Okay, so 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 much more than half the price you paid for it. They depreciate worse than cars. Like, one hour after you drive that new factory 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 million...
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: What is Double Declining Balanc...10 Views
Finance a la shmoop what is double-declining balance sheet
depreciation kind of sounds like that strange-looking British double-decker [Buses in London]
bus right but it's not instead it's a structure or formula under which [Definition of a double declining balance sheet]
companies assess the depreciating value of an asset that you know loses value
it's basically the way they lose or track the loss of value in it that's [Guy talking on a London street]
different from normal depreciation like a tractor smelting Factory or the break [A bucket of molten metal being poured]
room vending machine which used to deposit KitKat bars but has been hanging [KitKat bar gets stuck in the machine]
on to that one bar since 1992 we got to depreciate those well if Shmaterpiller
has a smelting Factory they paid a hundred million bucks to build which [100 million bucks price tag appears]
will be sold for salvage value or scrap for ten million bucks in 20 years then
the decline in total value over that time will be ninety million bucks yep [Decline in value calculation]
over twenty years or four and a half million dollars each year if the company
used straight-line depreciation to account for the loss in value of that [Straight line on a value/time graph]
smelting Factory but under double declining balance depreciation systems
the deduction rate is essentially double the straight-line amounts it's still the
same total amount of deduction it's not like the value of the tractor factory
changed either at purchase time or scrap time but the speed and timing of the [Timeline of depreciation]
depreciation changed to favor high depreciation in the early years giving
the company lower profits but also lower taxes [The first 5 years on the timeline are highlighted]
well the accounting rationale follows suit the utility or value of the asset
is in fact not declining in true market value in a steady state straight-line [Stop sign appears over the value graph]
over twenty years try to convince a buyer that your car
has depreciated only five percent in value a year after you bought it new [Car for sale on eBay]
yeah not happening depreciate way more than that so in double declining balance
depreciation instead of deducting four-and-a-half million bucks a year the
company would deduct nine million a year each year with some adjustments along
the way and yes we're way over generalizing on that statement until [Overgeneralizing flashing red]
that smelting Factory was fully deducted away to whatever terminal salvage value
or scrap value they predicted it would then sell [Factory value declining]
for that is if a normal depreciation was taking four-and-a-half million bucks a
year for 20 years or four-and-a-half percent of the total initial cost then [Straight line depreciation per year]
double declining balance depreciation would take double that number or nine
percent of the hundred million dollars in year one
so they deduct nine million right upfront and your one right goes from 100
to ninety one on the sheets and in reality that's probably a lot closer to [Price tag decreasing]
what the actual loss and market value of the smelting machine and would look like
all right well then in year two double declining balance depreciation would
again take double the flat rate of that four inhabitant they double it to nine
percent of the remaining book value of the smelter or nine percent of the
remaining 91 million that it's worth or about 8.2 million in incremental [Double declining balance depreciation per year]
depreciation for that year leaving the value ninety one - 8.2 or eighty two
point eight million dollars in year three the value of the shelter would
drop another nine percent to about seventy five point four million say we
did all the math therefore there no extra charge and in year four down nine [Post it note showing the calculation]
percent again to around sixty eight point six million dollars so up to this
point the set of deductions would look like this there we go all that stuff you [Amount depreciated in the first 4 years is shown]
notice that as we've gone along here we've taken the beginning of the year
book value of the smelter as the starting point against which to take our
nine percent deduction if we take nine percent always well we'll never get to
zero or rather to the scrap value target there of ten million bucks right nine [The value in the 20th year is shown]
percent and keep just being a tiny tiny amount on those out years so in practice
at some point when companies have depreciated the crap out of their
capital assets well then they switch to straight-line depreciation in this case
after say year five our smelter would be valued at sixty two point four million
dollars ish with fifty two point four million left to depreciate to hit that
ten million dollar scrap value for about three point five million a year for the [Calculation of loss per year is shown]
remaining fifteen years until finally yes Bessie is a put out to pasture the [The factory is thrown into the trash]
gist of double declining balance sheets appreciation is to let companies pay
less in taxes early in their history having more cash to
build their businesses and grow faster at the price of showing lower accounting
earnings and that's just okay with Wall Street so yeah here's to hoping they [Someone doing an okay sign next the Wall St. sign]
deploy that cash into after know something a little more fun [Money going down a water slide]
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