What is Depreciation?
We all know if you go out and buy a new car, over time it will lose value. In fact, with a car, once you drive it out of the garage and then try to resell it, you will not get the value you paid. This reduction in value is known as depreciation. So in essence, depreciation is the reduction in value of an asset over time due to wear and tear.
When a company or a business purchases an asset, such as a car or a piece of equipment, the cost is capitalized to the Statement of Financial Position. The full cost does not hit the Income statement in the period in which it was purchased. The reason for this is because an asset will give a company benefit over a period of time, not just in the period it was purchased.
Let’s Look at an Example.
Joe sets up a small recording studio. He purchases equipment on the first day to the value of $10,000. In his first year he has turnover of $12,000 and operating costs of $3,000. If Joe were to expense his equipment to the Income statement in the first year he would show a loss of $1,000.
|Year 1||Year 2|
The following year, Joe has a turnover again of $12,000 and operating costs of $3,000. Therefore he would show a profit of $9,000. That’s a sizable difference in profit and does not truly reflect the cost of the business. Joe is still using the same equipment in the second year. But the full cost was shown in the first year.
So what has Joe done wrong to see such a change in his profit from year 1 to year 2?
In Year 1 Joe should not expense his equipment to the Income statement. Instead the cost should be recorded in the Statement of Financial Position as an Asset. The cost of the equipment should be capitalized. Then cost should then be apportioned over the useful life of the asset. Joe knows that he will need to replace the equipment in 7 years, so the cost should be split over 7 years.
How to Calculate Depreciation
There are two methods for depreciation. Straight line depreciation and Reducing balance depreciation (also know as declining balance depreciation).
In this video you will learn how to calculate Straight line depreciation (please give it the thumbs up if you like it…..)
In this video you will learn how to calculate simple Reducing balance depreciation (please give it the thumbs up if you like it…..)
How does Depreciation Effect Profit
The annual depreciation charge effects the Income statement by the amount of depreciation charged to the depreciation expense account. It is a cost to the business and costs reduce profit.
In the example of reducing balance depreciation, the first year depreciation was 2,000. The Expenses would include this amount as it is a cost to the entity. In the second year the depreciation was 1,000, therefore the expenses would include this amount as a the cost to the entity. Each year the depreciation is reducing as the method used is the reducing balance method.
With the straight line method that was shown in the first video, the annual depreciation remained the same each year. So the cost to the business is 30,000 and this is accounted for in the income statement as an expense, reducing the profit.
How does Depreciation Effect Cash flow
Profit does not equal cash, and expenses do not always effect cash flow. When looking at the Statement of Cash Flows, we first need to calculate Cash flow from Operating activities. To do this, began with Profit before taxation, and then adjustments in respect of non-cash transactions. Depreciation is a non cash transaction. No cash is exchanged, and the bank account is not touched, as we will see in the video ‘how is depreciation accounted for – The double entry’. The effect of this is that depreciation must be added back to the profit before taxation.
The amount that is added back in the statement of cash flows is the value that is charged to the income statement for that period. A common mistake made when preparing the statement of cash flows is the accumulated depreciation is entered. You need to remember that the accumulated depreciation amount is found in the balance sheet and represents the total depreciation on the asset from the date of purchase. Where as the depreciation in the Income statement reflects the cost in the period and the cash flow statement is also prepared for the period.
Next week I will show you how to depreciation is recorded and accounted for, including the double entry. Make sure you sign up to my newsletter so you don’t miss out on the video posts!
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Paula Guilfoyle CPA.
Paula is a Qualified CPA with over 15 years’ experience in the fields of Accountancy, Business Management,Process improvement, Internal Audit, Group accountant, Operations management and Training. All across a broad range of industries and sectors. Paula has been Key Speaker at many Accounting Events where her talks on Excel are received very positively. Taken from her experiences in Accounting and business fields, Paula also has Udemy courses and Curious lessons for those wishing to up skill, especially in the area of Spreadsheets, Bookkeeping and Accounting.
Now an E-learning Educator 5+ years, Paula also has a focus on E-learning, Online Teaching and Instructional Design. Drawn from her online teaching experience,Paula has a number of courses available to online teachers to help bridge the skills gap for those that teach or wish to teach online.
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