Why Depreciation is Important

Funny story. I have a video that I have never uploaded to YouTube, and it’s the video I am going to show you this week, where I discuss the reason why depreciation is important. Let me give you some background. Last March, eight months ago, I was doing a six-part video series on capital assets. When it was time for the final week, that was the same week that the pandemic hit the United States, the president declared a national emergency, and the stock market crashed. Instead of uploading my video, I made a new video discussing what was going on in financial markets. And every week since then, I have not had a chance to upload my video on capital assets, because there has always been something crazy going on in the world that we have to talk about. Now here we are, eight months later, and I cannot wait any longer. So this week I will be playing for you the video that is my final installment of my capital asset series, on why Depreciation is Important. It is also funny to see me eight months ago. I feel like I have aged quite a bit dealing with the craziness of the last eight months. I don’t know if anyone else can relate to that. If you want to watch the whole playlist, I’ll put it in the description box down below.

Quick announcement before I start the video. I will be doing a live Excel training class this coming week on Thursday at 10am Phoenix time. It will be a free one-hour training class on how to set up your Excel worksheets. This will be the best Excel training class you have ever taken. It will be live so you will have a chance to ask me questions. If you miss it, I will also be uploading the video, so you can watch it after the fact. So keep your eyes open for that. It will be happening this Thursday.

VIDEO SUMMARY

We have been talking a lot about capital assets and depreciation. What I want to focus on in this video is why. Why do we use depreciation? It is very complicated. It takes a lot of work. Why do we do it? The reason we use depreciation is because of stock investors and I will explain how the owners of companies think about depreciation.

As accountants, our primary responsibility is to deliver a set of financial statements. Those financial statements are written for stock holders, owners of the company, debt holders, and stakeholders. When all these people read these financial reports, they are really asking one main question: Does the business model work?

Every organization is a business model. There is money going in, and money going out. For a business, you want this business model to generate a profit. For a non-profit organization, you want to make sure your organization remains solvent.

We have discussed how capital assets are a strategic purchase. These are big purchases you are making in an area of competitive advantage that will allow your business to operate. Stock investors look at depreciation to understand how profitable the business really is. You cannot just look at the profitability of operations. You have to evaluate operations plus the impact from the original investment.

Let us use the example from last week. You bought equipment for $100,000 that you are going to use for 5 years. If you used straight line depreciation, you would use $20,000 of that investment each year for the next five years.

This capital investment will allow your business to generate sales. Let’s do a sample income statement each year. Assume $40,000 in sales, $20,000 in Cost of Goods Sold (COGS) for a Gross Profit of $20,000 each year. This analysis is incomplete unless you also include the impact from Depreciation, which is another $20,000 expense each year. Your real profit is $0. This is telling stock investors that this business model does not work. Without depreciation, you would be getting misleading information.

It is also important to realize that depreciation affects both the balance sheet and the income statement. There are two things going on. You are reducing the value of the assets recorded on the balance sheet. At the same time, you are recording the expense on the income statement. This takes the form of a journal entry of debit to Depreciation Expense (income statement account) and a credit to Accumulated Depreciation (balance sheet account). So every year, you are showing how assets are decreasing in value as you use them. Decreasing the asset on the balance sheet shows investors how much assets they really have left. This is really important, because if they want to keep the business model going into the future, they are going to have to invest in more capital assets when the equipment in place becomes worn out.

These examples are very simplistic. But you have to realize, that real businesses are very complex. You are dealing with hundreds, if not thousands of capital assets, all with different life spans. The only way an owner of a company can make sense of all that complexity, is through depreciation. This enables them to look at a business and answer the question, does this business model still work?

Zach DeGregorio

www.WolvesAndFinance.com

If you have accounting questions, you can email me at my website www.WolvesAndFinance.com and I will reply with my rates.

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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.

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