Example: An expanding company buys office desks and chairs for 10 new employees at a total cost of $7,000. Generally speaking, this type of asset lasts for 10 years. This means that the company will be “using up” 1/10th, or $700, of the desks and chairs in each of the next 10 years. If it recorded depreciation of $700 per year, this would be straight-line. However, the government may purposely allow companies to record depreciation in the early year(s) that is higher than the straight-line amount (in this example, higher than $700). Or, it may allow the company to fully depreciate the asset over a period of less than 10 years. This is referred to as accelerated depreciation.
Investeach explains: Allowing companies to accelerate depreciation is what governments do to motivate companies to invest in equipment. When companies buy equipment, it boosts the economy because equipment makers will do well. They will employ more people, who then go out and spend their money, which supports other businesses. Depreciation is a business expense. The higher it is, the lower the profit a company will achieve. The lower the profit, the lower the taxes the company will have to pay. Less taxes means more money left in the company’s bank account.
But, wait. We all thought the idea is for companies to grow their profits. So, why would a company want to lower them? The answer is that companies actually keep two sets of “books”: one which uses accelerated depreciation that is used to compute incomes taxes on profits as set forth by the IRS (Internal Revenue Service) and another which follows GAAP (Generally Accepted Accounting Principles). The books for the IRS allows for greater depreciation early in an asset‘s life and therefore lowers income taxes. The books kept for GAAP show a lesser depreciation in the early years of an asset‘s life but also the lower income taxes. Therefore, the GAAP income will be higher in the early years of an asset‘s life and it is the GAAP set of books that investors pay attention to.
Riddle me this:
- Why do governments allow companies to accelerate the depreciation of their equipment?
- Identify the two types of books a company simultaneously keeps.
- Which of the two allows the company to record a lower profit by taking advantage of accelerated depreciation?
- Which set of books do investors examine to assess the company’s performance?