Business

What is depreciation? Accounting for non-accountants

adminSeptember 30, 2022

If you were to ask four people what depreciation is, you would probably get four different answers:

1. The amount of wear and tear on assets,
2. An allowance to help replace assets,
3. The device of an accountant to reduce taxes, or
4. A 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 in a way that:

1. You will understand something more about your accounts,
2. You can impress your bank manager and others with your knowledge of accounting,
3. You will understand why depreciation is in your accounts and budgets but not in the cash flow statements,
4. You can better understand and prepare budgets, and
5. You’ll be able to understand accounts and make better decisions about companies you might consider buying or investing in.

My explanation of depreciation begins with expenses and assets:

Anything you spend money on, in your business, is what we call a debit:

• You pay your phone bill so you have a phone expense.
• You pay for a new car, so you 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 – the phone bill runs out and now has nothing to show for it. it is an expense
• Any expense that doesn’t run out in a year (hopefully your car lasts more than a year) is called an asset. At the end of the year you still have a car to show.

Expenses go to Statement of income* and reduce the benefit and, therefore, the tax. The Income Statement shows your income and expenses.

Assets go to scale sheet* and have no effect on earnings. The balance sheet shows what you owe and what you own at any given time.

Now what about the assets?

So you buy your car, and its cost is listed on 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’re 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. Therefore, we leave the land on your balance sheet at its original cost, until you sell it. We do not depreciate land.

All other assets will wear out or “run out” in some way, a bit like your phone bill, but for 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’ll keep each one. The best we can do, at first, 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 might 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 its cost and will have a Balance Sheet book value of $0.00.

We might assume 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 will have transferred all of its cost and will have a Balance Sheet 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, right? It is 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 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 ($30,000 cost – $6,000 depreciation).

After the second year, its book value is $18,000 (last year’s book value $24,000 – depreciation $6,000)

Each year $6,000 goes from your Balance Sheet to your Income Statement and, since it is an expense, it reduces your profit by $6,000.

Earnings and cash flows are not necessarily the same

The above explains why you can have huge profits and a bank account that goes down… or big losses and a bank account that goes up… or both profits and bank balances go up or both go down.

There is no connection between earnings and the bank balance (or cash flows); depreciation is one of several reasons for this. Depreciation is simply an entry in the book, it is just a transfer between the financial statements.

So in the first year, his bank account was reduced by the cost of the car ($30,000), and his earnings were only reduced by the $6,000 depreciation expense.

In the second year, the car had no impact on his bank account, but he deducted another $6,000 (depreciation) from his earnings. And the same in the next three years.

The same thing happens when you prepare your budgets: depreciation expenses are in your earnings budgets but not in your cash flow budgets.

Buy businesses and make smart investment decisions

The above may seem like a lot of intellectual eexit of who that has no particular relation to your real life… no one’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 taken out. And, since depreciation is the best guess in the first place, nothing to do with it should be trusted in terms of asset values.

If you’re investing in a business, then don’t rely on book values ​​of assets for anything. Book values ​​mean absolutely nothing to you. If you don’t know what they are worth, don’t look at the accounts but get a value to value the assets for you.

what i left out

Depreciation is a broad topic and my goal has been to explain its main operation. It would be irresponsible if I didn’t warn you that there are things I haven’t explained:

1. Why don’t we depreciate most assets by the same amount (say, $6,000) each year,
2. What you (or your accountant) do when you sell an asset that has depreciated, and
3. The many rules of the Tax Office on depreciation.

If you have any more questions about depreciation, give me a call.

* Every once in a while, the people who control meters come up with different names for the same old things. I would never dare to suggest that it is to confuse people, but I have noticed that each new name for an old thing is progressively larger and larger each time.

For example:

What we used to call a Statement of income now you have to call Statement of financial performance. What we used to call a scale sheet now you have to call Statement of financial position. Anyway, I guess it keeps someone happily employed!