Half-Year Convention For Depreciation
Categories: Accounting, Metrics
You run a sausage-making factory. In February, you buy a brand new, shiny casing-stuffing machine. Fast-forward to the end of the year: you're getting the books ready for tax time, and you need to figure out how much depreciation to take on the casing stuffer. You know how much depreciation would be standard for the full year. But you bought the machine in February, installed it in March, and it didn't start stuffing casings until early April.
You've hit an accounting conundrum.
Luckily, there's a rule-of-thumb to help you out. It's called the half-year convention for depreciation.
It says that, if you acquire an asset during a year, you can assume a half-year of depreciation. So in the first year, you take half the depreciation that would be standard for the first year. The remaining half-year gets added to the final year of the asset's depreciation schedule.
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- a la shmoop. how does depreciation affect taxes? okay you're a waffle maker
maker. ironically named waffle- even though you're not. last year you use [man grins on screen]
manual labor to make your waffle makers and made a hundred million dollars in
profits pre-tax you paid 30% in taxes and showed net income of 70 million
bucks .but then the Union came to town threatened to strike wanting raises for [equation]
all and for you to hire a lot more people than you need, so ticked off you
bought a robot waffle maker making factory for three hundred million
dollars. well that factory is expected to last
twenty years before you can sell it for scrap for a hundred million dollars. you [equation]
apply straight-line depreciation. when you think about accounting for the
decline in value of the factory you've lovingly called the Union replacer, that
means that each year you will depreciate the same amount of value to the factory
until you sell it 20 years after you bought it. during that time it will [100 dollar bill]
depreciate in value two hundred million dollars declining from the three hundred
you paid for it to the hundred you'll sell it for got--it's that's a decline
of two hundred dollars over twenty years or a depreciation amount of ten million
dollars applied over that time each year. you have a decent year next year and
make the same hundred million dollars in pre-tax profits you did last year only [man gives presentation]
this time you have ten million dollars of depreciation you can apply to your
costs or expenses. you paid three hundred million dollars up front for that
equipment but you don't lose three hundred million dollars in that one year.
rather you account for a decline in that value one year at a time. so you can [balance sheet]
depreciate ten million dollars against your hundred million dollars of profits
and pay taxes on the remaining ninety million of taxable profits. at thirty
percent you pay twenty seven million dollars in taxes. well the
depreciation you took that ten million dollars each year saved you three
million dollars in taxes, or made you an extra three million dollars in earnings. [equation]
did your cash profits change? well you kept three million more cash dollars
because you saved that amount in taxes you'd have had to pay otherwise.
but other than that, nothing changed. except now you have a whole lot fewer [man speaks to robot]
workers to give you grief about your lousy curried coffee and a shiny new set
of robots to hang out with and beat you at chess. so the math above is derived by
applying straight-line depreciation. but in real life if you just paid 300
million dollars for a new factory and one year later wanted to sell it well [2 smiling men]
you'd be lucky to get a lot more than half the price you paid for it. and
factories depreciate way worse than cars
you know like one hour after you drive that new factory off the lot blammo it's
worth a lot less. so what if you used more of a market value approach to the [man drives red sports car]
depreciation you're applying. and in year one you depreciated the value of the
factory to be eighty million dollars less holding it now at a Book value than
to be worth only two hundred twenty million dollars after year one. well
remember that hundred million dollars of pre-tax profits, and we're ignoring the [man speaks to camera]
depreciation up to this point to get that hundred million. if you depreciated
80 million dollars against those profits well you'd show only 20 million dollars
as taxable profits in year one after you bought the factory. and all those union
people would be crowing. in reality however nothing changed other than the
way you are accounting for things. you still earn the hundred million dollars
in cash you still owe taxes but instead of paying taxes of 30 million against a [equation]
hundred million in pre robot factory day profits. this time in year 1 you show
only 20 million dollars in taxable profits and you pay 30 percent on that
number or 6 million dollars in total taxes to show net income of 14 million
bucks. your real cash profits well you made a
hundred million dollars in cash profits and you paid 6 million in taxes and Wow
now you have 94 million dollars in cash profits even though from an accounting [equation]
perspective you show earnings or net income of just 14 million dollars. the
downside in depreciating a lot of the factory up front well? you have fewer tax
deductions from its depreciation in the future but the value of having that cash
handy dandy today is a lot to most companies so they don't mind having a [robots standing around man in a pile of cash]
notionally high tax Eric a decade in the future. most of the
management will be retired by then anyway, and worried a lot more about
their putting and wedge game and you know staying out of sand traps made with
old robot waffle maker makers. [golf ball in sand]