Help on depreciation vs taxation

[TheMotorcycleBoy]

I'd appreciate a bit of help, i.e. some words of explanation, with an analysis issue in which the maths part is pre-school, but my lack of accountancy background is giving me slight trouble in rationalising/visualising.

By way of an intro. my latest hobby horse is the Earnings Power Value valuation technique. What I'd like a bit of help understanding is after EBIT is adjusted for cyclical roughness, and exceptional charges are either omitted or averaged, this pre-tax amount then taxed at this point. Then the next step is add back a portion (or all) of depreciation+amortisation and subtract away a portion of Capex: which I'm fine with as discussed right here. What I can't totally convince myself about.....and hence my question, is why does this adjustment occur after tax?

My feeble attempt to justify is underpinned by my similarly feeble attempt to really understand depreciation, in particular, with a view to how the company accountant and the taxman work together with the firm's tax bill.

To me, it might go like this:

1. Depreciation happens when a firm spends e.g. £500k on a machine, which will have a working life of 5 years. This goes down on their balance sheet an asset at that "book" value.
2. After a year, it's only worth £400k (straight line depreciation yeah?), so that's they put down on the balance sheet for it.

However on the income side of things, I'm imagining that they sold £2m of goods that year, and the total cost of making and selling the goods was £1. Hence the gross profit is £1m.

So, regarding the tax side of things, do they now say to the taxman, "I know we've £1m extra now from making and selling these goods, but £100k of that needs to be taken into consideration because our production line has lost that much value over the last year". "So can we now only pay the tax due on £900k, not on the full mill please?".

Is that how it works? If so, I think I have just explained to myself that that is why the A&D and capex adjustments for EPV calculation are done after the tax deduction. Can someone please confirm or deny this for me?

many thanks,
Matt

[Alaric]

However on the income side of things, I'm imagining that they sold £2m of goods that year, and the total cost of making and selling the goods was £1. Hence the gross profit is £1m.

It's only £ 900 thousand in profit because £ 100 thousand a year is set aside to buy a new machine in 5 years time. That's sometimes why Companies lease rather than buy, they swop the depreciation cost for rental costs.

The other side of depreciation is pretending that you didn't spend the money. So spend £ 500,000 on a machine, but pretend you didn't spend it. However you had to borrow £ 500,000 to pay for it.

That part of the balance sheet looks like
£ 000s
Asset 500
Debt 500

In a year's time,if you set aside 100 out of profits, you've got

Asset 500
Depreciation (100), so net asset 400
Loan 500
Cash from profits (100), so net liability 400

[TheMotorcycleBoy]

It's only £ 900 thousand in profit because £ 100 thousand a year is set aside to buy a new machine in 5 years time. That's sometimes why Companies lease rather than buy, they swop the depreciation cost for rental costs.

Thanks Alaric,

So of course because the £100k gets set aside, it does not get taxed. Correct?

Matt

[PinkDalek]

So of course because the £100k gets set aside, it does not get taxed. Correct?

Broad, not in depth, reply.

Depreciation is not an allowable cost for Corporation tax purposes. Instead, companies may claim capital allowances, if the expenditures qualifies.

HMRC basic guide (for the self-employed but it probably gives the gist) https://www.gov.uk/capital-allowances

This could give rise to timing differences between the book value and the tax written down value. Thus the need for Deferred Taxation provisions in the sets of Financial Statements you've seen. Those accounts will explain in greater detail.

A simple example would be along these lines.

Net book value of tangible fixed assets qualifying for capital allowances in what used to be called a Balance Sheet £5,000,000
Remaining pool of allowable expenditure in the tax computations £3,000,000

Deferred tax liability in the Balance sheet £2,000,000 at the CT rate of 19% (it gets more complicated in view of the rate changes) = £380,000

In this case, the difference would be due to the tax relief being obtained faster than depreciation. The provision would be made to cover the eventuality of one catching up with the other (all other things being equal ...).

[TheMotorcycleBoy]

Thanks for your reply PD,

Depreciation is not an allowable cost for Corporation tax purposes. Instead, companies may claim capital allowances, if the expenditures qualifies.

Hmm...

I just looked at this HMRC basic guide (for the self-employed but it probably gives the gist) https://www.gov.uk/capital-allowances.

You can claim capital allowances when you buy assets that you keep to use in your business, eg:

    equipment
    machinery
    business vehicles, eg cars, vans or lorries

These are known as plant and machinery.

You can deduct some or all of the value of the item from your profits before you pay tax.

So I'm guessing that is why in the EPV workings there is justification for the A&D (or at least a portion of it) to added back after the operating profit (EBIT) has been taxed (note that the EPV model ignores net interest effect).

This could give rise to timing differences between the book value and the tax written down value...

In this case, the difference would be due to the tax relief being obtained faster than depreciation.

I think I get it. So in my very simple example in my OP, if the firm buy £500k of machine and depreciate it at 20%, and their annual tax allowance is £100k, then every year for the next 5 years, they can withhold £100k of profits from the tax man and on their income statement it gets booked as depreciation?

thanks Matt

[tjh290633]

For some items, like computer equipment, there may be a 100% allowance in the first year.

TJH

[PinkDalek]

For some items, like computer equipment, there may be a 100% allowance in the first year.

TJH

Yes, that was covered via one of the sub-links but the Annual Initial Allowance maximum was, when I last looked, £200,000. Not a large amount, in the scheme of things, for the type of quoted company the OP is looking at.

[PinkDalek]

... from today’s Budget papers:

Annual Investment Allowance (AIA) – The government will increase the Annual Investment Allowance to £1 million for all qualifying investment in plant and machinery made on or after 1 January 2019 until 31 December 2020, to help stimulate business investment.

[bluedonkey]

Realistically, I don't think you are going to be able to work out the tax on the profits of the company. Can't you just take the actual tax charge per the a/cs? If you're looking for a more cash-based calculation, maybe just take the actual tax paid in the year.

[TheMotorcycleBoy]

Realistically, I don't think you are going to be able to work out the tax on the profits of the company. Can't you just take the actual tax charge per the a/cs? If you're looking for a more cash-based calculation, maybe just take the actual tax paid in the year.

Hi Bluedonkey,

Thanks for your interest. To be honest, in this thread, I'm really just trying to figure this out:

By way of an intro. my latest hobby horse is the Earnings Power Value valuation technique. What I'd like a bit of help understanding is after EBIT is adjusted for cyclical roughness, and exceptional charges are either omitted or averaged, this pre-tax amount then taxed at this point. Then the next step is add back a portion (or all) of depreciation+amortisation and subtract away a portion of Capex: which I'm fine with as discussed right here. What I can't totally convince myself about.....and hence my question, is why does this adjustment occur after tax?

i.e. from my OP.

thanks Matt

[bluedonkey]

Sorry, I don't know anything about the Earnings Power Valuation technique.