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Finance: How Does Depreciation Affect Taxes? 40 Views
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How does depreciation affect taxes? Depreciation accounts for a company’s assets losing their value over time. Companies are able to factor this in when calculating their taxable income, which leads to them paying less in taxes.
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Transcript
- 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]
Full Transcript
- 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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