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Whitepaper A Guide to Reducing Tax and Increasing ProďŹ tability Through Your Fixed Asset Register

Real Asset Management


Whitepaper: reducing tax and increasing profitability

Real Asset Management

A Guide To Reducing Tax and Increasing Profitability Through Your Fixed Asset Register Before the advent of modern fixed asset accounting software, many companies followed a policy of calculating depreciation for tax purposes and then using the same dollar amount for periodic financial reporting under GAAP. This paper will explore the benefits of using different depreciation for tax and book accounting and how professional fixed asset management systems can create ‘what if’ analyses of depreciation options to assist in creating a new policy.

Tax vs. Book Accounting for Fixed Assets When property records and depreciation calculations were manual, there was significant time saved in using the same depreciation amount for both tax and financial reporting. For many companies this developed into a policy of using the same depreciation for book and tax. With there being no requirement in either the Internal Revenue Code or GAAP for using the same data for both book and tax, the availability of specialist fixed asset accounting software, such as Asset4000 from Real Asset Management, allows organizations to seriously consider disconnecting tax depreciation calculations from the financial reporting of depreciation. Just because it is permissible to use the same calculations for both book and tax does not make it an optimum strategy. In the absence of net operating losses, most tax professionals strongly recommend that companies take full advantage of IRS permitted depreciation methods for taxes; this means maximizing depreciation charges for tax reporting. Using this same maximum allowed tax depreciation for financial reporting, however, might present a distorted profit picture. In turn, this can have adverse effects on earnings per share, price/earnings ratios and, ultimately, the value of the company’s stock. The reason that tax depreciation may misrepresent reported net profi t is easy to understand. Congress has repeatedly adjusted depreciation allowances for taxpayers in an effort to encourage corporate capital expenditure. Increasing allowances has the effect of boosting cash flow (lower taxes paid) and this in turn increases the prospective return on investment (ROI) on any proposed capital addition. In periods of economic stress, increasing the ROI encourages investment. Put simply, current tax depreciation has the effect of ‘writing off’ assets substantially before they have come to the end of their useful or economic life. If one uses the accelerated tax depreciation amounts for the depreciation expense in financial reports, this will have adverse consequences. The company will be overstating expense and understating net profit. Effectively, the company will continue to use many assets that have been totally written off when they still have real economic value. Once assets have been written down to zero there will no longer be a depreciation charge for financial reporting, yet the assets are producing economic benefits. In short, there will be a mismatch between reported profit and the true underlying economic position of the firm if accelerated depreciation is used for financial reporting. Both management and external financial analysts want a company’s financial statements to refl ect as accurately as possible

Real Asset Management

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Whitepaper: reducing tax and increasing profitability

Real Asset Management

the real underlying economics of the business. In that way, both parties can evaluate the company against other comparable organizations. If assets are over-depreciated relative to competitors, this will have an adverse impact in a number of areas. Selling prices that incorporate variable depreciation charges will fluctuate, possibly removing competitive advantage. With less reported profit, return on investment will be reduced and this metric is often utilized in capital budgeting. A company’s reported performance may, in some years, appear to be worse than its competitors, putting it at a disadvantage in searching for outside capital. In short, inconsistent depreciation charges in management accounts have virtually no positive benefits, but they can carry significant downside risks. Companies should maximize the depreciation claimed for tax purposes, as there is no reason to pay more taxes to the IRS or state authorities than is necessary. However, maximizing tax depreciation should have no impact on the calculation of depreciation for financial reporting, much less for property taxes or the determination of insurable values. The only way to accomplish these diverse goals, at asset level, is to have software flexible enough to calculate depreciation expense for each separate purpose, including financial reporting, property taxes and insurable values. Dedicated fixed asset accounting software, such as Asset4000, can provide this flexibility.

‘What if’ Analysis One of the great advantages of specialist fixed asset software is its ability to test out alternatives. For example, if a company believes that a certain number of assets have been depreciated too quickly for financial reporting, before going to the auditors and requesting that they concur with what is a ‘change in accounting estimate’ or ‘correction of an error’, it should know in advance the exact impact of the potential future depreciation expense under new guidelines. Management should be able to show the auditors that by extending the anticipated useful lives, the depreciation expense will go from $x per year down to $y per year; auditors can then determine the materiality of the change. If the proposed change is considered immaterial the company can probably go ahead. If, on the other hand, the amount is material, then it has to demonstrate why it wishes to make the change. An argument that a change should be permitted simply to increase reported income and earnings per share is not going to be very persuasive. Instead, show that if the same lives are used for book and tax, that the tax lives are simply too short relative to economic useful lives. To do this it will help to demonstrate that there are numerous examples where assets have become fully depreciated but are still in use. Professional fixed asset accounting and tracking software can be set up to prepare a schedule of all fully depreciated assets. It will not be necessary to try to find every single asset to see whether it is still in service or not. A statistical sample, perhaps 10% - 20% should be the subject of inquiry. If, of the sample, 60% of the fully depreciated assets are still in use, it would be reasonable to conclude that 60% of the assets not yet fully depreciated are being written off too quickly. Next, the fixed asset register should be sorted by asset class or asset type, such as machine tools and IT equipment. The final stage of the analysis is to determine the age of the fully depreciated assets in each category. Should the average life be beyond the original fully depreciated date, it can then be applied to the active file. So, if on balance existing fully depreciated assets were written down to zero five years ago, it is obvious that existing asset lives can be extended by a minimum of fi ve years, and probably more. The ‘what if’ capabilities of fixed asset accounting software can then be utilized to see the impact on annual depreciation expense of extending the remaining lives by five years, eight years and ten years.

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White Paper


Whitepaper: reducing tax and increasing profitability

Real Asset Management

During this investigation it may be found that a number of fully depreciated assets are not present. Those items should be removed from the property register and this will save on both property taxes and insurance. While it is possible to extend the accounting lives in the corporate book, it is usually not permissible to change the tax lives. Tax lives are set up based on the Internal Revenue Code and applicable IRS regulations. For taxes, it makes no difference to fully write off an asset before its real useful life expires. There is, however, one circumstance where a company might want to review tax lives and what usually is accelerated depreciation. If a company has a Net Operating Loss carry forward it may not be possible to extend tax lives on existing assets, so check with a tax advisor. The company certainly would want to stop accelerated depreciation on all new acquisitions and go to a much longer life for tax depreciation than the minimum life currently provided. In this instance, many companies profitably explore the possibility of leasing, where the tax benefits are captured by the lessor and in exchange the company obtains a lower cost of funds. Again, this is something to be discussed with a tax advisor. Dedicated fixed asset software can provide many benefits in terms of maximizing cash flow from reduced tax payments. At the same time companies can often extend the anticipated lives of assets for financial reporting, which will decrease expense and increase reported earnings, earnings per share and Return on Investment. The important message to take from this whitepaper is that companies should consider running ‘what if’ analyses. Companies should not tie their hands with an outdated practice or policy such as making the book and tax depreciation identical. It is permissible to separate them, the tools for doing this are available, and the benefits will be substantial.

About Real Asset Management Real Asset Management (RAM) is a leading provider of CMMS and fixed asset management solutions. RAM’s solution is used by over 3,000 clients in more than 70 countries. RAM delivers high-quality, customizable software solutions worldwide. We offer a range of training and consulting services designed to enable our clients to make the most of their CMMS system. Please visit www.realassetmgt.com to find out more or call 617 457 7838 to arrange a call to discuss your requirements and setup a web demonstration.

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Real Asset Management

Real Asset Management . 50 Franklin Street . Boston, MA 02110 Real Asset Management . 309 Court Avenue . Des Moines, IA 50309

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617 457 7838

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610 646 3221

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A guide to reducing tax & increasing profitability  

Before the advent of modern fixed asset accounting software, many companies followed a policy of calculating depreciation for tax purposes a...

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