Depreciation is a type of expense that is used to reduce the carrying value of an asset. It is an estimated expense that is scheduled rather than an explicit expense. Depreciation is found on the income statement, balance sheet, and cash flow statement. Depreciation can be somewhat arbitrary which causes the value of assets to be based on the best estimate in most cases.
Key Takeaways
- Companies use investing cash flow to make initial payments for fixed assets that are later depreciated.
- Depreciation is a type of expense that is used to reduce the carrying value of an asset.
- Depreciation is entered as a debit on the income statement as an expense and a credit to asset value (so actual cash flows are not exchanged).
Depreciation
Depreciationis a type of expense that when used, decreases the carrying value of an asset. Companies have a few options when managing the carrying value of an asset on their books. Many companies will choose from several types of depreciation methods, but a revaluation is also an option.
Depreciation is an accounting method for allocating the cost of a tangible asset over time. Companies must be careful in choosing appropriate depreciation methodologies that will accurately represent the asset’s value and expense recognition. Depreciation is found on the income statement, balance sheet, and cash flow statement. It can thus have a big impact on a company’s financial performance overall.
Ultimately, depreciation does not negatively affect the operating cash flow (OCF) of the business.
Depreciation Accounting
The use of a depreciation method allows a company to expense the cost of an asset over time while also reducing the carrying value of the asset. There are several accounting entries associated with depreciation. Initially, most fixed assets are purchased with credit which also allows for payment over time. The initial accounting entries for the first payment of the asset are thus a credit to accounts payable and a debit to the fixed asset account.
If the asset is fully paid for upfront, then it is entered as a debit for the value of the asset and a payment credit. Companies use their cash flow to make payments for fixed assets.
Depreciation spreads the expense of a fixed asset over the years of the estimated useful life of the asset. The accounting entries for depreciation are a debit to depreciation expense and a credit to fixed asset depreciation accumulation. Each recording of depreciation expense increases the depreciation cost balance and decreases the value of the asset.
For example, if a company buys a vehicle for $30,000 and plans to use it for the next five years, the depreciation expense would be divided over five years at $6,000 per year. Each year, depreciation expense is debited for $6,000 and the fixed asset accumulation account is credited for $6,000. After five years, the expense of the vehicle has been fully accounted for and the vehicle is worth $0 on the books. Depreciation helps companies avoid taking a huge expense deduction on the income statement in the year the asset is purchased.
Financial Statement Effects
On the balance sheet, a company uses cash to pay for an asset, which initially results in asset transfer. Because a fixed asset does not hold its value over time (like cash does), it needs the carrying value to be gradually reduced. Depreciation expense gradually writes down the value of a fixed asset so that asset values are appropriately represented on the balance sheet.
On the income statement, depreciation is usually shown as an indirect, operating expense. It is an allowable expense that reduces a company’s gross profit along with other indirect expenses like administrative and marketing costs. Depreciation expenses can be a benefit to a company’s tax bill because they are allowed as an expense deduction and they lower the company’s taxable income. This is an advantage because, while companies seek to maximize profits, they also want to seek ways to minimize taxes.
Taxes
The use of depreciation can reduce taxes that can ultimately help to increase net income. Net income is then used as a starting point in calculating a company's operating cash flow. Operating cash flow starts with net income, then adds depreciation or amortization, net change in operating working capital, and other operating cash flow adjustments. The result is a higher amount of cash on the cash flow statement because depreciation is added back into the operating cash flow.
Ultimately, depreciation does not negatively affect the operating cash flow of the business.
Where cash flow effects can be seen are in investing cash flow. Cash must be paid to buy the asset before depreciation begins. While this is merely an asset transfer from cash to a fixed asset on the balance sheet, cash flow from investing must be used.
As such, the actual cash paid out for the purchase of the fixed asset will be recorded in the investing cash flow section of the cash flow statement. Companies may choose to finance the purchase of an investment in several ways. They may wish to pay in installments. They might get a loan or they could possibly even issue debt. Regardless they must make the payments for the fixed asset in separate journal entries while also accounting for the lost value of the fixed asset over time through depreciation.
Special Considerations
Return on equity (ROE) is an important metric that is affected by fixed asset depreciation. A fixed asset’s value will decrease over time when depreciation is used. This affects the value of equity since assets minus liabilities are equal to equity. Overall, when assets are substantially losing value, it reduces the return on equity for shareholders.
Earnings before interest taxes, depreciation, and amortization (EBITDA) is another financial metric that is also affected by depreciation. EBITDA is an acronym for earnings before interest, tax, depreciation, and amortization. Analysts can look at EBITDA as a benchmark metric for cash flow. It is calculated by adding interest, tax, depreciation, and amortization to net income. Typically, analysts will look at each of these inputs to understand how they are affecting cash flow.
