Help on depreciation vs taxation
Posted: October 28th, 2018, 3:37 pm
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
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