What is Depreciation?

By: Donald Archer

Having completed more than fifteen hundred cost segregation studies, I have come to realize many of our clients do not understand the concept of depreciation as it relates to their businesses. Many of my students likewise had a vague idea of depreciation and its value as a measure of a company’s worth. Simply stated, depreciation is the cost a company charges itself for the use of an asset it has purchased for the purpose of earning revenue.

An asset has value when first purchased and is used to produce a product or assist in earning revenues as a supporting element of the business (i.e. office furniture, sales force automobiles, office buildings and warehouses, etc.). Companies must recover the cost of an asset by using it in their business over a pre-determined time period. This is typically accomplished by depreciation methods calculated on an annual basis. The yearly depreciation cost is included in the annual operating cost of a business and subtracted from total revenues to determine the gross profit of the company. In this simplified example, it is readily seen how depreciation can affect the company’s performance.

Depreciation can be managed to increase the profitability or tax liability of a business. For example, a business may want to decrease their tax liability in a given time period by increasing their depreciation cost. Note that by increasing their depreciation cost a company is reducing their taxable profit (other things being equal) thus decreasing their taxes in that year.

One may ask how does a company increase their depreciation costs? The answer lies in the structure of the depreciation schedules. For the most part, depreciation is divided between real and personal property. The former is depreciated over thirty-nine years at a straight-line rate (an equal amount each year for the depreciable period) whereas personal property is depreciated at an accelerated rate in most cases for five or seven years. A third category allows a company to depreciate land improvements at an accelerated rate over fifteen years. As one can see, the accelerated rates produce a larger depreciation cost in the early years decreasing to zero depreciation at the end of their time periods resulting in a sizeable positive cash flow.

Using the accelerated depreciation methods allows a company to take advantage of an unforeseen benefit. If a company compares the straight-line depreciation for an asset versus the accelerated amount, then the company will realize a positive cash flow for several years before turning negative when the personal property components have reached their zero-economic (the initial investment cost shall have been fully recovered) value. The positive cash flow is the result of an exchange of a cash transaction (tax liability) for a non-cash transaction (depreciation). The cash flow is cumulative until the personal property is fully depreciated (typically in year six to year fifteen). See the attached spreadsheet for an illustration of the annual and cumulative cash flow generation.

The lesson to be learned here is that businesses would be wise to increase their early depreciation costs for new assets and defer their tax liability in order to increase their real cash flow. The value of the tax deferrals will decline the longer the depreciation-induced cash flow remains positive due to the time value of money.

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