In a scenario with tax depreciation of $20mm and asset depreciation of $10mm over 10 years, with a 21% tax rate, what is the impact on GAAP net income?

• A. Decreases by $8mm
• B. Increases by $8mm
• C. Decreases by $2mm
• D. Increases by $2mm

Answer: (A)

The key idea is that GAAP net income is affected by both accounting depreciation and taxes, and a difference between tax depreciation and book depreciation creates a tax shield that changes the net income for the period.

Here, book depreciation (GAAP) is 10 million, while tax depreciation is 20 million. The accounting depreciation reduces pre-tax income by 10 million, which lowers net income by 10 million before considering taxes. The larger tax depreciation reduces current tax expense by the tax rate times the difference between tax and book depreciation: 0.21 × (20 − 10) = 2.1 million. This tax shield offsets part of the depreciation’s impact on net income.

Net effect on GAAP net income = −10 + 2.1 = −7.9 million, i.e., about an 8 million decrease.