“It’s widely known that depreciation is a non-cash accounting/tax principle.” That’s what one reader said when questioning the fact that depreciation affects the statement of cash flow. He said it didn’t and we could disregard it. Well, depreciation is a real expense and does affect the statement. More importantly, it represents real cash as well. I trust the following brilliant explanation will answer questions you might have on the topic once and for all.
Let’s begin at the beginning. An asset is something of value that we own or control such as equipment. The value of equipment decreases with usage and age. When we buy it, we record its value on our balance sheet at the purchase price of, say, $100,000. Now wait five years, run off a few million impressions, and sell it. We won’t get $100,000 for it. Of course not.
What we will get varies, but let us say we get $10,000 after five years. So, what did the equipment cost? It cost $90,000 ($100,000-$10,000). Now, when was the $90,000 “used up”? In year five when we sold it? No, obviously, it was over the five year period, or $18,000 a year on average.
Now, as a business owner, do we want to wait until year five to recognize the $90,000 cost of the equipment? Or would we prefer to “estimate” the loss in value each year, and thus reduce our income taxes in these in between years? Duh!
Nuts & Bolts of Depreciation
And this is where the whole argument of an “estimate” and the fact that it’s not “real money” comes into play. Well, it is real money. Just follow the cash trail. We pay $100,000 from our checkbook on day one to get the equipment (borrowing to pay for the equipment is a more complex explanation, but, essentially, is similar to this example).
Now, in year one (disregarding any Section 179 or bonus depreciation) we charge $18,000 against our earnings as depreciation. That’s the same depreciation that my friend argues isn’t real money. What happens to the $18,000? It goes back into our checking account to replenish the $100,000 we withdrew to buy the equipment. So in year one, we withdrew $100,000 and put $18,000 back in, leaving us down $82,000 on the transaction.
In year two, we charge another $18,000 estimate in the form of depreciation, so we deduct that from the $82,000 negative balance, and we have a negative $64,000 at the end of year two. At the end of year three our balance is $46,000; year four it’s $28,000; and year five it’s $10,000. Again, at the end of year five we sold the equipment for $10,000, so when we put that money in the bank, our balance on this transaction is now $0. We took out $100,000 from our checkbook and we put back in $100,000 through depreciation and the final sale on the equipment.
So, does depreciation represent real cash? Yes.
The Debt Element
The example is essentially the same when we borrow money to buy the equipment, although it’s a little harder to see. The cash on day one doesn’t come out of our checkbook; rather the bank puts $100,000 into our checkbook in exchange for a note (loan). We then pay it out to the equipment vendor.
Our depreciation calculation is the same, so we’re estimating a cost of $18,000 each year to go back into our checkbook. The difference here is that it doesn’t stay there. No, we then make a “hidden” payment to the bank on the note.
That payment is made up of two components: principal and interest. Interest is the cost to us for borrowing the money, and shows up on our income statement. But the principal is the amount we reduce the loan, so it’s not an expense. Rather, it’s like a distribution, dividend, or withdrawal. We take cash out of our checkbook and pay down our debt. No expense is involved. And this is why it is a “hidden” transaction, for it doesn’t show on the income statement.