A new study of tax treatment of capital assets explains that depreciation, a common accounting method used to calculate the cost of equipment and machinery in financial statements, understates the cost of the assets being acquired and results in a tax system that reduces capital—meaning it hurts the economy.

Companies typically allocate costs for plant and equipment directly via subtracting from their cash flow at the time they are incurred or through depreciation, where the cost is calculated over the economic life of the asset. In filing their financial reports, CFOs and their staffs choose between using a “straight-line” depreciation method, where costs are allocated in equal installments over the life of the asset, and a form of “accelerated depreciation,” where more of the asset can be written off in the early years of the asset’s life compared to the later years, such as a Modified Accelerated Cost Recovery System (MACRS).

It’s easy to see why companies use accelerated depreciation. They pay less tax in the early years and more in the later years versus the straight-line method. This increases the value of a firm’s cash flow and means a higher return on investment, says Stephen J. Entin, author of the report (“The Tax Treatment of Capital Assets and Its Effect on Growth”) and senior fellow at the Tax Foundation, a nonpartisan research organization that monitors fiscal policy.

But “even though the present value of the business’ cash flow is in fact enhanced by the accelerated depreciation, that benefit is masked in the presentation of its book profit in the financial report,” writes Entin. “The value does not show up as an increase in the business’ highly visible bottom line (current net income) in the financial statement.”

To be sure, certain companies benefit more from depreciation than others. As Entin says, those companies with a lot of intellectual property rights, for example, would benefit a lot from it, while those with more capital intensive operations would not benefit as much since they typically require a steadier stream of cash and expenses.

But the problem is “in the accounting world, depreciation may be just a ‘matter of timing,’” and “in the real world, time is money,” he notes. Thus, choosing depreciation over expensing via cash flows when an asset is actually acquired, he says, runs counter to what business economists prefer though it is what accountants prefer. “Delayed cost recovery (from the use of depreciation) increases the tax burden on investment and reduces capital formation, employment, and the incomes of workers, shareholders, and other owners of businesses.”

Though companies often use depreciation instead of expensing directly from cash flows, stock analysts and others look at cash flows to determine whether an asset is worth buying. A company’s lenders also look beyond a firm’s accounting income to the underlying cash to determine value.

And while there are different kinds of depreciation routinely applied in corporate financial statements in accordance with Generally Accepted Accounting Principles (GAAP), that kind of “book” depreciation can be different from what Congress favors, according to Entin. “Congress sets the tax depreciation rules with many factors in mind, and they do not necessarily follow GAAP,” said the report, noting that governments in general would prefer to have their tax revenue sooner.

With the high corporate tax rate in the United States discussed almost daily in Washington, the paper is a timely reminder that U.S. tax reform should not be performed in a vacuum. To achieve a lower corporate tax rate than the 35% top rate (and even higher marginal rate), the U.S. government is mulling alternative funding, such as a reduction in some of the current tax write-offs, says Entin.

Some companies are already on board with this, such as those who do not have much in the way of depreciable assets, according to Entin. They are petitioning Washington to do away with some of the accelerated depreciation allowances for plants and equipment in order to have a lower corporate tax rate, even though it is certainly not a direct swap.

Though any immediate changes to the corporate tax rate could still be far out on the horizon, Entin says firms need to be aware now of what kinds of tax reform can impact their operations and their accounting. “Proper tax treatment of the cost of plant, equipment, and buildings is an important and underappreciated prerequisite for a pro-growth tax system,” said the report.

As Entin maintains, even though it is convenient for corporations to use depreciation for budget purposes, economic growth “should be the determining factor in crafting cost recovery in tax reform.”


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