EBITDA and Other Scary Words: Scary Word No. 6 – PP&E
"This article originally appeared on Financial Poise and is reprinted here with permission."
PP&E, or Property, Plant and Equipment (okay, this is definitely more than one word), is a vital component in the operation of your business. And for many businesses, PP&E can be one of the largest numbers on the balance sheet. PP&E may consist of land, building, equipment, furniture, computers… the list can (and does) go on and on. So what do you need to know about PP&E? Well, you need these fixed assets, so you buy them…the end. Oh, if it was only that simple.
When you are starting a business, PP&E is usually one of your biggest investments. And unless a rich uncle left you a huge inheritance or you have a money tree growing in the backyard, you may need some type of financing. We will be talking about financing and its related components in one of our future installments, but for now let’s take a closer look at PP&E and the recovery of these expenses.
PP&E is shown as a non-current asset on your balance sheet. Under GAAP (scary word #1), PP&E is recorded at historical cost; so, in other words, what you pay for the PP&E, plus any additional costs incurred to put it into service, is the amount that will appear on your balance sheet. Many may not see PP&E as what it is: a capital expenditure. What do we mean by that? Many business owners see this as an expense and feel it should be a reduction from the bottom line. Since we seem to have a theme going here, let’s go back to the bar example from our previous installments.
You are the owner of your neighborhood bar. You hire a friendly bartender who knows how to make everyone’s favorite drink and pour their favorite beer. But the bar does not (yet) have enough televisions. So you go out and buy a couple of big screen, high resolution televisions to draw in more customers. These televisions cost you a total of $10,000. At the end of the year, you close out your books. Let’s see, your sales were about $50,000 and your total expenses, including the televisions, were $40,000. So you made a profit of $10,000. Well that’s what you think! You see, those televisions are not really expenses. They are in fact capital expenditures. And these capital expenditures make up the PP&E number on your balance sheet. So for book purposes, you really made a profit of $18,000. What? How did I get a profit of $18,000 when I paid $10,000 for the televisions? Seems a little unfair, so your next question is how do I recover all the costs of these televisions?
Under GAAP, the costs of your PP&E are recovered over the useful lives of the assets. Since these televisions will be providing you with an economic benefit for a few years, the costs are recovered or recognized in the same manner: through depreciation expense on your income statement. Here is an example:
The total cost of putting these televisions into service was $10,000. You determine that the useful life of these assets is 5 years and they have no salvage value. Therefore, $10,000/5 years would result in yearly depreciation expense of $2,000. By year 5, you would have recovered the full cost of the televisions, and it will probably be time for some new ones.
However, for tax purposes, you are allowed to recover the cost of fixed assets on an accelerated basis and, depending on the type of asset, you may even be able to completely deduct the full cost of the assets and lower your tax liability. Your book profit would remain the same, but when preparing the business income tax returns, this greater deduction allows for less tax profit and this could significantly reduce your tax liability.
Let’s take this one step at a time.
For income tax purposes, businesses are allowed a different method of depreciation, called MACRS (Modified Accelerated Cost Recovery System). Under this method, depreciation is accelerated so businesses can deduct greater amounts of depreciation during the beginning years of an asset’s life. This allows for a quicker recovery of the expense of the fixed asset and, as a result, greater tax savings in the year the capital expenditure is placed in service.
There are also special tax depreciation rules that allow for even greater tax savings when you purchase equipment. Section 179 depreciation allows you to expense the entire cost of some fixed assets in the year they are placed in service. There are several conditions that must be met but here is the 10,000 foot view:
- The asset must qualify for Section 179.
- The business cannot already have a loss for tax purposes.
- Taking Section 179 cannot create a loss for tax purposes.
- The maximum deduction for 2016 is $500,000 of the cost of qualified fixed assets placed in service during the year.
But don’t go running out to buy a bunch of equipment yet. There is a spending cap. The $500,000 begins to be reduced on a dollar-for-dollar basis when your equipment purchases exceed $2 million in the year.
But wait, there is more. There is also bonus depreciation. Bonus depreciation currently allows you to depreciate half of the cost of your new fixed assets placed in service in 2015, 2016 and 2017. In 2018, this deduction will be reduced to 40 percent and for 2019 the deduction will be only 30 percent. And bonus depreciation can be used together with Section 179 for even greater tax savings. Let’s take a look at a quick example:
- You purchase equipment totaling: $700,000
- The 2016 maximum Section 179 allowed: $500,000
- Remaining equipment purchases to be depreciated: $200,000
- The 2016 50% bonus depreciation on remaining amount: $100,000
- Your total special tax depreciation for 2016: $600,000
Keep in mind that this example does not include the normal first-year depreciation deduction that can be taken under MACRS for the remaining $100,000. For assets in a class life of 5 years, the depreciation expense would be $20,000. Combined with the special tax depreciation, your total depreciation deduction for 2016 would be $620,000 compared with your book depreciation of $140,000 ($700,000/5). That’s a big difference. Your tax liability has just been lowered $480,000, which will equate into big tax savings!
So there you have it. This may not be all you need to know about PP&E, but it definitely helps to know that you can recover the costs of those televisions and save some tax dollars in the process!
- EBITDA and Other Scary Words: What Did They Just Say?
- Scary Word No. 1 – GAAP
- Scary Word No. 2 – Financial Statements
- Scary Word No. 3 – Cash
- Scary Word No. 4 – Accounts Receivable
- Scary Word No. 5 – Inventory
- Scary Word No. 6 – PP&E
- Scary Word No. 7 - 'Intangible' Assets
- Scary Word No. 8 - Accounts Payable
- Scary Word No. 9 - Accrued Expenses
- Scary Word No. 10 - Commitments and Contingencies
- Scary Word No. 11 - Debt, Collateral, Covenants, Guarantees and More
- Scary Word No. 12 - "The Deferreds"
- Scary Word No. 13 - "Equity"