I wanted to continue our discussion about depreciation. Last week we talked about the general idea of depreciation. In this video, I wanted to share with you a depreciation example. WATCH NOW!
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VIDEO SUMMARY
When you talk about depreciation, there are two main concepts you need to understand:
- Depreciation uses accrual accounting
- Depreciation expense is a non-cash transaction
Let us start out with accrual accounting. I have talked about accrual accounting before. I have a whole video on it. Accrual accounting means that you record revenues and expenses in the period they occur. This highlights the biggest problem with capital assets. They are, by definition, multi-year assets, but you are required to report on them in your financial statements every year. If you have an asset for five years, how do you describe how much you have used that asset for only one year. The way you do that is through depreciation.
Let us use a simple example. Imagine you bought equipment for $100,000 that you are going to use for 5 years. We are going to use straight line depreciation, although there are many different methods you can use. If you used straight line depreciation, you would use $20,000 of that investment each year for the next five years. It takes a multi-year asset, and splits it up so you can report on it each year.
Now take this example and imagine you did not use depreciation. You would not be using accrual accounting. You would record massive amounts of expense in year 1. That is not really accurate because you are using that asset for the next five years. Year 2-5 is also not accurate because you are reporting no expense at all.
Second point, depreciation expense is a non-cash transaction. Even though depreciation expense is usually very large, no money is involved. There is no actual cash exchanging between parties. This expense only exists in what accountants write down on the books. This is the difference between cash accounting and accrual accounting.
Let us go back to the example. In year one, you spent $100,000. This is when the cash exchanges hands. But the accountants only recorded $20,000 worth of depreciation expense. In year two, no money exchanged hands, but you recorded another $20,000 worth of depreciation expense. So there is a significant difference between what is happening with the cash and what is being recorded as an expense.
So this is where every accounting student raises their hand and asks the question, “If no cash is changing hands, why are we doing this?” This is a very fair question. Depreciation is a lot of work. Imagine a large company. You might have many different buildings, equipment, and vehicles. Each one of these items will have its own separate depreciation schedule. You are going to have one person just dedicated to figuring out depreciation. So why are we doing all this work, when there is not even any money involved. This just sounds like a whole lot of paperwork.
There is a very good reason for calculating depreciation. Remember that as an accountant, you are organizing the financial information of your business. The way you communicate this information is that every year you write a set of financial statements. Depreciation is the way you are able to communicate what is happening with your capital assets every single year on your financial statements. You must remember that capital assets are very important, massive purchases for your company. We are talking about enormous amounts of money. If you do not calculate depreciation, you are grossly misrepresenting the impact of your capital assets on your financial statements every year. What it gives you is powerful information you get to share with all the stakeholders of your company about what is happening with the capital assets.
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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.