From the footnotes of the 1967 10-K (shown below), one can see that prior to October 2, 1965, PP&E was depreciated on a straight-line basis. But after Buffett took over in 1965, all PP&E was being depreciated using the double declining method. Why?
There are a couple reasons why Buffett might have done this. The first reason could be that the assets of the textiles company simply were not as valuable as they once were, so they were losing value more quickly. Hence, their value on the book should be depreciated more quickly.
The second reason is that this generates a form of float in the form of deferred tax liabilities. It’s a 0% interest loan from Uncle Sam by being able to pay taxes that you owe later. In the end, the amount that’s eventually paid in taxes to Uncle Sam is the same. Timing-wise, you’re able to pay taxes with a lag. This extra cash is like an accounts payable that has been extended. You used to have to pay your vendors every 30 days, but now your accounts payable is 90 days. With 60 extra days of cash, you can do a lot with it.
Let’s see an example below. We’re starting with existing PP&E of $14 billion. Here we are using the straight-line method. All the existing assets have 7 year lives, which means that 1/7 of the original $14 billion value is being depreciated each year. So roughly, 14.3% (1/7 = 14.2857%) of this original value (or $200 million of the asset) is depreciated each year. Note, that we have zero deferred taxes (highlighted in the orange row) because the GAAP depreciation (purple row) on the income statement and the depreciation on the “tax books” (green row) match.
Now, let’s see below what happens when we switch from the straight-line method above to a double-declining method. Just to walk through the calculation of how this might work: We double the depreciation percentage to 28.6%. And this 28.6% is used to depreciate the remaining value of the PP&E, not the original $14 billion. So in 2016, the year starts with $10 billion of value in PP&E, which gets depreciated by 28.6% or $2.857 billion to $7.143 billion. Notice, compared to the $2 billion/year straight-line amount that continues to be depreciated via GAAP on the income statement, in 2016, we’ve depreciated $2.857 or $857 million more on our tax books. So if the tax rate is 23.7%, we multiply this excess $857 in depreciation by the tax rate to arrive at $204 million of taxes that we have deferred to the future. In other words, we are taking future depreciation and bringing it forward. And because depreciation is a tax-deductible expense, we are bringing forward future tax-deductible expenses.
This $204 million of deferred taxes is added onto the existing balance of deferred tax liabilities from the prior year in 2015 of $475 million to arrive at $678 million in deferred tax liability for the year ended 2016.
Note, in the very last year in 2021, we end up depreciating 100% of the remaining balance – this is a simplified assumption based on the fact that the original asset had 7-year lives. The critical thing to note is that the deferred tax liability has reverted to $0.
If you look at the last line, you see the deferred tax liability float, you’ll see the “borrow” from Uncle Sam at 0% interest. It’s roughly a $500 million plus loan that starts to get paid down in year 5. Note that the deferred tax payments start to turn negative in 2018. That’s when the deferred tax liability “float” starts getting paid down.
If we were to sum the total deferred taxes accrued (positive) and paid (negative), it will equal zero by 2021, with all the deferred taxes having been paid off and the GAAP taxes paid and cash taxes paid being equal.