Introduction to depreciation

Introduction to Depreciation

from businessbankingcoach.com

in association with

There’s a lot of confusion

about what depreciation

actually is. Some think it

has something to do with

an asset losing its

value……..

…….. while others think

that it’s a mechanism for

a business to create a

fund for the replacement

of the asset when it’s no

longer functional.

So, in this

presentation, let’s

take a look at what

depreciation really is,

how it’s calculated

and ……

….what impact it has on

the income statement,

the balance sheet and the cash flow statement.

Depreciation is a term used in

accounting to spread the cost of

a fixed asset over the span of its useful life.

In this context, an asset’s

useful life is the expected

period of time over which it will

contribute additional profits to the business through its use…..

….. that is, by being more

productive either by

increasing output or

reducing the cost of

production.

The “useful life” of fixed

assets is often confused

with the period of time

that the tax authorities

allow an accelerated tax

deduction on the cost of

certain types of fixed

assets.

This tax allowance is

usually known as a “wear

and tear allowance” or

something similar.

There is no direct

relationship between

depreciation and the “wear

and tear allowance”.

The amount of depreciation

calculated annually is

included as an expense in

the income statement and

therefore has the effect of

reducing profits.

It’s important to note that depreciation does

not affect the actual (or market) value of the

asset being depreciated; only it’s value on

the statement of financial position.

On the balance sheet, the assets that are

being depreciated are shown at the net

book value…..

….. that is, the initial cost

of the asset less the

accumulated amounts of

depreciation that have

been calculated in

respect of that asset.

Let’s give an example

to explain the impact

on the balance sheet

and what happens

when cost and market

value are sometimes

different…..

Imagine that a business buys a

piece of equipment for

100,000……...

…….that is the

amount of the

transaction that will

initially appear in

the accounts of the

business.

However, the business may have bought that

equipment cheaply from another business

that needed to raise some cash quickly.

Let’s say that the

equipment was worth

200,000, i.e. more than the

business actually paid for it.

In calculating the

depreciation, the actual (or

market) value is irrelevant –

the equipment will be

depreciated based on its

cost (100,000)…..

… not its value (200,000).

Now imagine that the

business depreciates

the equipment over 3

years and….

…..at the end of the 3

years the equipment’s

cost (100,000) has been

fully depreciated and

there is no amount

attached to it in the

accounts of the

business.

That doesn’t mean that

the asset has no market

value if the business

wanted to sell it, only that

its cost has now been

fully depreciated.

Because it was

purchased cheaply, the

equipment still has a

market value after 3

years of 50,000.

So, in this example, the

market value of the asset

has not reduced to zero as

a result of depreciation…..

…..it was simply an

accounting procedure to

expense the cost of the

equipment over its useful

life.

The key point to take away

from this is that the value of

an asset that you see on the balance sheet …..

…….usually bears no

relation to its actual value

and in your analysis you

should keep that firmly in

mind and try to get actual

assets values if you want to

determine the true value of the business.

One final point; no cash

changes hands following the

calculation of depreciation

so it never features on a

cash flow statement.

We do hope that you enjoyed this presentation.

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