If you asked four people what depreciation is, you would probably get four different answers:
- The amount of attrition of the assets,
- An allowance to help replace assets,
- Device of an accountant to reduce taxes, or
- One way to allow inflation.
All four would be wrong. Accountants aren’t known for explaining things well, which may explain the misconceptions above, but I’ll try to explain it so that:
- You will understand something more about your accounts,
- You can impress your bank manager and others with your accounting skills,
- You will understand why depreciation is on your accounts and budgets, but not on the cash flow statements.
- You can better understand and prepare budgets and
- You will be able to understand the accounts of companies that you might consider buying or investing in and make better decisions about them.
My explanation of depreciation begins with expenses and assets:
Anything you spend money on, in your business, is what we call debit:
- You pay your phone bill so that you have a phone expense.
- You pay for a new car to have an asset, the car.
We pay for both, but accountants treat them differently. Why is that?
The reason is time.
- Any expense that “runs out” a year from now is an expense – your phone bill is sold out and now you have nothing to show for it. It is an expense.
- Any expense that is not spent in a year (your car lasts more than a year, hopefully) is called an asset. At the end of the year you still have a car to prove it.
Expenses go to Statement of income* and reduce profit and therefore taxes. The income statement shows your income and expenses.
Assets go to Balance sheet* and have no effect on profits. The balance sheet shows what you owe and own at any given time.
Now, what about assets?
So you buy your car and its cost is entered on the Balance Sheet, along with the land, buildings, plant, equipment, and other assets. The balance sheet shows you what assets you own … but not how much they are worth. These assets stay on your balance sheet until your accountant does something with them … and what he does is depreciate them.
As you know, all assets except land wear out and eventually cease to exist. So we keep the land on Balance at its original cost, until you sell it. We do not depreciate the land.
All other assets will wear out or “wear out” in some way, a bit like your phone bill, but for much longer. Of course, when you buy a car, excavator, trawler, or computer, we don’t know how long each will keep. The best we can do, in the beginning, is to guess how long it will continue to be productive for you. The attitude of accountants is that an educated guess is better than nothing at all.
We could assume that a building will last 50 years, so we will transfer 2% of its cost from the balance sheet to the income statement each year. After 50 years, we will have transferred all of your cost and we will have a balance sheet value of $ 0.00.
We could assume that your office furniture will last 10 years, so we will transfer 10% of your cost from the balance sheet to the income statement each year. After 10 years, we will have transferred all of your cost and we will have a balance book value of $ 0.00.
Depreciation is the cost of an asset, distributed over its useful life. The amount we transfer from your balance sheet to your income statement each year is what we call depreciation.
So now you can quote the accounting definition of depreciation, can’t you? It is the cost of an asset, distributed over its useful life. Talk like this and people will think you are an accountant!
I’ll make it easier with numbers:
You buy your car for $ 30,000. He estimates that it will last you 5 years, so we depreciate it at $ 6,000 per year, one fifth per year.
After the first year, its book value is $ 24,000 (cost $ 30,000 – depreciation $ 6,000)
After the second year, your book value is $ 18,000 (last year’s book value $ 24,000 – depreciation $ 6,000)
Every year, $ 6,000 goes off your balance sheet and into your income statement, and because it’s an expense, it reduces your earnings by $ 6,000.
Earnings and cash flows are not necessarily the same
The above explains why you can have big profits and a falling bank account … or big losses and a rising bank account … or both profits and bank balances go up or both go down.
There is no connection between earnings and bank balance (or cash flows); depreciation is one of several reasons for this. Depreciation is simply a book entry, it is just a transfer between financial statements.
So in the first year, your bank account was decreased by the cost of the car ($ 30,000) and your profit only decreased by the depreciation expense of $ 6,000.
In the second year, the car had no impact on his bank account, but it took another $ 6,000 (depreciation) from his earnings. And the same for the next three years.
The same is true when you are preparing your budgets: depreciation expenses are in your earnings budgets but not in your cash flow budgets.
Buying businesses and making smart investment decisions
The above may seem like a lot of intellectual ideas.exit quine that has no particular relation to your real life … to anybody’s real life, really!
However, one thing you may have learned here (or elsewhere) is that the book values at which assets are shown on balance sheets have no relevance to the value of those assets. Book values are simply the mathematical balance of what is left after some depreciation is removed. And since depreciation is the best guess in the first place, nothing to do with it in terms of asset value should be relied upon.
If you are investing in a business, don’t trust asset book values at all. Book values mean absolutely nothing to you. If you do not know how much they are worth, do not look at the accounts, find an appraiser to value the assets for you.
What i’ve left out
Depreciation is a broad topic and my goal has been to explain its main function. It would be irresponsible if I did not warn you that there are things that I have not explained to you:
- Why don’t we depreciate most assets by the same amount (for example, $ 6,000) each year,
- What you (or your accountant) do when you sell an asset that has depreciated, and
- The numerous rules of the Bureau of Taxes on depreciation.
If you have more questions about depreciation, give me a call.
* From time to time, the people who control the accountants come out under different names for the same old things. I would never dare to suggest that it is to confuse people, but I have come to realize that each new name of an old thing is progressively bigger and bigger each time.
What we used to call a Statement of income now has to be called Financial performance statement. What we used to call a Balance sheet now has to be called Statement of financial position. Anyway, I guess it keeps someone happily employed!