How to get the Most Hardware for your Buck

To follow up on last week’s blog post, we are going to do a series of accounting problems — yes, an actual series of accounting problems — to depict the differences between a cash purchase, a capital lease, and an operating lease. Since accounting can get a little boring, we will break these blog posts up and just focus on a cash purchase for today.

Let’s assume the following:

XYZ Corporation needs to purchase $600,000 of hardware for 2016. The purchase price includes all taxes, shipping, and setup costs to get the equipment up and running. For the sake of simplicity, this will be XYZ’s only purchase of a capital asset for the entire year, and it will purchase and place the hardware into service on January 1, 2016. We will also assume that XYZ’s corporate tax rate is 35%.

Upon receiving the hardware, the company would pay for the equipment and record the following journal entry.

Each month, XYZ would record a depreciation expense related to the hardware. Since there are multiple ways that a company can realize depreciation on its books, we will assume that XYZ uses the straight line method, the useful life of the equipment is 5 years, and that there is zero salvage value. The monthly depreciation expense would be calculated as follows:

The accountant would record the following journal entry:

At the end of the year, the book value of the equipment would be $480,000, which would appear on the balance sheet and the total depreciation expense for the year would be $120,000, which would appear on the income statement. The key thing to remember is that these accounting entries only reflect the book value of the asset. To really understand the benefits of a cash purchase, we need to examine the cash flow and tax implication of the purchase. After all, in finance, cash is king.

Obviously, the $600,000 in cash that you paid for the hardware would walk out the door the day of your purchase. However, some of that cash may come back in the form of tax deductions.

§179 Deduction

In this particular case, the hardware can be classified as §179 qualified property, which allows XYZ to immediately expense $500,000 of the purchase. For those of you unfamiliar with §179 qualified property, it allows business with less than $2,000,000 in capital purchases to expense up to $500,000 of qualifying property within the first year. For the most part, any business related assets qualify, and like all things tax related, there are several ins and outs to know to take full advantage of the §179 Deduction. For more information on the §179 Deduction and a brief history, check out www.section179.org.

After taking the §179 Deduction, XYZ Company is left with a $100,000 basis in the equipment. Luckily Congress allows Bonus Depreciation to be taken in addition to the §179 Deduction.

Bonus Depreciation

For 2016, Bonus Depreciation of 50% can be taken on assets placed into service during the year. If the §179 Deduction was taken, Bonus Depreciation is calculated on the basis of an asset after taking the §179 Deduction. This means that $50,000 of the remaining $100,000 basis in the hardware can be deducted for 2016. This dwindles the total basis of the hardware to $50,000. Thinking it is too good to be true? Well, it gets even better.

MACRS Depreciation

In addition to the §179 Deduction and Bonus Depreciation, the tax code still allows you to recognize regular MACRS Depreciation. Since the hardware was placed in service on January 1 and it is classified as 5-year property, the MACRs rate it 20%, which means another $10,000 of the hardware can be expensed bringing the basis to $40,000.

So in total, the $560,000 of the $600,000 in hardware can be expensed within the first year. Since XYZ’s tax rate is 35%, this means that $165,000 of taxes can be saved. Or another way of looking at it is that the $600,000 in hardware only really cost $435,000.

For our next accounting related blog post, we will discuss how a capital lease works and its advantages and disadvantages over a cash purchase.

Metric Loop and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Originally published at metricloop.com on April 27, 2016.