| If I was to ask four people what depreciation was, I'd | | | | we call depreciation. |
| probably get four different answers: | | | | So now you can quote the accounting definition of |
| | | | depreciation, can't you! It's the cost of an asset, spread |
| 1. The amount of wear and tear on assets, | | | | over its useful life. Talk like that and people will think |
| 2. An allowance to help replace assets, | | | | you're an accountant! |
| 3. An accountant's device to reduce tax, or | | | | I'll make it easier with numbers: |
| 4. A way of allowing for inflation. | | | | You buy your car for $30,000. You estimate that it will |
| All four would be wrong. Accountants are not known | | | | last you 5 years so we depreciate it at $6,000 per |
| for explaining things well - which may account for the | | | | year - one fifth per year. |
| above misconceptions - but I'll try to explain it so that: | | | | After year one, its book value is $24,000 (cost |
| | | | $30,000 - depreciation $6,000) |
| 1. You will understand something more about your | | | | After year two, its book value is $18,000 (last year |
| accounts, | | | | book value $24,000 - depreciation $6,000) |
| 2. You can impress your bank manager and others | | | | Each year $6,000 goes out of your Balance Sheet |
| with your accounting knowledge, | | | | and into your Income Statement and, as it's an |
| 3. You will understand why depreciation is in your | | | | expense, it reduces your profit by $6,000. |
| accounts and budgets but not in cash flow statements, | | | | Profits and Cash Flows are not necessarily the same |
| 4. You can understand and prepare budgets better, | | | | The above explains why you can have huge profits |
| and | | | | and a falling bank account... or huge losses and a rising |
| 5. You will be able to understand the accounts of - and | | | | bank account... or both profits and bank balances going |
| make better decisions about - businesses you might | | | | up or both going down. |
| consider buying or investing in. | | | | There is no connection between profits and bank |
| My explanation of depreciation starts with expenses | | | | balance (or cash flows) - depreciation is one of |
| and assets: | | | | several reasons for that. Depreciation is simply a book |
| Anything you spend money on, in your business, is | | | | entry - it's just a transfer between accounting |
| what we call a debit: | | | | statements. |
| - You pay your phone account so you have a phone | | | | So, in the first year, your bank account went down by |
| expense. | | | | the cost of the car ($30,000) and your profits only |
| - You pay for a new car so you have an asset, the | | | | went down by the depreciation expense of $6,000. |
| car. | | | | In the second year, the car had no impact on your |
| We pay out for both but accountants treat them | | | | bank account but you took another $6,000 |
| differently. Why is that? | | | | (depreciation) off your profits. And the same in the |
| The reason is time. | | | | next three years. |
| - Any spending which is "used up" within a year is an | | | | The same thing happens when you're preparing your |
| expense - the phone bill is used up and you now have | | | | budgets - depreciation expenses are in your profit |
| nothing to show for it. It's an expense. | | | | budgets but not in your cash flow budgets. |
| - Any spending which is not used up in a year (your | | | | Buying businesses and making intelligent investing |
| car lasts more than a year, hopefully) is called an | | | | decisions |
| asset. At the end of the year you still have a car to | | | | The above may seem like a lot of intellectual equine |
| show for it. | | | | output that has no particular relationship to your real |
| Expenses go into the Income Statement* and reduce | | | | life... to anyone's real life, really! |
| profit and, therefore, tax. The Income Statement | | | | However, one thing you will have learned here (or |
| shows your income and expenses. | | | | somewhere else) is that the book values that assets |
| Assets go into the Balance Sheet* and have no | | | | are shown at in Balance Sheets have no relevance to |
| effect on profit. The Balance Sheet shows what you | | | | the value of those assets. Book values are simply the |
| owe and own at any point of time. | | | | mathematical balance of what's left after some |
| Now, what happens to assets? | | | | depreciation is taken off. And, since depreciation is a |
| So, you buy your car and its cost goes into the | | | | best-guess in the first place, anything to do with it |
| Balance Sheet, along with land, buildings, plant, | | | | should not be relied on in terms of asset values. |
| equipment and other assets. The Balance Sheet | | | | If you're investing in a business, then, don't rely on the |
| shows you what assets you own... but not how much | | | | assets' book values for anything. The book values |
| they are worth. These assets stay in your Balance | | | | mean absolutely nothing to you. If you don't know what |
| Sheet till your accountant does something with them... | | | | they're worth, don't look at the accounts but get a |
| and what he or she does is depreciate them. | | | | valuer to value the assets for you. |
| As you know, all assets except land wear out and | | | | What I've left out |
| eventually cease to exist. So we leave land in your | | | | Depreciation is a large subject and my aim has been |
| Balance Sheet at its original cost, till you sell it. We do | | | | to explain the main workings of it. I would be |
| not depreciate land. | | | | irresponsible if I did not warn you that there are things I |
| All other assets will wear out or get "used up" | | | | have not explained: |
| somehow - a bit like your phone bill, but over a much | | | | |
| longer time. Of course, when you buy a car, a | | | | 1. Why we do not depreciate most assets the same |
| bulldozer, a trawler or a computer, we don't know how | | | | amount (e.g. $6,000) every year, |
| long you will keep each one. The best we can do, at | | | | 2. What you (or your accountant) do with when you |
| the start, is to guess just how long it will remain | | | | sell an asset you've depreciated, and |
| productive for you. Accountants' attitude is that an | | | | 3. The Tax Office's many rules on depreciation. |
| educated guess is better than nothing at all. | | | | If you have any more questions about depreciation, call |
| We might guess that a building will last 50 years so | | | | me. |
| we'll transfer 2% of its cost from the Balance Sheet | | | | * Every so often, the people who control accountants |
| to the Income Statement each year. After 50 years | | | | come out with different names for the same old things. |
| we'll have transferred all of its cost and we'll have a | | | | I'd never dare suggest that it's to confuse people but I |
| Balance Sheet book value of $0.00. | | | | have noticed that each new name for an old thing is |
| We might guess that your office furniture will last 10 | | | | progressively bigger and bigger each time. |
| years so we'll transfer 10% of its cost from the | | | | For example: |
| Balance Sheet to the Income Statement each year. | | | | What we used to call an Income Statement now has |
| After 10 years we'll have transferred all of its cost and | | | | to be called Statement of Financial Performance. |
| we'll have a Balance Sheet book value of $0.00. | | | | What we used to call a Balance Sheet now has to be |
| Depreciation is the cost of an asset, spread over its | | | | called Statement of Financial Position. Anyway, I guess |
| useful life. The amount we transfer from your Balance | | | | it keeps someone happily employed! |
| Sheet to your Income Statement each year is what | | | | |