If I was to ask four people what depreciation was, I’d probably get four different answers:
- The amount of wear and tear on assets,
- An allowance to help replace assets,
- An accountant’s device to reduce tax, or
- A way of allowing for inflation.
All four would be wrong. Accountants are not known for explaining things well – which may account for the above misconceptions – 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 knowledge,
- You will understand why depreciation is in your accounts and budgets but not in cash flow statements,
- You can understand and prepare budgets better, and
- You will be able to understand the accounts of – and make better decisions about – businesses you might consider buying or investing in.
My explanation of depreciation starts with expenses and assets:
Anything you spend money on, in your business, is what we call a debit:
- You pay your phone account so you have a phone expense.
- You pay for a new car so you have an asset, the car.
We pay out for both but accountants treat them differently. Why is that?
The reason is time.
- Any spending which is “used up” within a year is an expense – the phone bill is used up and you now have nothing to show for it. It’s an expense.
- Any spending which is not used up 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 show for it.
Expenses go into the Income Statement* and reduce profit and, therefore, tax. The Income Statement shows your income and expenses.
Assets go into the Balance Sheet* and have no effect on profit. The Balance Sheet shows what you owe and own at any point of time.
Now, what happens to assets?
So, you buy your car and its cost goes into the Balance Sheet, along with 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 in your Balance Sheet till your accountant does something with them… and what he or she does is depreciate them.
As you know, all assets except land wear out and eventually cease to exist. So we leave land in your Balance Sheet at its original cost, till you sell it. We do not depreciate land.
All other assets will wear out or get “used up” somehow – a bit like your phone bill, but over a much longer time. Of course, when you buy a car, a bulldozer, a trawler or a computer, we don’t know how long you will keep each one. The best we can do, at the start, is to guess just how long it will remain productive for you. Accountants’ attitude is that an educated guess is better than nothing at all.
We might guess that a building will last 50 years so we’ll transfer 2% of its cost from the Balance Sheet to the Income Statement each year. After 50 years we’ll have transferred all of its cost and we’ll have a Balance Sheet book value of $0.00.
We might guess that your office furniture will last 10 years so we’ll transfer 10% of its cost from the Balance Sheet to the Income Statement each year. After 10 years we’ll have transferred all of its cost and we’ll have a Balance Sheet book value of $0.00.
Depreciation is the cost of an asset, spread 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’s the cost of an asset, spread over its useful life. Talk like that and people will think you’re an accountant!
I’ll make it easier with numbers:
You buy your car for $30,000. You estimate that it will last you 5 years so we depreciate it at $6,000 per year – one fifth per year.
After year one, its book value is $24,000 (cost $30,000 – depreciation $6,000)
After year two, its book value is $18,000 (last year book value $24,000 – depreciation $6,000)
Each year $6,000 goes out of your Balance Sheet and into your Income Statement and, as it’s an expense, it reduces your profit by $6,000.
Profits and Cash Flows are not necessarily the same
The above explains why you can have huge profits and a falling bank account… or huge losses and a rising bank account… or both profits and bank balances going up or both going down.
There is no connection between profits and bank balance (or cash flows) – depreciation is one of several reasons for that. Depreciation is simply a book entry – it’s just a transfer between accounting statements.
So, in the first year, your bank account went down by the cost of the car ($30,000) and your profits only went down by the depreciation expense of $6,000.
In the second year, the car had no impact on your bank account but you took another $6,000 (depreciation) off your profits. And the same in the next three years.
The same thing happens when you’re preparing your budgets – depreciation expenses are in your profit budgets but not in your cash flow budgets.
Buying businesses and making intelligent investing decisions
The above may seem like a lot of intellectual equine output that has no particular relationship to your real life… to anyone’s real life, really!
However, one thing you will have learned here (or somewhere else) is that the book values that assets are shown at in Balance Sheets have no relevance to the value of those assets. Book values are simply the mathematical balance of what’s left after some depreciation is taken off. And, since depreciation is a best-guess in the first place, anything to do with it should not be relied on in terms of asset values.
If you’re investing in a business, then, don’t rely on the assets’ book values for anything. The book values mean absolutely nothing to you. If you don’t know what they’re worth, don’t look at the accounts but get a valuer to value the assets for you.
What I’ve left out
Depreciation is a large subject and my aim has been to explain the main workings of it. I would be irresponsible if I did not warn you that there are things I have not explained:
- Why we do not depreciate most assets the same amount (e.g. $6,000) every year,
- What you (or your accountant) do with when you sell an asset you’ve depreciated, and
- The Tax Office’s many rules on depreciation.
If you have any more questions about depreciation, call me.
* Every so often, the people who control accountants come out with different names for the same old things. I’d never dare suggest that it’s to confuse people but I have noticed that each new name for an old thing is progressively bigger and bigger each time.
What we used to call an Income Statement now has to be called Statement of Financial Performance. 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!