What is Depreciation? Accounting For Non-Accountants

If I was to ask four people what depreciation was, I’d probably get four different answers:

  1. The amount of wear and tear on assets,
  2. An allowance to help replace assets,
  3. An accountant’s device to reduce tax, or
  4. A way of allowing for inflation.

All four would be wrong. Accountants are not known for explaining things well – which may account for the above misconceptions – but I’ll try to explain it so that:

  1. You will understand something more about your accounts,
  2. You can impress your bank manager and others with your accounting knowledge,
  3. You will understand why depreciation is in your accounts and budgets but not in cash flow statements,
  4. You can understand and prepare budgets better, and
  5. You will be able to understand the accounts of – and make better decisions about – businesses you might consider buying or investing in.

My explanation of depreciation starts with expenses and assets:

Anything you spend money on, in your business, is what we call a debit:

  • You pay your phone account so you have a phone expense.
  • You pay for a new car so you have an asset, the car.

We pay out for both but accountants treat them differently. Why is that?

The reason is time.

  • Any spending which is “used up” within a year is an expense – the phone bill is used up and you now have nothing to show for it. It’s an expense.
  • Any spending which is not used up in a year (your car lasts more than a year, hopefully) is called an asset. At the end of the year you still have a car to show for it.

Expenses go into the Income Statement* and reduce profit and, therefore, tax. The Income Statement shows your income and expenses.

Assets go into the Balance Sheet* and have no effect on profit. The Balance Sheet shows what you owe and own at any point of time.

Now, what happens to assets?

So, you buy your car and its cost goes into the Balance Sheet, along with land, buildings, plant, equipment and other assets. The Balance Sheet shows you what assets you own… but not how much they are worth. These assets stay in your Balance Sheet till your accountant does something with them… and what he or she does is depreciate them.

As you know, all assets except land wear out and eventually cease to exist. So we leave land in your Balance Sheet at its original cost, till you sell it. We do not depreciate land.

All other assets will wear out or get “used up” somehow – a bit like your phone bill, but over a much longer time. Of course, when you buy a car, a bulldozer, a trawler or a computer, we don’t know how long you will keep each one. The best we can do, at the start, is to guess just how long it will remain productive for you. Accountants’ attitude is that an educated guess is better than nothing at all.

We might guess that a building will last 50 years so we’ll transfer 2% of its cost from the Balance Sheet to the Income Statement each year. After 50 years we’ll have transferred all of its cost and we’ll have a Balance Sheet book value of $0.00.

We might guess that your office furniture will last 10 years so we’ll transfer 10% of its cost from the Balance Sheet to the Income Statement each year. After 10 years we’ll have transferred all of its cost and we’ll have a Balance Sheet book value of $0.00.

Depreciation is the cost of an asset, spread over its useful life. The amount we transfer from your Balance Sheet to your Income Statement each year is what we call depreciation.

So now you can quote the accounting definition of depreciation, can’t you! It’s the cost of an asset, spread over its useful life. Talk like that and people will think you’re an accountant!

I’ll make it easier with numbers:

You buy your car for $30,000. You estimate that it will last you 5 years so we depreciate it at $6,000 per year – one fifth per year.

After year one, its book value is $24,000 (cost $30,000 – depreciation $6,000)

After year two, its book value is $18,000 (last year book value $24,000 – depreciation $6,000)

Each year $6,000 goes out of your Balance Sheet and into your Income Statement and, as it’s an expense, it reduces your profit by $6,000.

Profits and Cash Flows are not necessarily the same

The above explains why you can have huge profits and a falling bank account… or huge losses and a rising bank account… or both profits and bank balances going up or both going down.

There is no connection between profits and bank balance (or cash flows) – depreciation is one of several reasons for that. Depreciation is simply a book entry – it’s just a transfer between accounting statements.

So, in the first year, your bank account went down by the cost of the car ($30,000) and your profits only went down by the depreciation expense of $6,000.

In the second year, the car had no impact on your bank account but you took another $6,000 (depreciation) off your profits. And the same in the next three years.

The same thing happens when you’re preparing your budgets – depreciation expenses are in your profit budgets but not in your cash flow budgets.

Buying businesses and making intelligent investing decisions

The above may seem like a lot of intellectual equine output that has no particular relationship to your real life… to anyone’s real life, really!

However, one thing you will have learned here (or somewhere else) is that the book values that assets are shown at in Balance Sheets have no relevance to the value of those assets. Book values are simply the mathematical balance of what’s left after some depreciation is taken off. And, since depreciation is a best-guess in the first place, anything to do with it should not be relied on in terms of asset values.

If you’re investing in a business, then, don’t rely on the assets’ book values for anything. The book values mean absolutely nothing to you. If you don’t know what they’re worth, don’t look at the accounts but get a valuer to value the assets for you.

What I’ve left out

Depreciation is a large subject and my aim has been to explain the main workings of it. I would be irresponsible if I did not warn you that there are things I have not explained:

  1. Why we do not depreciate most assets the same amount (e.g. $6,000) every year,
  2. What you (or your accountant) do with when you sell an asset you’ve depreciated, and
  3. The Tax Office’s many rules on depreciation.

If you have any more questions about depreciation, call me.

* Every so often, the people who control accountants come out with different names for the same old things. I’d never dare suggest that it’s to confuse people but I have noticed that each new name for an old thing is progressively bigger and bigger each time.

For example:

What we used to call an Income Statement now has to be called Statement of Financial Performance. What we used to call a Balance Sheet now has to be called Statement of Financial Position. Anyway, I guess it keeps someone happily employed!

I am a writer with business qualifications and experience…

I am a qualified accountant (BBS ACA) and have been a company director and business owner, university lecturer, business coach and corporate trainer. Then I was a newspaper reporter. Then I was editor and then publisher (owner) of a national, monthly magazine for several years. I have 9 published books – 6 paper ones and 3 ebooks on SmashWords website. And now I am a freelance writer, writing for clients in Australia, Czech Republic, Norway, Germany, Romania, Arabia, Britain and America…

… and I’m always looking for more work. See articles at The Write Site website – [http://www.thewritesite.biz]

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The Importance of Business Financial Analysis and Management

Planning and Control are the two most important ingredients to a Successful Business. A Business Plan takes most of the guess work out of Business Strategy and Control through solid Financial analysis. Financial Data provides a way to gauge where you are in your Strategic Plan, telling you where changes in your Plan are necessary. Because of this, Financial Data Analysis and Management are vitally important to running a successful business.

It is extremely important to have a suitable Accounting System installed throughout your business so data acquisition is easy. You cannot manage your Business for Profitability without a good Accounting System. My CPA has a bookkeeper who comes out to the business to help install the Accounting System and show us how to work it. All of this is done with the guidance of the CPA but at a fraction of the cost. A good Bookkeeper is invaluable in helping capture Financial Data. Having an established working Accounting System in place will minimize the fees a CPA charges to analyze your tax liability and prepare your tax returns.

An Accounting System is typically built around the following key Financial Management tools:

– Income Statement (Profit & Loss Statement)

– Cash Flow Statement

– Balance Sheet

– Budget

– Breakeven Analysis

By having a Financial Management system in place, you can easily identify early warning signs or spot particularly profitable areas. Not having a system in place to analyze and organize Financial Data makes it impossible to effectively manage, grow and control a business. It makes it impossible to gauge the success (or lack there-of) of your Planning and Strategy. Moreover, used incorrectly, inaccurate Financial Data can be disastrous for a company’s livelihood.

An Accounting and Financial Management System is only as useful as it is used systematically throughout an entire business. It is extremely important to implement the system into the very fabric of the business and be used systematically. The Accounting System is a reflection of the health, or lack thereof, of a business and from which business decisions are made. Make sure to set it up right, train your people on it and most importantly, use it!

Two principal objectives of any business are to be Profitable and have Cash Flow to pay obligations. The Income Statement and Cash Flow Statement figure prominently in this area. The Income Statement represents how well a Company is operating, and the Cash Flow Statement shows how well a business is managing its Cash. Profit or Loss on one side and Liquidity on the other.

The trick is to find a good balance between Profits and Liquidity, which when not well planned for, can be very difficult to maintain. Fast Growth with high profits can drain the liquidity of a business, so being Profitable is no guarantee you’ll stay in business. The role of the existing and projected Cash Flow and Income Statement is to help you identify problems areas so you can effectively plan for them, such as raising more capital, infusing more equity or obtaining finance. Moreover these two statements help you identify areas which can be better controlled and managed, forestalling the need of additional capital and funding.

The Breakeven Analysis is based on the Cash Flow and Profit & Loss Statement. The Breakeven Statement and Chart is extremely important because it shows the revenue volume from sales that are required to precisely balance the sum of your fixed and variable expenses. The Breakeven Analysis can be extremely helpful when:

– Setting Product and Service Price Levels

– Deciding whether to purchase or lease equipment / building

– Figuring out profit projections based on various sales levels

– Determining if new employees are required

– Planning ahead for finance / capital required in the future

– Making Strategic Objectives more tangible and achievable

– Measuring your Company’s progress toward Profit goals

The Balance Sheet records the past effects of company decisions (or lack thereof) and projects the affect of future Plans. The Balance Sheet is a record of the company’s Liquidity and Owner’s Equity. These variables are directly affected by the Income and Cash Flow statements. The Balance Sheet is the often overlooked Financial but it has a lot of utility:

– Shows the effect of past decisions

– Keeps track of a Company Cash Liquidity Position

– Records the level of Owner’s Equity

– Quickly shows the condition of the business

A Budget Analysis compares a Company’s Actual Performance to Projected Performance on a monthly, quarterly and annual basis. The Budget is a great tool to guard against excessive, unmitigated expenses and is closely tied to the Strategic Objectives the company has set. Analyzing the Income Statement and Cash Flow Statement projections against Actual Performance is an excellent control tool, which can quickly address problems before they become too severe. Little oversights and mistakes in a Company’s Projections spread over time can have a disastrous affect. The Budget Analysis is your guard against that.

Working together, the Income Statement, Cash Flow Statement, Balance Sheet, Breakeven Analysis and Budget Analysis provide a complete picture of a company’s Current Operations, Liquidity, Past Operations and Future Viability. Working through an interactive Accounting System can be a very useful tool in determining future business scenarios and analyzing past mistakes. Understanding the financial implications of your Financial Decisions can mean the difference between your company’s success and failure. Probably the most important financial is your Cash Flow Statement but understanding all of these financials and how they work together is the key to a company’s success. Projections are based on assumptions – make sure these are well thought out and as realistic as possible.

Frank Goley is a business consultant and business coach, and he works for ABC Business Consulting. He is an expert in developing, writing and implementing business plans, funding plans, marketing plans, strategic plans and business turnaround plans. Frank is author of The Comprehensive Business Plan Workbook – A Step by Step Guide to Effective Business Planning, and he writes the Business Success Strategies Blog.

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http://EzineArticles.com/expert/Frank_Goley/497870

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The Importance of Business Financial Analysis and Management

Planning and Control are the two most important ingredients to a Successful Business. A Business Plan takes most of the guess work out of Business Strategy and Control through solid Financial analysis. Financial Data provides a way to gauge where you are in your Strategic Plan, telling you where changes in your Plan are necessary. Because of this, Financial Data Analysis and Management are vitally important to running a successful business.

It is extremely important to have a suitable Accounting System installed throughout your business so data acquisition is easy. You cannot manage your Business for Profitability without a good Accounting System. My CPA has a bookkeeper who comes out to the business to help install the Accounting System and show us how to work it. All of this is done with the guidance of the CPA but at a fraction of the cost. A good Bookkeeper is invaluable in helping capture Financial Data. Having an established working Accounting System in place will minimize the fees a CPA charges to analyze your tax liability and prepare your tax returns.

An Accounting System is typically built around the following key Financial Management tools:

– Income Statement (Profit & Loss Statement)

– Cash Flow Statement

– Balance Sheet

– Budget

– Breakeven Analysis

By having a Financial Management system in place, you can easily identify early warning signs or spot particularly profitable areas. Not having a system in place to analyze and organize Financial Data makes it impossible to effectively manage, grow and control a business. It makes it impossible to gauge the success (or lack there-of) of your Planning and Strategy. Moreover, used incorrectly, inaccurate Financial Data can be disastrous for a company’s livelihood.

An Accounting and Financial Management System is only as useful as it is used systematically throughout an entire business. It is extremely important to implement the system into the very fabric of the business and be used systematically. The Accounting System is a reflection of the health, or lack thereof, of a business and from which business decisions are made. Make sure to set it up right, train your people on it and most importantly, use it!

Two principal objectives of any business are to be Profitable and have Cash Flow to pay obligations. The Income Statement and Cash Flow Statement figure prominently in this area. The Income Statement represents how well a Company is operating, and the Cash Flow Statement shows how well a business is managing its Cash. Profit or Loss on one side and Liquidity on the other.

The trick is to find a good balance between Profits and Liquidity, which when not well planned for, can be very difficult to maintain. Fast Growth with high profits can drain the liquidity of a business, so being Profitable is no guarantee you’ll stay in business. The role of the existing and projected Cash Flow and Income Statement is to help you identify problems areas so you can effectively plan for them, such as raising more capital, infusing more equity or obtaining finance. Moreover these two statements help you identify areas which can be better controlled and managed, forestalling the need of additional capital and funding.

The Breakeven Analysis is based on the Cash Flow and Profit & Loss Statement. The Breakeven Statement and Chart is extremely important because it shows the revenue volume from sales that are required to precisely balance the sum of your fixed and variable expenses. The Breakeven Analysis can be extremely helpful when:

– Setting Product and Service Price Levels

– Deciding whether to purchase or lease equipment / building

– Figuring out profit projections based on various sales levels

– Determining if new employees are required

– Planning ahead for finance / capital required in the future

– Making Strategic Objectives more tangible and achievable

– Measuring your Company’s progress toward Profit goals

The Balance Sheet records the past effects of company decisions (or lack thereof) and projects the affect of future Plans. The Balance Sheet is a record of the company’s Liquidity and Owner’s Equity. These variables are directly affected by the Income and Cash Flow statements. The Balance Sheet is the often overlooked Financial but it has a lot of utility:

– Shows the effect of past decisions

– Keeps track of a Company Cash Liquidity Position

– Records the level of Owner’s Equity

– Quickly shows the condition of the business

A Budget Analysis compares a Company’s Actual Performance to Projected Performance on a monthly, quarterly and annual basis. The Budget is a great tool to guard against excessive, unmitigated expenses and is closely tied to the Strategic Objectives the company has set. Analyzing the Income Statement and Cash Flow Statement projections against Actual Performance is an excellent control tool, which can quickly address problems before they become too severe. Little oversights and mistakes in a Company’s Projections spread over time can have a disastrous affect. The Budget Analysis is your guard against that.

Working together, the Income Statement, Cash Flow Statement, Balance Sheet, Breakeven Analysis and Budget Analysis provide a complete picture of a company’s Current Operations, Liquidity, Past Operations and Future Viability. Working through an interactive Accounting System can be a very useful tool in determining future business scenarios and analyzing past mistakes. Understanding the financial implications of your Financial Decisions can mean the difference between your company’s success and failure. Probably the most important financial is your Cash Flow Statement but understanding all of these financials and how they work together is the key to a company’s success. Projections are based on assumptions – make sure these are well thought out and as realistic as possible.

Frank Goley is a business consultant and business coach, and he works for ABC Business Consulting. He is an expert in developing, writing and implementing business plans, funding plans, marketing plans, strategic plans and business turnaround plans. Frank is author of The Comprehensive Business Plan Workbook – A Step by Step Guide to Effective Business Planning, and he writes the Business Success Strategies Blog.

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http://EzineArticles.com/expert/Frank_Goley/497870

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Understanding Financial Statements

Financial accounting’s focus is on the financial reports distributed to people outside of the company. The major component of financial reporting is the financial statements: income statement, balance sheet, statement of cash flows, and the statement of stockholders’ equity. The income statement indicates a company’s profitability during a specified time period such as one year, three months or one month.

Under accrual accounting the income statement reports the amount of revenues earned and the expenses that were incurred to earn the revenues. Expenses also include costs that expired during the period of the income statement. If a corporation’s stock is publicly traded, the income statement will also report the earnings per share of common stock. The balance sheet reports a corporation’s assets, liabilities, and stockholders’ equity as of a specific instant, such as midnight of December 31. Most balance sheets will group all of the current assets and all of the current liabilities. This allows readers to easily see the corporation’s working capital and current ratio. The statement of cash flows organizes the explanations of the change in cash and cash equivalents into three sections: operating activities, investment activities, and financing activities. The statement of stockholders equity provides a summary of the changes occurring to stockholders’ equity during the accounting period. The changes include net income, dividends declared, purchase of treasury stock, and other comprehensive income.

In order for the readers of these financial statements to make comparisons with other companies, it is necessary that the financial statements follow some common rules. The rules are referred to as generally accepted accounting principles or GAAP (pronounced gap) and consist of several components. One component of GAAP is the basic or fundamental accounting principles and concepts such as cost, matching, going concern, economic entity, materiality, conservatism, consistency, reliability, and others. You can see a brief explanation of these basic principles along with an example of each at AccountingCoach.com.

Another part of GAAP includes the detailed rules established by the Financial Accounting Standards Board or FASB (pronounced fas Bee). These pronouncements are entitled statements of financial accounting standards. FASB interpretations are also part of GAAP. You can view these pronouncements at [http://www.FASB.org/st]. The accounting rules established by the predecessors of the FASB remain as GAAP unless they have been superceded by the FASB.

Lastly, GAAP includes industry practices. For example, the balance sheet of a public utility will list the plant assets ahead of its current assets. Unique reporting practices often occur in industries that are regulated by government agencies.

The financial accounting and financial reporting of publicly traded corporations also include the annual report to the Securities and Exchange Commission (Form 10-K), the annual report to stockholders, and various press releases on financial matters.

The Accounting Coach is a former university instructor known for his clarity in presenting accounting information. He now spends his time developing a free website of accounting material, http://www.AccountingCoach.com

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http://EzineArticles.com/expert/Harold_Averkamp/103017

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