As part of our Business Financial Intelligence training seminars we focus some time unraveling confusion. We have found there are many commonly-heard financial terms that are commonly misunderstood in business. Perhaps one that is most commonly misunderstood is the “D” word — depreciation.
We believe it’s important to understand the language of business and nothing makes us more foolish-looking as we progress in our careers than when we misunderstand financial terms. So what is depreciation?
Depreciation is an accounting adjustment to match the cost of using up a tangible fixed asset against the benefit of using that tangible fixed asset in the business. A “tangible” asset is something we can touch and feel like for example a computer. A “fixed” asset is not only tangible but it also has to be an asset that’s used in the normal operations of the business (like our computer) and it’s not offered for sale. If we were in the business of selling computers (like Best Buy), the computers wouldn’t be an asset to be depreciated — it would be a different asset called inventory.
Lets consider a simple example using the computer we just mentioned: imagine your business spent $100,000 replacing their computers. What’s the initial transaction in the books of the business? Cash down (may go through Accounts Payable first admittedly) and Fixed Assets, Computers up. Agree? Notice this is a balance sheet transaction initial as Cash and Fixed Assets are on the balance sheet.
Lets imagine the life of these computers is determined to be 10 years and lets assume there’s no residual value to the computers, so the full $100,000 is going to be depreciated over the years. Even I can do the math on this one in my head – that’s $10,000 a year depreciation correct? So what’s the transaction in the books of the business? Fixed Assets, Computers down $10,000 and Depreciation Expense (on the Income Statement aka Profit and Loss Account) up $10,000. Can you see how this is a Balance Sheet and an Income Statement transition? Assets down, Expenses up.
Why do we push up expenses? Well another way of explaining expenses is that they’re something that’s been USED in the business. Wouldn’t you agree we’ve USED up 1/10th of the computers? The good news is because we’re used up $10,000 worth of the computers, we can recognize that as an expense in the business which in turn brings down the profits of the business (as profits are simply income less expenses, right?) If we bring the profits down, we pay less tax.
Without getting all “Accounting-Geek” about this, depreciation is what we call a Pre-Paid Expense. I love living in America but outside of the States, we call these what they really are which is a Pre-Paid Asset. These are assets (i.e. computers) that turn into expenses (depreciation) when they’ve beed USED. #boom!
So if you didn’t know this already, I hope this has clarified what the “D” Word means — it’s commonly heard, commonly misunderstood in the management meetings of the world.