Reading 27, page 86, #48 Question: How would a higher than expected inflation rate effect the value of the real tax savings from depreciation? Answer: Real tax savings from depreciation would be higher Why? In the explanation on page 97 it says “Higher than expected inflation increases the corporation’s real taxes because it reduces the value of the depreciation tax shelter.” Doesn’t the explanation say essentially that higher taxes reduce the value of depreciation? Which is basically the opposite of the actual answer? Can someone please give an explanation?
say the company bought a piece of equipment at a 100$ 2 years ago. and was depreciating it at 10$ SL per year. on that basis - 10$ was the depreciation expense - which would have been reduced from the revenues - and you would have a tax amount attributed due to that. if the same piece of equipment had been bought today - you would have paid 150$ for it (50$ say due to inflation) - your depreciation expense would have been HIGHER - so your tax expense would have been lower. But you do not get the advantage of the newer depreciation amount because your equipment is still being depreciated according to the historical value - hence your real value of tax savings due to depreciation is correspondingly LOWER. (You are paying higher taxes because of that). HTH
CPK, thanks for the response. I put together a quick income statement with made up revenues, depreciation, pre tax income, tax rate, taxes, and net income Do you think this is correct? Higher inflation leads to higher equipment cost, which leads to higher depreciation, which leads to HIGHER “real tax savings” (which basically means you pay less taxes) ?
that is how I understood it.
seems logical to me
The question probably assumes that the asset to be depreciated has yet to be acquired, and hence would entail the buyer shelling out more money to buy it. Hence, real tax savings would be higher upon purchase at a higher price due to inflation.
Hey CPK123 … you say But you do not get the advantage of the newer depreciation amount because your equipment is still being depreciated according to the historical value - hence your real value of tax savings due to depreciation is correspondingly LOWER. (You are paying higher taxes because of that). but doesnt your last sentence go against the below answer ? Answer: Real tax savings from depreciation would be higher sorry but im confused , do you mind clarifying?
My sentence should say -> tax savings due to depreciation - not REAL tax savings due to depreciation. The tax savings are lower - but REAL tax savings would have been higher. the example that I wrote up helps to explain the difference.
so the value of the dep tax shelter is lower, but infact with unexp inflation, real tax savings is higher? i cant get my head around this, can someone break it down for me again sorry?
your depreciation is always based on historic cost right. so your depreciation expense would be lower based on historic cost. so your tax expense based on the historic lower depreciation would be higher… does that make sense?
ok thks . I have colleagues that are CIMA chartered accoutants, and theyve demonstrated that real tax savings through depreciation infact goes down during inflationary periods. theyve shown me this via actual cashflows on a spreadsheet. anyhow, itll have to be one to mark down where CFAI may be oversimplifying their statements/answers.