 Hello and welcome to the session. This is Professor Farhad in which we will explain depreciation as a tax shield. A shield is something that's going to protect you, but how does depreciation protect from taxes? Well, first we have to understand what is depreciation in order to understand how does it function as a tax shield? Well, depreciation is a cost allocation of long-term asset. What does that mean? It means you buy a truck and the truck is an asset. And what you do, and you paid 100,000 for that delivery truck for your business, it's an asset. And what's going to happen? You're going to allocate this expense. Let's assume this truck, you would estimate that this truck would last you for 10 years with no salvage value to keep everything simple. Simply put, what you do for year one, you will deduct 10,000 in depreciation expense. In year two, you will deduct 10,000 in depreciation expense. Year three, year four, all the way till year 10. And those are the depreciation expense, basically taking the 100,000 and allocating, splitting the 100,000 into 10,000 of depreciation expense. When you expense depreciation, it would look something like this. You will debit depreciation expense 10,000. You will credit accumulated depreciation 10,000. So this is the journal entry. So this what goes in the accounting record? Well, let's look at this. Let's examine this entry. We increased an expense. That's bad. When we have expenses, we don't like expenses because it's going to reduce our profit. That's bad. However, we credited something other than cash. Accumulated depreciation is a non-cash. You can see, we did not debit expense and we credit cash. We debited expense, credit accumulated depreciation. So simply put what we did, we increased our expense without reducing our cash. Now, the cash took place when we purchased the asset itself. But we're going to take advantage of this payment over the years and do what? And expense it against our income. Well, how is it exactly as a tax shield? The best to illustrate through an example. So let's assume we have a taxable income with no depreciation expense of 100,000. So simply put, I told you your taxable income or your profit, no depreciation taken into account is 100,000. So what do you have to do? You have to pay 21% of the IRS. 100,000 times 21%, you're going to have a tax bill of 21,000. Well, let's change the scenario a little bit. Let's assume your taxable income after depreciation. Now we included the depreciation expense 100,000 minus 15 equal to 85,000. Now this is your taxable income. Your tax rate is 21%. Your tax bill is now 17,850. So you were able to reduce your tax bill by 3,150. How? How did we come up with this figure? It's easy. All you have to do is take your depreciation, the amount of depreciation that you generated that you accounted for, multiplied by the tax rate. We said the depreciation is 15,000 multiplied by 0.21 will give you a reduction in your tax savings as we saw of 3,150. Simply put, to figure out how much of tax benefit or tax shield you will get from depreciation, you will take the depreciation expense and that doesn't only work for depreciation expense. Any non-cash expense works the same way. But since we are talking about depreciation, we need to emphasize depreciation. Take your expense, the non-cash expense, multiplied by the tax rate and this is going to give you your tax shield, all your tax savings. So the depreciation was 15.21. Your benefit is 3,150. And this is how depreciation will shield us, will protect us, will reduce our income tax bill. What should you do now? You should go to forhatlectures.com, work MCQs through false exercises with capital budgeting as well as other issues to solidify your knowledge about these topics. Good luck, study hard, stay safe.