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If you capitalize a fixed asset, you are required to depreciate it on the business financial books.

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Quick reference

Depreciation

Depreciation has two purposes.  It is the way that the cost of a fixed asset investment is recorded on the Earnings Statement as a business expense and it provides a mechanism to determine a fixed asset value after it has been in service for several years.

When to Use Depreciation

If you capitalize a fixed asset, you are required to depreciate it on the business financial books.

Instructions

The concept of depreciation is very simple.  The acquisition value of the fixed asset is allocated over a number of years that normally represents the useful life of the asset. 

  • The allocation of the value to multiple years (sometimes it is even further sub-allocated by quarter or month) is known as the depreciation schedule. 
  • There are many different ways to allocate the value; finance will tell you which method to use based upon the asset type. 
  • Once a depreciation schedule is established for a fixed asset, it is not changed until the depreciation is complete or the asset is disposed of.
    • If you dispose of an asset before the depreciation schedule is complete, all remaining depreciation must be recorded at the time of disposal.
  • To start depreciating, you must know the value of the asset, the life in years over which the asset will be depreciated, the remaining residual value of the asset (normally $0) and the depreciation schedule that is to be used.
  • The amount of depreciation for a given year is recorded on the Earnings Statement as part of the fixed cost in the operations expense category.
    • Although it is in the operations expense category on the Earnings Statement, it is not part of OpEx.  The depreciation amount is still referred to as CapEx since it is the charge for a capital fixed asset.
  • Because the depreciation for a given year is in the Earnings Statement for that year, the Net Income is reduced by the amount of the depreciation.  However, since the value of the acquisition of the fixed asset was already recorded in the Cash Flow Statement as a Cash for Investment Activities at the time of the asset acquisition, the deprecation costs must be reversed in the Cash Flow from Operating Activities since that section starts with the Net Income for the given year.   
  • The value of the fixed asset is shown on the Balance Sheet as the original acquisition value less any accumulated depreciation.  This is also referred to as the Book Value.

 

Hints and Tips

  • The amount of depreciation can impact the amount of income tax due since it affects the Net Income and it will impact property tax due since property tax is calculated based upon the value of the asset.  Therefore taxing agencies pay very close attention to depreciation and that means that the Finance department will also pay close attention.
  • Once an asset goes into service, the depreciation must start and it cannot stop, even if you stop using the asset.  The only way to stop the depreciation is to dispose of the asset.
  • An asset can be fully depreciated and be on the books showing a “$0” asset value yet still providing value to the company.  This is often the case with equipment that has been in service for a long time.
  • If you dispose of an asset and receive more than its book value, you must show that as a capital gain on the Earning Statement; if you receive less than the book value you may show it as a capital loss on the Earnings Statement.
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  • 00:04 Hi I'm Ray Sheen.
  • 00:05 It's now time to talk about depreciation.
  • 00:08 We've mentioned this topic in many other modules, but
  • 00:11 let's dig deeper and understand how it really works.
  • 00:14 Let's go.
  • 00:15 Depreciation is often considered a complex and
  • 00:18 scary topic, but it is really very simple to understand.
  • 00:21 Depreciation is a special case of amortization.
  • 00:25 It applies to fixed assets.
  • 00:27 It is the allocation of the purchase price for an asset across multiple time periods.
  • 00:31 Instead of recording it as though the asset was paid for all at once, it is
  • 00:35 recorded in a way that spreads the cost of the asset over the life of the asset.
  • 00:40 It's still a capital asset expense so there's no shifting of accounts.
  • 00:44 This is done to reflect a better representation of the value of
  • 00:47 the asset to the business.
  • 00:49 Recall one of the principles that we tried to achieve in the business
  • 00:52 financial records is to line the costs and benefits in the same time period.
  • 00:56 The asset provides benefits across multiple time periods, so
  • 01:00 the costs are spread over those time periods.
  • 01:03 You can think of it as we're using up the value of that asset over time.
  • 01:08 Exactly how much depreciation should be charged in each time period,
  • 01:11 is found in the depreciation schedule.
  • 01:13 This calculation can be difficult and complex.
  • 01:17 But fortunately, as an operating manager, you don't need to do this calculation.
  • 01:21 Finance will do the calculation, and then give you the schedule that shows how much
  • 01:25 depreciation will be charged to your accounts in each time period.
  • 01:29 Let's look at how those depreciation charges are recorded
  • 01:32 in the financial reports of the business.
  • 01:35 On the earnings statement, the depreciation is treated as an operating or
  • 01:38 overhead expensive.
  • 01:40 This increase in expenses reduces the operating profit and
  • 01:44 eventually the net income by the depreciation amount.
  • 01:47 On the balance sheet the depreciation is subtracted from the value of
  • 01:50 the fixed assets.
  • 01:51 But here is the tricky part.
  • 01:53 The balance sheet must stay balanced.
  • 01:55 So what offsets the change?
  • 01:56 The value of retained earnings has absorbed the reduction
  • 01:59 of the amount of depreciation.
  • 02:01 Remember that net income is used for two things, dividends to shareholders and
  • 02:05 retained earnings.
  • 02:07 If the net income is lowered and
  • 02:08 the dividends stay the same, the retained earnings must be lowered.
  • 02:12 The cash flow statement is also a bit tricky.
  • 02:15 Remember we already accounted for
  • 02:16 the cost of this asset as an investing activity when the asset was capitalized.
  • 02:21 If we were to include the depreciation charge we
  • 02:24 would end up double counting the cost of the asset.
  • 02:27 Although that income, which is the first entry into the operating activities in
  • 02:30 the cash flow statement, does include the depreciation charge in its calculation.
  • 02:35 So we must add the depreciation charge back in, which offsets the depreciation.
  • 02:40 That means that the actual cash flow is zero.
  • 02:44 Just as with capitalization, there are numerous and complex accounting and
  • 02:47 tax rules with depreciation.
  • 02:49 Check with your local finance person to understand what applies to your situation.
  • 02:54 Let me show you what those impacts look like on the financial reports.
  • 02:58 On the earnings statement, depreciation charges are added to operating expenses,
  • 03:02 which reduces net income.
  • 03:04 On the balance sheet, depreciation is subtracted from the value of the fixed
  • 03:08 assets and the retained earnings have been suppressed by the amount of depreciation.
  • 03:12 On the cash flow statement, since that income has been reduced by the amount of
  • 03:16 depreciation, that amount is added back in.
  • 03:20 This highlights a key characteristic of depreciation.
  • 03:23 Although it is a charge to the business on the earnings statement,
  • 03:26 no cash flows anywhere.
  • 03:28 No one writes a check to make a deposit that is marked depreciation.
  • 03:32 Why is that?
  • 03:33 Because we've already accounted for the cash for
  • 03:36 the purchase of that asset when we capitalized it.
  • 03:38 I wanna close this module by showing an example of what happens with the assets
  • 03:42 while it was being depreciated.
  • 03:45 Let's say we have an asset that cost $110,000.
  • 03:48 Further, we will stipulate that the asset has a five year life.
  • 03:51 Incidentally, finance has set the life span for
  • 03:53 different categories of assets based upon standard accounting rules.
  • 03:57 It's not open for debate so don't waste your time.
  • 04:00 From my example, we will say the asset has a residual value of $10,000.
  • 04:04 And finally, I will use what is called the straight line method for
  • 04:07 determining the amount of depreciation each year.
  • 04:09 I'm doing that just because it makes the math easy.
  • 04:12 Finance will calculate your depreciation schedule based upon the asset type and
  • 04:15 the current accounting rules.
  • 04:17 So let's look at what happens over time.
  • 04:19 The asset is initially valued at $110,000 when it goes into service.
  • 04:24 The first year there is a $20,000 depreciation charge, and
  • 04:28 the value decreases to 90,000.
  • 04:30 The next year is another $20,000 charge,
  • 04:33 the accumulated depreciation is now $40,000.
  • 04:36 So the current value of the asset, called the book value, is $70,000.
  • 04:40 We continue taking a depreciation charge every year, and
  • 04:43 the book value drops to 50,000, then to 30,000, then finally 10,000.
  • 04:48 That is our residual value, and no further depreciation is done below that level.
  • 04:53 The asset stays on the financial books at a $10,000 value.
  • 04:57 Just because an asset is fully depreciated,
  • 04:59 a company does not need to take it out of service.
  • 05:01 I've worked in manufacturing operations where we had equipment
  • 05:04 that had been in service for many years after it was fully depreciated.
  • 05:08 And that equipment was still making some very good parts.
  • 05:13 >> So let's summarize.
  • 05:14 Depreciation is the process that allows a company to spread the costs of a capital
  • 05:19 investment asset across the years when that asset will be in use.
  • 05:23 But, it does create a set of special rules for recording and reporting those charges.

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