Difference Between Income Statement And Balance Sheet And Cash Flow What is Depreciation? Accounting For Non-Accountants

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What is Depreciation? Accounting For Non-Accountants

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

  1. The amount of depreciation of the property,
  2. Allowance for assistance in the replacement of property,
  3. Accountant device to reduce taxes, or
  4. A way to allow for inflation.

All four would be wrong. Accountants aren’t known for explaining things well – which might explain the above misconceptions – but I’ll try to explain it by:

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

My explanation of depreciation begins with expenses and assets:

Everything you spend money on in your business is what we call debt:

  • You pay your phone bill so you have a phone expense.
  • You pay for a new car in order to have an asset, a car.

We pay for both, but accountants treat them differently. Why is that?

The reason is time.

  • Any expense that is “spent” within a year is an expense – the phone bill is gone and now you have nothing to show for it. That’s the cost.
  • Any consumption that is not used up over the course of a year (hopefully your car will last more than a year) is called an asset. At the end of the year, you still have a car to show.

Costs go into Profit and loss account* and reduce profit, and thus tax. The income statement shows your income and expenses.

Property goes into Balance sheet* and have no impact on profit. The balance sheet shows what you owe and what you own at any given time.

Now, what happens to the property?

So, you buy your car and its cost goes on the balance sheet, along with land, buildings, plant, equipment and other assets. A balance sheet shows 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 or she does is depreciate.

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 price until you sell it. We do not depreciate the land.

All other assets will somehow wear out or “wear out” – kind of like your phone bill, but over a much longer period of time. Of course, when you buy a car, bulldozer, trawler or computer, we don’t know how long you’ll keep each one. The best we can do, in the beginning, is to guess how long it will remain productive for you. The accountant’s view is that an educated guess is better than nothing.

We could assume that the building will last 50 years, so each year we will transfer 2% of its cost from the balance sheet to the profit and loss account. After 50 years, we will have transferred all of its costs and will have a book value balance of $0.00.

We could assume that your office furniture will last 10 years, so we will transfer 10% of its cost from the balance sheet to the profit and loss account each year. After 10 years, we will have transferred all of its costs and will have a book value balance of $0.00.

Depreciation is the cost of an asset spread over its useful life. The amount that we transfer from your balance sheet to your profit and loss account each year is called depreciation.

Now you can quote the accounting definition of depreciation, right! It is the cost of the asset, spread over its useful life. Talk like that and people will think you’re an accountant!

I’ll make it easy with the numbers:

You are buying a car for $30,000. You estimate that it will last you 5 years, so we depreciate it to $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)

Every year, $6,000 goes from your balance sheet to your income statement, and because it’s an expense, it reduces your profit by $6,000.

Profit and cash flow are not necessarily the same

The above explains why you can have huge profits and a declining bank account… or huge losses and a rising bank account… or both profits and bank balances rising or both falling.

There is no connection between profit and bank balance (or cash flow) – depreciation is one of several reasons for this. Depreciation is simply a book entry – it’s just a transfer between accounting reports.

So in the first year, your bank account decreased by the cost of the car ($30,000) and your profit decreased only by the depreciation expense of $6,000.

In the second year, the car had no effect on your bank account, but you took another $6,000 (depreciation) from your profit. And so in the next three years.

The same thing happens when you prepare your budgets – depreciation expense is in your profit budgets, but not in your cash flow budgets.

Buying businesses and making intelligent investment decisions

The above may seem like a lot of intellectual equine output it has nothing to do with your real life… anyone’s real life, really!

However, one thing you will learn here (or elsewhere) is that the book values ​​at which assets are shown on balance sheets have no bearing on the value of those assets. Book values ​​are simply the mathematical balance of what’s left after a portion of the depreciation is taken out. And since depreciation is a best guess, you shouldn’t rely on anything to do with it in terms of property value.

If you’re investing in a business, don’t rely on the book value of the assets for anything. Book values ​​mean absolutely nothing to you. If you don’t know how much they are worth, don’t look at the bills, get an appraiser to value your property.

What I left out

Depreciation is a big topic and my aim was to explain its main working. I would be remiss 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 (eg $6,000) each year,
  2. What do you (or your accountant) do with when you sell the asset you depreciated, i
  3. Many IRS rules on depreciation.

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

* Every so often the people who control the accountants come up with different names for the same old things. I’d never dare say it’s to confuse people, but I’ve noticed that every new name for an old thing gets bigger and bigger each time.

For example:

What we used to call an Profit and loss account must be called now Report on financial results. What we used to call a Balance sheet must be called now Report on the financial position. Either way, I guess that keeps someone happily busy!

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