Depreciation
Depreciation is the distribution of the cost of fixed assets over a period of time.
Two types:
- Straight-line depreciation: Distribution of the cost is the same amount for each year.
- Accelerated depreciation: Distribution in larger amount during initial years and
smaller during the later years.
Importance of depreciation:
1) Since it is an expense, the firm's earning and taxes are altered by it.
2) Since it is a non-cash expense, it can be treated as a source of cash for the firm.
Straight-line depreciation
E.g. A company buys an equipment at $400 which has a useful life of four years. Using a straightline depreciation, the annual depreciation is $400/4 = $100. The sale of goods is $900, and the
operating cost and administrative expenses is $500. The company will have $900 - $500 - $100 =
$300 profit. The company then pays corporate income tax on its earning of $300 and not on the
earnings before the depreciation expense ($400). If the corporate income tax is 25%, the company
pays $75 (0.25 X $300) in taxes instead of the $100 (0.25 X $400) it would have to pay if the
depreciation expense were omitted.
Key point: Since depreciation reduces the company's earnings, it also reduces its income taxes.
Continuing with the above example, the $100 depreciation expense did not involve the company
forking out cash. The operating cost and administrative expenses required the company to fork out
money but not the depreciation expenses. The company only needs to purchase the equipment
initially and not while it was being used i.e. depreciation is a non-cash expense. Only the operating
expenses and the tax required an expenditure of cash ($500 + $75). The company has $325 ($900 $575) left. This is the $225 profit and the $100 depreciation expense that is added back to the
profits to get the cash flow generated by operations. So, the company may use this $100 generated
by the depreciation asset to purchase a different asset or pay dividends etc.
Key point: Since depreciation is a non-cash expense, it can be treated as a source of cash.
A simple income statement for the company:
Sales
Operating expenses
Income before depreciation
Depreciation
Taxable income
Taxes
Net income
900
500
400
100
300
75
$225
Accelerated depreciation
Depreciation charges are larger when the plant and equipment are new and smaller when the plant
and equipment are old. This variation affects the company's earnings. When the depreciation charge
is larger, the company's profits and corporate income taxes are smaller. Using accelerated
depreciation helps the company to decrease its profits and taxes but increase its cash flow
initially.
Comparison of methods of depreciation
All methods of depreciation distribute the cost of plant and equipment over a period of time. The
differences are their effects on the company's earnings, which in turn affect the company’s taxes
and cash flow. Both straight-line and accelerated depreciation methods give the same amount of
total depreciation expense, net income after taxes etc.
If both methods give the same results, why bother to use accelerated depreciation?
Timing of taxes and the cash flows. Accelerated depreciation increases the company's cash flow
during the early years of the asset's life and delays the payment of taxes to the later years of the
asset's life. Thus, this allows the company to invest and increase earnings. By deferring taxes, the
company is receiving a current loan from the government.
Accelerated depreciation
Increased cash flow, deferred taxes
Invest in more plant & equipment
Increased productivity
Increase level of employment for workers must
build and operate the plant and equipment after it
has been installed