Financial Accounting I¶

Depreciation is straight-line for financial reporting (same amount each year = investment/num of years).
Depreciation is accelerated for tax purposes: double declining balance with a switch to straight line when that is optimal and a half-year in the first and last years.
Congress passed accelerated depreciation to encourage investment. Accelerating depreciation improves near-term cash flows (more later).
Tax schedule is called MACRS (Modified Accelerated Cost Recovery System).

Invest $100 in five-year equipment
Straight-line is 20% per year.
Double-declining balance is 40% of the remaining balance each year.
But first year of service is only a half year, so 20%.
Switching to straight-line means computing balance / (num years left) and switching to that when higher.

Assume revenue $50 per year beginning in year 1 and there are no costs other than depreciation.
Assume the tax rate is 30%.

Depreciation is not an actual cash expense.
Cash inflow in this example, excluding the initial $100 outlay for equipment, is revenue - taxes.
We can also calculate cash inflow as net income + depreciation (depreciation add back).
- Net income = 0.7 x (revenue - depreciation)
- Net income + depreciation = 0.7 x revenue + 0.3 x depreciation
- 0.3 x depreciation = depreciation tax shield

The statement of cash flows starts with net income and makes adjustments to get to cash flow (cash flow = cash inflow).
Like adding back depreciation
The cash inflow goes on the company's balance sheet as an increase in the cash account (or a decrease if the cash flow is negative).

The effect of depreciation is to increase cash flow by the depreciation tax shield = 0.3 x depreciation.
If we increase depreciation in early years (and therefore reduce it in later years) then we move some of the depreciation tax shields from late years to early years.
Accelerating depreciation accelerates cash flows.
How would cash flows change if the cap ex could be fully depreciated in year 0?
- And how would the balance sheet change?
- This would be called expensing as opposed to capitalizing.

Revenues $\ne$ cash inflows
Costs $\ne$ cash outflows
Difference between revenue/cost and cash inflow/outflow is always manifested in a change in a balance sheet item.
To calculate cash inflow/outflow from revenue/cost, the adjustment we make is to always add/subtract the change in a balance sheet item.
Cash flow = net income - $\Delta$ (assets-liabilities)

Year	0	1	2	3	4	5
Net PP&E	80	48	28.80	17.28	5.76	0
$\Delta$ Net PP&E	80	-32	-19.20	- 11.52	- 11.52	- 5.76

Short-term assets minus short-term liabilities
Main categories:
- Assets = inventory + accounts receivable
- Liabilities = accounts payable

Record costs and revenues at time of sale
If cash outflows/inflows occur at other times,
- cash outflow before recording $\mapsto$ asset (inventory)
- cash outflow after recording $\mapsto$ liability (accounts payable)
- cash inflow before recording $\mapsto$ liability (pre-paid sales)
- cash inflow after recording $\mapsto$ asset (accounts receivable)

Cash Flow = Net Income - $\Delta IC$

Direct costs of production (materials + labor) are costs of goods sold or costs of revenue
- COGS or COR
Other costs are selling, general, and administrative
- SG&A