There’s a lot of confusion about what depreciation actually is. Some think it has something to do with an asset losing its value while others think that it’s a mechanism for a business to create a fund for the replacement of the asset when it’s no longer functional. Over the next few episodes, let’s take a look at what depreciation really is, how it’s calculated and what impact it has on the income statement, the balance sheet and the cash flow statement. In this presentation, we’ll define depreciation and clarify the concept.

1. Introduction to
Depreciation
from
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2. There’s a lot of confusion
about what depreciation
actually is. Some think it
has something to do with
an asset losing its
value……..

3. …….. while others think
that it’s a mechanism for
a business to create a
fund for the replacement
of the asset when it’s no
longer functional.

4. So, in this
presentation, let’s
take a look at what
depreciation really is,
how it’s calculated
and ……

5. ….what impact it has on
the income statement,
the balance sheet and
the cash flow statement.

6. Depreciation is a term used in
accounting to spread the cost of
a fixed asset over the span of its
useful life.

7. In this context, an asset’s
useful life is the expected
period of time over which it will
contribute additional profits to
the business through its use…..

8. ….. that is, by being more
productive either by
increasing output or
reducing the cost of
production.

9. The “useful life” of fixed
assets is often confused
with the period of time
that the tax authorities
allow an accelerated tax
deduction on the cost of
certain types of fixed
assets.

10. This tax allowance is
usually known as a “wear
and tear allowance” or
something similar.
There is no direct
relationship between
depreciation and the “wear
and tear allowance”.

11. The amount of depreciation
calculated annually is
included as an expense in
the income statement and
therefore has the effect of
reducing profits.

12. It’s important to note that depreciation does
not affect the actual (or market) value of the
asset being depreciated; only it’s value on
the statement of financial position.

13. On the balance sheet, the assets that are
being depreciated are shown at the net
book value…..
….. that is, the initial cost
of the asset less the
accumulated amounts of
depreciation that have
been calculated in
respect of that asset.

14. Let’s give an example
to explain the impact
on the balance sheet
and what happens
when cost and market
value are sometimes
different…..

15. Imagine that a business buys a
piece of equipment for
100,000……...

16. …….that is the
amount of the
transaction that will
initially appear in
the accounts of the
business.

17. However, the business may have bought that
equipment cheaply from another business
that needed to raise some cash quickly.

18. Let’s say that the
equipment was worth
200,000, i.e. more than the
business actually paid for it.

19. In calculating the
depreciation, the actual (or
market) value is irrelevant –
the equipment will be
depreciated based on its
cost (100,000)…..
… not its value (200,000).

20. Now imagine that the
business depreciates
the equipment over 3
years and….

21. …..at the end of the 3
years the equipment’s
cost (100,000) has been
fully depreciated and
there is no amount
attached to it in the
accounts of the
business.

22. That doesn’t mean that
the asset has no market
value if the business
wanted to sell it, only that
its cost has now been
fully depreciated.

23. Because it was
purchased cheaply, the
equipment still has a
market value after 3
years of 50,000.

24. So, in this example, the
market value of the asset
has not reduced to zero as
a result of depreciation…..

25. …..it was simply an
accounting procedure to
expense the cost of the
equipment over its useful
life.

26. The key point to take away
from this is that the value of
an asset that you see on the
balance sheet …..

27. …….usually bears no
relation to its actual value
and in your analysis you
should keep that firmly in
mind and try to get actual
assets values if you want to
determine the true value of
the business.

28. One final point; no cash
changes hands following the
calculation of depreciation
so it never features on a
cash flow statement.

29. We do hope that you enjoyed this presentation.
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