Depreciation creates deferred taxes,
which have equity-like qualities
Depreciation is the systematic allocation of
the cost of property, plant and equipment over their useful lives. (Land is
not subject to depreciation.)
As background, there
are various depreciation methods used; each with the intent to properly
match depreciation expense on the P&L, to the usage and decline in value of
the underlying assets. Some of the methods used are the straight-line
method, and accelerated depreciation methods, such as double declining
balance and sum-of-the-years-digits.
While deprecation is
a non-cash expense, fixed assets need to be repaired and maintained, and
retiring assets need to be replaced. This costs money and therefore is a
negative cash flow.
Replacement of, and
additions to fixed assets, as well as repairs that extend their useful
lives, are cash expenditures that are capitalized on the balance sheet.
These expenditures are not reported in the P&L.
To appreciate the
complete cash picture, depreciation expense should always be analyzed in
conjunction with capital expenditures.
For tax returns, the
IRS allows even faster depreciation methods, to give businesses incentives
to purchase equipment that will stimulate the economy. The tax differential
between GAAP depreciation and the faster tax deprecation methods results in
deferred tax liabilities that are reported on the balance sheet.
Depreciation is usually one of the main timing differences that generate
Deferred taxes on the balance sheet result
from the tax effect of the timing differences between book income and the
tax return income. All events being held constant, deferred taxes become
payable as the underlying transactions close out. That said, if a company is
in a growth mode, and new deferred taxes get added annually and grow in
amount, then deferred taxes never get closed out; they are essentially
liabilities, with equity attributes. This tax relief reduces a company’s
debt or equity needs. There is more money to grow the business. Some
companies, moreover, pass on these benefits to their customers.
Investors can benefit from those asset intensive
companies that generate deferred taxes. General Electric (GE) is a good
example of a company that benefits from deferred taxes. As of 9/30/06 they
had shareholders’ equity of $111 billion, and deferred taxes of $16 billion.
If not for deferred taxes, they would have had to issue more debt or equity.
Their use of deferred taxes increases their ROE, and therefore their
In general, deferred taxes are usually attributed to
depreciation, and can also be viewed as free government financing. Free
equity ultimately increases the overall value of a company.