Part 1, Lesson 7

Overview

Depreciation is the “expensing” of a fixed asset over its useful.  Depreciation is associated with tangible assets (assets that you can touch/feel).  Whereas, amortization is the “expensing” of an intangible asset.  This may include the cost of a patent, software development costs, and organizational costs.

The purpose of depreciation and amortization expense is to match the usage of an asset with the revenues it generates.  For example, if a business purchases a car with a useful life of 15 years.  The business will not simply “expense” this asset on the first day of purchasing it because this car will help the business to generate revenue over the course of its 15-year useful life.  Instead, the business will depreciate the cost of the car evenly over the course of 15 years.

Depreciating an asset evenly over the cost of its life is called “straight-line depreciation.”  However, we will not always depreciate an asset down to zero.  Even this car may have a value at the end of its 15-year life.  The remaining value of the asset at the end of its useful life is referred to as “salvage value.”

Let’s look at an example:

 Asset Purchased: Car Depreciable Life: 15 years Purchase Price: \$32,000 Salvage Value: \$2,000 Yearly Depreciation: \$2,000

How do we get to the \$2,000 yearly depreciation expense?

Depreciation Expense = (Purchase Price – Salvage Value) / Depreciable Life

Depreciation Expense = (\$32,000 – \$2,000) / 15 years

Depreciation Expense = \$2,000 per year

Let’s look at the depreciation schedule over the first five years:

 Year 1 Year 2 Year 3 Year 4 Year 5 FF&E \$32,000 \$32,000 \$32,000 \$32,000 \$32,000 Depreciation \$2,000 \$2,000 \$2,000 \$2,000 \$2,000 Accumulated Depreciation \$2,000 \$4,000 \$6,000 \$8,000 \$10,000 FF&E Less Accumulated Depreciation \$30,000 \$28,000 \$26,000 \$24,000 \$22,000

In the above depreciation schedule, we have introduced a new term, “accumulated depreciation.”  Accumulated depreciation sounds like what it is.  It is simply the sum of all prior years of depreciation.

When we study public company balance sheets, many companies will record FF&E at the original cost paid for these assets less the total amount of accumulated depreciation, which results in a net FF&E value.

Net FF&E = Gross FF&E – Accumulated Depreciation

Let’s look at a real-world example:

This is the balance sheet for Verizon (Ticker: VZ).  Notice that the above figures are reported in “USD \$ in Millions.”  Therefore, the \$257,143 in Total Assets at Dec 31, 2017 represents \$257 Billion worth of assets.

Now, let’s draw our attention to the red box, which we have highlighted in the Verizon balance sheet.  You will notice that Verizon lists the value of its Property, plant and equipment at its original cost of \$246.5 Billion.  Verizon then subtracts the total of all prior depreciation (accumulated depreciation) of \$157.9 Billion to arrive at a Net PP&E value of \$88.6 Billion.  Remember: “PP&E” and “FF&E” are terms that are often used interchangeably.

Straight-Line Depreciation vs. Accelerated Depreciation

In the preparation of GAAP financial statements, depreciation is predominantly presented on a straight-line basis.  As previously stated, this is meant to match the usage of the asset (depreciation) with the associated revenues.  If companies were allowed to depreciate 100% of an asset day 1 in their income statement, this would create exceptional lumpiness in the financial statements that may not convey the true profitability of the business.

For example, if John’s Pizzeria purchased a car for \$32,000 and recorded the entire amount as depreciation expense in year 1.  Then, the remaining 14 years of the useful life of the car would have no depreciation expense associated with it even though the car is still in service.  This would make Year 1 look less profitable and Years 2-15 look more profitable than it should be.  Avoiding these types of misinterpretations of profitability is generally why GAAP calls for the usage of straight line depreciation in company financial statements.

However, when it comes to the Internal Revenue Service (IRS), the taxing authorities have set up a different set of rules for depreciation, which has generally been created to encourage businesses to make capital expenditures (capex) by providing favorable tax treatment.

The IRS allows for accelerated depreciation of tangible assets, which is referred to as Modified Accelerated Cost Recovery System (MACRS).

MACRS depreciation sets out the schedule by which different types of fixed assets can be depreciation on a timeline that is faster than what would be possible under straight-line depreciation.  After the tax law changes of 2018, many fixed assets with lives under 15 years can be 100% depreciated in year 1.

Let’s use a hypothetical example to compare straight-line depreciation expense under GAAP vs. MACRS depreciation:

 Year 1 Year 2 Year 3 Year 4 Year 5 Straight-Line Depreciation FF&E (Car) \$32,000 \$32,000 \$32,000 \$32,000 \$32,000 Depreciation \$2,000 \$2,000 \$2,000 \$2,000 \$2,000 Accumulated Depreciation \$2,000 \$4,000 \$6,000 \$8,000 \$10,000 FF&E Less Accumulated Depreciation \$30,000 \$28,000 \$26,000 \$24,000 \$22,000 MACRS Depreciation* FF&E (Car) \$32,000 \$32,000 \$32,000 \$32,000 \$32,000 Accelerated Depreciation \$10,000 \$7,500 \$2,500 \$2,000 \$1,000 Accumulated Depreciation \$10,000 \$17,500 \$20,000 \$22,000 \$23,000 FF&E Less Accumulated Depreciation \$22,000 \$14,500 \$12,000 \$10,000 \$9,000

*For illustration purposes only, current IRS rules for depreciation of vehicles will differ from what is presented in this table

You will notice in this table that MACRS depreciation typically results in higher depreciation early in the life of the asset (Year 1 depreciation of \$10,000 under MACRS vs. \$2,000 under straight line), but lower depreciation later in the life of the asset (Year 5 depreciation of \$1,000 under MACRS vs. \$2,000 under straight line).

The reason why companies and investors prefer accelerated depreciation is due to the time value of money.  Reporting higher depreciation expense earlier on results in tax savings, which can be reinvested into other ventures which may generate additional returns.

Money today is always more valuable than money received tomorrow.  In Part 2 of this guide, we will discuss the principles of present value, which will explain why money received today is more valuable than money received in the future.

Due to the two different types of depreciation, companies will maintain two sets of records – 1) GAAP financials and 2) tax financials.  The GAAP financials are used in the presentation to investors, reporting to the Securities and Exchange Commission, reporting to lenders, etc.  Whereas, the tax financials are only reported to the IRS for the calculation of cash taxes owed to the government.

Does MACRS depreciation manifest itself at all in the GAAP financial statements?

Yes.  MACRS depreciation essentially results in changes to the timing of the payment of income taxes.  This results in actual cash tax payments that will be lower than what appears in the GAAP income statement in the early years of the depreciable life of an asset and higher cash tax payments vs. the GAAP income tax liability in the later years of an asset.

This is accounted for in the cash flow statement typically in a line item such as “Deferred Income Taxes.”  There are numerous factors that can affect the deferred income taxes line item in the cash flow statement, but accelerated depreciation is one of these items.

For example, if our pre-tax income in our GAAP financial statement is \$100, and we use an assumed tax rate of 30%, then our income tax expense will be \$30 as it appears in the income statement.  However, if the pre-tax income under the tax books is \$70 due to higher depreciation from MACRS, then, the actual cash tax payment for income taxes will be \$21.

In the cash flow statement, deferred taxes would show a source of cash of \$9 to account for the difference in the \$30 income tax expense which was recorded in the income statement vs. the \$21 that was actually paid to the IRS.