Stereotypically, accountants aren’t depicted as the coolest people in the office (unless you’re talking about the movie, sorry y’all…). Often, you’ll see them sitting in a room for an eternity, adding and subtracting the same numbers across millions of pages of financial documents–I know, I know, you must be hanging on the edge of your seat by now.
However, what the accounting-types tend to be very good at is creatively ‘cooking the books’ to make a company’s financials seem better–or worse–than they actually are. How? Well, there are tons of different tax codes that can be used to play with the bottom line, but today we’re going to focus on something that even a second-rate accountant can handle: depreciation.
Depreciation is a fun accounting procedure that allocates an asset’s cost over it’s usable life. From a “finance perspective,” depreciation is how you pretend that you’ve been paying for something over several years instead of just on the day that you actually bought it.
For example, let’s say that you own a long-distance delivery company and you need to buy a new delivery truck. You typically run these trucks, which cost $136,000, into the ground in about 8 years. Instead of marking the whole $136,000 as an expense during the purchase year, you decide to work the expense into multiple years. Sounds strange to do, right? Well, it’s not without its advantages.
By depreciating an asset over a length of time, you are able to manipulate your expenses in the coming periods, which has a multitude of effects across the three financial statements: Income Statement, Balance Sheet, and Statement of Cash Flows. But before we get into the effects of depreciation, let’s take a look at how it’s done.
Of the many types of depreciation, there are two that tend to come up often: straight-line depreciation and double-declining-balance depreciation (mostly because they are the most straight-forward, pun intended). The annual straight-line depreciation (SL) is found by simply taking the cost of the asset, subtracting the value of it at the end of its useful life (assuming it can be sold or scrapped), and dividing it over the number of periods in the useful life. To put it in a formula, we have SL= (asset purchase cost – scrap value)/useful life.
Taking it back to our delivery truck example, the cost was $136,000, the useful life is estimated at 8 years, and let’s assume it can be sold/scrapped for $16,000 at the end of the useful life. That would mean we can depreciate it at a rate of $15,000 each year for 8 years. It’s An important to note is that depreciation expense is a non-cash expense, which means that, since there is no cash being physically moved around, it doesn’t affect a company’s cash position in.
If you thought straight-line depreciation was easy, double-declining-balance depreciation (DDB) is even easier. DDB doubles the depreciation percentage from straight-line, so the formula is DDB= 2 x ((asset purchase cost – scrap value)/useful life). The big thing to remember about DDB is that, since you are doubling the depreciation amount, you have a larger depreciation in the first few years, but a smaller depreciation in subsequent years. That’s because you’re depreciating based on a percentage of the remaining value each year, instead of the original value. Otherwise, by the fourth or fifth year, you’re depreciating a worthless asset–which is tax fraud.
Alright, so we used some fancy words and made some fancy formulas, but what does it all mean? As promised, let’s take a look at how depreciation makes its way across the different financial statements (which, by the way, is a popular interview question in the world of finance).:
Let’s assume your shipping company uses straight-line depreciation, meaning that we will be depreciating the truck at $15,000/year for 8 years:
On the income statement, an outline of a company’s profitability, we have that the depreciation expense of $15,000 lowers the Earnings Before Income and Taxes (EBIT) by $15,000, and at an assumed tax rate of 40%, this translates to a $9,000 decrease in Net Income.
The statement of cash flows, a “follow the money” view of a company’s cash, but if you remember from above that depreciation is a non-cash expense, you might think there is no effect on cash flows, right? Wrong. Since you are adding $15,000 in depreciation expense, and decreasing net income by $9,000, there is actually a $6,000 increase in Cash Flow from Operations. Why? Since you are decreasing your taxable income, you are no longer paying $6,000 in taxes that you would have paid, you have “earned” $6,000 in operating cash–pretty cool, right?
A company’s balance sheet is a bit more complicated, as it is the snapshot of its resources and the funds used to accumulate those resources (in accounting lingo, assets and liabilities). Accumulated depreciation is a line item that tracks all of the depreciation that has appeared in the statements thus far; so in year one of the truck you’ll see an accumulated depreciation of $15,000, year two will be $30,000, and so on. Accumulated depreciation is a contra-asset and falls under a Property, Plant, and Equipment (PP&E), which is an asset. Therefore, Net Property, Plant, and Equipment is lowered by $15,000. Since we increased our cash position by $6,000, we add that to the asset side. The $9,000 decrease in net income leads to a decrease in retained earnings of $9,000 (since it is a collection of all the retained income over the years).
Wait a second, did you see what just happened? We decreased the asset side of the balance sheet by $9,000 (-$15,000 in Net PP&E +$6,000 in Cash) and lowered the liability side of the balance sheet by $9,000 as well–presto change-o, the balance sheet is balanced!
Now that you know how it works, be wary the next time you take a look at a company with strange depreciation values–they are likely trying to manipulate their net income balances to make certain periods look better than others. However, if you’re the one inside of the company who needed a way to “tweak” the appearance of the company “on-paper,” you’re welcome.
*This article was edited to correct an error that Double-declining Balance Depreciation depreciates an asset in half the time. Instead, it depreciates a larger portion of the value in the beginning.