Depreciation directly affects a corporation's tax liability. How much effect it has in a given year depends on the value of the asset being depreciated, the length of time over which the company is depreciating the asset, and the depreciation schedule the company uses. The larger the depreciation expense in a given year, the larger the tax savings in that year.
Depreciation allows a company to spread the cost of an asset over that asset's anticipated lifespan. If a company buys a factory that it expects to last for 40 years, for example, it doesn't immediately report an expense for the full cost. Rather, it claims a depreciation expense every year for a portion of the cost. This is line with the "matching principle" of corporate accounting, which says that when companies report revenue, they must also report any expenses involved in earning that revenue, and they must report those expenses in the same period as the revenue. Depreciating the factory, then, allocates a chunk of the purchase price to each year that the factory is expected to produce revenue.
Income and Tax Effects
A corporation's depreciation expense directly reduces that company's pretax earnings, which is the amount upon which the company pays corporate income taxes. So, the larger the depreciation expense, the greater the reduction in pretax earnings, and the greater the reduction in the corporation's tax liability.
Accounting standards give corporations a choice in how they handle depreciation. The simplest method, and the most common, is straight-line depreciation. Under this method, the company records the same amount of depreciation expense each year, and thus realizes the same tax benefit every year. But companies can also choose an "accelerated" depreciation schedule, which allows for bigger depreciation expenses -- and bigger tax savings -- in earlier years and smaller ones in later years. In theory, since the same amount will be depreciated over the life of the asset, the tax benefit will even out, and the company will pay the same as it did under straight-line depreciation. But as an old saying goes, a dollar today is worth more than a dollar tomorrow. The company can take the early tax savings, invest that money, and, if all goes well, earn a return that at least partially offsets the future taxes. Also, the company is pushing its taxes into the future, where inflation may have the effect of reducing their cost.
Say a company buys a $100,000 machine that has a useful life of 10 years and that will have no residual value at the end of that 10 years, so the full cost can be depreciated. Under straight-line depreciation, the company simply takes a $10,000 depreciation expense each year, reducing pretax earnings by $10,000. Assuming the company pays 35 percent in corporate income taxes, that translates into a $3,500 tax savings each year. Under an accelerated depreciation schedule, the company might take a yearly depreciation expense of 40 percent of the "net book value" of the machine -- that is, the cost minus the accumulated depreciation. In the first year, the company claims an expense for 40 percent of $100,000, or $40,000. That translates into a $14,000 tax savings. The next year's expense is 40 percent of $60,000, or $24,000, which produces a tax savings of $8,400. Each year, the expense decreases, and so does the tax savings. In the last year, the company claims a depreciation expense for whatever's left. Under this schedule, that's about $1,000, or a tax savings of $350.
A Note on IRS Rules
The Internal Revenue Service (IRS) has a say in how long a company can depreciate certain assets. It may say, for example, that a particular type of vehicle has a useful life of seven years while the company believes the life is 10 years. The company can still claim a 10-year depreciation schedule in its own financial statements, but for tax purposes, it must follow the IRS standards. However, it can still choose between straight-line and accelerated depreciation.
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