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The Effects of Depreciation on Cash Flow

The Effects of Depreciation on Cash Flow
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  • 0:04 Depreciation and Cash Flow
  • 1:07 MACRS
  • 2:54 Book Value and Market Value
  • 4:43 Depreciation Effects…
  • 5:09 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Businesses depend on having cash to meet expenses. Large purchases tend to be deducted on taxes over a period of years rather than just the year of purchase. We will discuss how depreciation for tax purposes affects a business' cash flow.

Depreciation and Cash Flow

Billy started a small landscaping business and bought a truck, a lawnmower, and other associated tools just for use in the company. Like any other business, Billy has to spend money on equipment that will eventually wear out and have to be replaced. Fortunately, depreciation allows Billy to save a bit on his taxes each year to account for this property, which is going down in value from age and use. And every dollar Billy doesn't pay in taxes is money he can use to grow his business.

Cash is essential to any business. In Billy's landscaping business there is never enough cash. He needs it to pay for things like gasoline for equipment, repairs, hiring part-time help, and making payroll in slow business times. A high cash flow would give the business the means to pay business commitments as they come up.

One of the liabilities coming due for Billy is taxes. Since tax payments eat into a business' cash flow, any deductions he can take reduce the amount of taxes due on the money he's made from mowing lawns.

MACRS

It has been mentioned that depreciation can help Billy save money on his taxes, but what does that actually mean? Many of Billy's expenses can be written off the year they occur, like gasoline and replacement blades for the lawnmower. However, the tax code requires that any equipment that's expected to last more than one year be depreciated over its expected useful life rather than expensed.

The modified accelerated cost recovery system, or MACRS covers how different items are depreciated in the US tax system. Under MACRS, different items are assigned to classes based on how long each item is expected to last. For example, a computer is expected to have a relatively short useful business life of three years, while a commercial building has a useful life of 39 years, according to the IRS. The comprehensive listing of classes and guidelines can be found in IRS Publication 946.

In Billy's case, his business truck would be depreciated over five years and his lawnmower over seven years. So if Billy buys a new lawnmower for $2,000, rather than getting a $2,000 deduction that tax year, he gets to deduct 1/7th of $2,000, prorated to the month he bought the mower. Let's say he purchased the mower on July 1st, halfway through the year. This means he would get to deduct approximately $143 on his taxes that year: ((2000/7) x .5). Then over the next six years he would deduct approximately $286 per year. Finally, in the eighth calendar year after he bought the mower, he would be able to take the deduction for the last six months of the seven-year depreciation allowance, or $143.

Book Value and Market Value

Each depreciable item in a business has its own MACRS accounting sheet. The price paid for the equipment sets the initial book value. Each year when the business completes its tax return, the book value is decreased by the amount of depreciation taken. So six months after Billy bought that $2,000 lawn mower, it now has a book value of $1,857 ($2,000 - $143). The following January it would have a book value of $1,571 ($1,857 - $286). The book value continues to drop each year until the item is fully depreciated and reaches a book value of $0.

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