2.3. Depreciation tax shield

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Do curso por Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

ratings

Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

ratings

Curso 3 de 5 em Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

Na lição

Operational Assets. Depreciation. Short-Term Investments. Long-Term Liabilities. Shareholders’ Equity. Some Tax Issues

Week 2 is devoted to long-term assets and liabilities. We start with operational assets and see the role of depreciation and amortization in financial accounting and compare it to the way depreciation is used in valuation of investment projects. Then we discuss how financial investments in securities – stocks and bonds – are treated in accounting dependent upon goals and time horizon of holding and/or issuing of these securities. You will see how financial concepts (present values) are used in accounting for bond premium/discount amortization. Finally, an overview of the accounting approach to taxes is provided. On an example, you will study the core idea of deferred taxes.

2.1. Operational assets – types and accounting approach13:17

2.2. Depreciation11:14

2.3. Depreciation tax shield8:53

2.4. Intangible assets – accounting and amortization7:22

2.5. Short-term investments in bonds10:19

2.6. Short-term investments in stocks12:33

2.7. Bonds (1) – parameters and accounting approach10:31

2.8. Bonds (2) – amortization of premium/discount13:34

2.9. Equity (1) – accounting for common and preferred stock11:37

2.10. Equity (2) – treasury stock and stock dividends12:15

2.11. Accounting for taxes – an overview9:11

2.12. Deferred taxes – an example8:32

Conheça os instrutores

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now let's say a few words about why we care so much about depreciation.

We said that this is because depreciation produces, quotedly, some cash savings.

Namely because it reduces the taxable income.

It leads to the lower tax payments, and therefore the bottom line is higher.

Now, what I am talking about right now is not quite new.

Because we dealt with that in our corporate finance course.

Then we talked about depreciation tax shield.

Now I'd like to say a few words that they're mostly similar.

But it's, first of all, worthwhile repeating.

And second of all, in the context of accounting, it shows that we see

full consistency of the approaches that are used by accountants and financiers.

All right, so we talk about depreciation tax shield.

So we claimed before that depreciation sort of shields cash flow.

Let's see how exactly that goes.

So we said that it reduces taxable income.

We will go on and say this is the income statement, in the most general way.

And it starts with revenues, right?

Then we subtract cost of goods sold.

Well, this is gross margin, but I will also subtract all other,

Cash, Expenses, and

that results in the famous abbreviation that's called EBITDA.

That stands for earnings before interest, taxes, depreciation, amortization.

Now, and I will put that in red because this is the key topic,

we subtract depreciation and amortization.

And that results to the next line in our income statement, that is EBIT.

So you see we sort of cut some of these.

Then we subtract interest, and then we arrive at earnings before taxes.

And then, finally, we here subtract taxes, and

that leads to our net income.

So this is the bottom line of the income statement.

Well, let's, for simplicity, ignore interest.

And therefore, that will be sort of like this, like this.

But everything else will stay the same.

And in this case, the first question goes, how

much do we pay in terms of the tax payment, the cash tax payment?

Well, in order to do so, we first of all have to take the taxable income and

then multiply that by the tax rate.

So let's say that T is the tax rate.

What is the taxable income here?

You see that all this are expenses, but

then also depreciation amortization is also.

Again, I will not use DA, I will use only D.

Because for amortization it's sort of similar.

So basically, if we ignored interest, then this line becomes the same.

So we see that this is our taxable income.

And for us, it will be EBITDA, D,

so this is the taxable income.

Then we multiply by tax, so this is tax payment.

Now, let's see, what do we have left?

We can say that our cash flow.

I will put is approximately equal, just because there are some other

minor items that we're sort of not paying much attention at right now.

So this is this, and from that,

if we ignore interest, we just subtract our tax payment.

Because, again, depreciation is not a cash expense, so this is sort of on paper.

So when we recognize this expense, not a penny of cash changes hands.

Then cash flow is approximately equal to EBITDA.

This is less tax payment,

Which is equal to EBITDA -, and

here we'll put this amount,

(EBITDA- D)T.

And then I regroup and get the result, which is EBITDA,

Times (1- T) +, and I will put that in red, DT.

This is depreciation tax shield of the multiple

of depreciation charge for this year times the tax rate.

So basically, see what happens.

So if we take the income before depreciation,

and then we apply taxes to this amount,

then our cash flow to get the proxy of that,

we have to add back this depreciation tax shield in the form of DT.

Well, let me remind you what we did.

Remember, in corporate finance, we dealt with accrual and annual costs.

And for costs, we used these depreciation tax shields.

So that was exactly what I put on the previous page of the flip chart.

However, when people engage in evaluation,

oftentimes they look over the income statement.

And they say, wait a minute, we've been taught to take the net income and

then add back the full amount of depreciation.

And this is right, there is no contradiction here.

Let's see why is that so.

Well, we go back to some formulas.

NI = (EBITDA- D) (1-T).

So this is by definition, and now I regroup.

This is (EBITDA) (1- T), so

I multiply that EBITDA times 1-T.

Now,- D + DT, see what happens, so this,

Is sort of cash flow that we had before.

So now we can say that cash flow is approximately equal to NI + D.

This is this one, so this goes here, and this, it becomes cash flow.

So basically, you really have to keep this in mind.

So when you see all these huge financial statements, so

you see the income statement, boom, boom, boom, boom, boom, boom,

boom, you go all the way down to EBITDA.

Then you see the line, depreciation, and then you go back to the line, net income.

Then the proxy for cash flow, if you did the NPV or

PV calculations, you just take this and add back this line of depreciation.

And that would be the same as if you would be working on a cost basis,

as we had in the previous page of the flip chart.

Well, I've seen in my practice many a time that people were really confused by that,

but there's no confusion.

That is why I am torturing you with derivation of these formulas for

the second time in this specialization, because it's worth it.

Because if people do not get confused, then they sort

of cope with that easier, and they feel much better.

So this is why we put so much emphasis on that.

Because after all, remember that in our evaluation procedures,

we have to deal with the forecasts of cash flows.

And that is why we said that accounting may be better in this.

And that is why we use the income statement data instead of just the data

from the statement of cash flow.

But then if we added back depreciation, we have a good proxy for

cash flow to later use that evaluation process.

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