As an example consider the depreciation of long term

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As an example, consider the depreciation of long-term assets. For shareholder reports, com- panies typically depreciate long-term assets using straight-line depreciation (meaning the same amount of depreciation expense is reported each year over the useful life of the asset). However. for reports sent to tax authorities, companies use an accelerated method of depreciation (meaning more depreciation is taken in the early years of the asset's life and less depreciation in later year When a company depreciates assets at an accelerated rate for tax purposes, the depreciati deduction for tax purposes is higher and taxable income is lower in the early years of the assets" lives. As a result, tax payments are reduced and after-tax cash flow is increased. That excess cas can then be reinvested in the business to increase its returns to shareholders. To illustrate, assume that Pfizer purchases an asset with a five-year life. It depreciates th asset using the straight-line method (equal expense per year) when reporting to shareholders all!
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Module 5 I Revenue Recognition and Operating Income 5-20 -ates the asset at a faster rate (accelerated depreciation) for tax purposes. Annual (full year) eeiation expense under these two methods is depicted in Exhibit 5.3. - - -------- =xHIBIT 5.3 Straight-Linevs Accelerated Depreciation 250 k-----.~----------__1.., Straight-line depreciation .., Accelerated depreciation 50 5: 200 c Q) Q. >< ~ 150 o :; '0 e 100 Q. Q) o o ~-----.-----.-----.-----r----~ 234 Years (no partial years) 5 Juring the first 2.5 years in this example, depreciation is higher in the company's tax returns ;.,.is in its report to shareholders. In the last 2.5 years, this is reversed, with lower deprecia- expense for tax purposes. Taxable income and tax payments are, therefore, higher during the _ - years. The same total amount of depreciation is recognized under both methods over the =: ear life of the asset. Only the timing of the recognition of the expense differs.' 'e use this timing concept to illustrate the accounting for a deferred tax liability. Assume company purchases a depreciable asset with a cost of $100 and a two-year useful life. - ancial reporting purposes (for GAAP-based reports for shareholders), it depreciates the using the straight-line method, which yields depreciation expense of $50 per year. For reporting (when filing income tax returns), it depreciates the asset on an accelerated basis, ields depreciation deduction of $75 in the first year and $25 in the second year (the total amount of depreciation is reported under the two depreciation methods; only the t of depreciation reported per year differs). Assume that this company reports income depreciation and taxes of $200 and that its tax rate is 40%. Its income statements, for financial reporting and tax reporting, for the asset's first year are in Exhibit 5.4A. - -- ~~--. =xHIBIT 5.4A Year1 Income Statements: FinancialReportingvs TaxReporting Financial Reporting Tax Reporting e before depreciation .
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