,500       2,500       2,500       2,500
        Total expenses Single Line12,500 Single Line12,500 Single Line12,500 Single Line12,500
Net operating income Single Line$   2,500Double line Single Line$   2,500Double line Single Line$   2,500Double line Single Line$   2,500Double line
Net operating income $   2,500 $   2,500 $   2,500 $   2,500
Subcategory, Add back non-cash expense
  Depreciation 10,000 10,000 10,000 10,000
Cash flow Single Line$  12,500Double line Single Line$  12,500Double line Single Line$  12,500Double line Single Line$  12,500Double line

 

In this case, our net operating income can be used for taxable income (there are many more adjustments between financial accounting and tax accounting, but we’re just isolating depreciation here). Let’s assume that our investor in this case has a marginal tax rate (rate paid on the next dollar or taxable income) of 25%.

Here is an income statement including taxes at 25% without equipment depreciation:

Income Statement without depreciation
YR 1 YR 2 YR 3 YR 4
Sales Revenue $  5,000 $  5,000 $  5,000 $  5,000
Cost of Goods Sold 10,000 10,000 10,000 10,000
Gross Profit Single Line15,000 Single Line15,000 Single Line15,000 Single Line15,000
Subcategory, Expenses Single Line Single Line Single Line Single Line
    Depreciation             –             –             –             –
    Shipping       2,500       2,500       2,500       2,500
      Total expenses Single Line      2,500 Single Line      2,500 Single Line      2,500 Single Line      2,500
Taxable income Single Line    12,500 Single Line    12,500 Single Line    12,500 Single Line    12,500
Income tax expense       3,125       3,125       3,125       3,125
Net income after tax Single Line$  9,375 Single Line$  9,375 Single Line$  9,375 Single Line$  9,375

 

And here is that same statement including depreciation:

Income Statement (accrual basis)
YR 1 YR 2 YR 3 YR 4
Sales Revenue $  25,000 $  25,000 $  25,000 $  25,000
Cost of Goods Sold 10,000 10,000 10,000 10,000
Gross Profit Single Line15,000 Single Line15,000 Single Line15,000 Single Line15,000
Subcategory, Expenses Single Line Single Line Single Line Single Line
    Depreciation 10,000 10,000 10,000 10,000
    Shipping       2,500       2,500       2,500       2,500
      Total expenses Single Line    12,500 Single Line    12,500 Single Line    12,500 Single Line    12,500
Taxable income Single Line      2,500 Single Line      2,500 Single Line      2,500 Single Line      2,500
Income tax expense           625           625           625           625
Net income after tax Single Line$   1,875Double line Single Line$   1,875Double line Single Line$   1,875Double line Single Line$   1,875Double line

 

Notice that by allowing companies to deduct the cost of the asset (in this case the embroidery machine) ratably over the life of the asset, the company gets to deduct that original investment to arrive at taxable income. The difference is called the tax shield or tax benefit.

In this case, the tax shield is $2,500 per year (the $3,125 in taxes without the benefit less the $625 in taxes with the benefit). Traditionally, the annual tax shield is calculated by multiplying the amount of the deduction ($10,000) by the tax rate (25%).

Often, in calculating cash flows, the tax shield is included as a positive cash flow, since it represents a decrease in expense.

Residual value is the amount of proceeds expected to be realized on the sale of the asset. It is not necessarily the market value, since an asset may be disposed of other than by selling.

Let’s check your understanding of depreciation and taxes.

Practice Question