by J. Β. Weaver and W. E. Staudt1 Atlas Powder Co.
I COSTS A
W O R K B O O K
F E A T U R E
Appreciating Depreciation
E C
How a noncash expense contributes to corporation funds • D E P R E C I A T I O N is one of the most discussed and least understood con cepts in the fields of accounting, finance, or economic analysis. Its constant use demands that cost engineers grasp and use it daily.
Depreciation Defined Depreciation might best be intro duced by looking first at the betterunderstood term of corporate in come, not considering taxes or depre ciation. Corporation income would then be the revenues of the period less the cash expenses associated with the obtaining of those revenues. A prob lem arises in measuring the cost of using buildings and equipment over a period of time. A chemical proc essing plant which is expected to be used for 15 years could not logically be considered as an expense to be fully charged against the revenues re alized in the one year in which the plant was purchased. T h a t year's income would be disproportionately low, and succeeding years would show exaggerated profits. This is where depreciation comes into the picture. Instead of charging the cost of the plant as an expense in the year of purchase, a portion of the cost is charged against revenues each year throughout the useful life of the plant. Depreciation then is a pe riodic charge against revenues that distributes the first cost of a fixed asset over its expected service life. It is clear that depreciation is not a fund received and set aside to replace equipment. Funds enter a corpora tion only from the sale of goods or services, and a reserve fund for re placement arises only if management sees fit to actually set aside some funds for this purpose and no other. T h e familiar Reserve for Depreciation then is only a dollar amount—a part of initial fixed investment in a group of assets shown, which has already been charged as an expense against revenues of previous periods. No 1
Present address, Cornell University, Ithaca, Ν. Υ.
corresponding fund exists. Account ants prefer Allowance for Deprecia tion to avoid any hint of this fund.
rate of 5 2 % on corporate income, and no depreciation, the after-tax profit is represented by Ρ = (1.00 - 0.52) (R = 0.48 (R - E)
Noncash Expense
Part of the confusion surrounding depreciation stems from the differ ence between depreciation expense and usual revenue and expense trans actions which involve the receipt or expenditure of cash in the same ac counting period (or in periods not far removed). A report of depreciation expense entails no current receipt or outlay of cash. Such a noncash ex pense means that, in addition to the net reported profit, a corporation has available the additional funds cor responding to this expense which was included when figuring net income but which did not require an outlay of cash during the period. This cash is a partial regeneration of the first cost of fixed assets, and is as available for use as is other retained cash. If there is no depreciation, I = R - Ε where / = income of period R = revenues of period Ε = expenses of period involving cash out lay
If there is depreciation, I = R - Ε - D
where D = annual depreciation charge
However, D does not involve a cash expense, and the total cash flow is: CF=I
+ D =
R-E
where
E)
where Ρ = after-tax profit of period
Each dollar of such business expense, involving a cash outlay, thus reduces profit by 48 cents. Consider the dollar which can be reported as an expense for tax pur poses although no cash outlay is in volved. Like other expenses, each such dollar reduces before-tax in come by $1 and reduces after-tax profit by 48 cents. However, as each such dollar is still available to be spent, the net effect is to add 52 cents to company funds, as follows: CF = Ρ + D = 0.48 (R - Ε - D) + D = 0.48 (R - E) + 0.52D Because it is able to charge de preciation against revenues, ' a cor poration has available after taxes more funds than it would otherwise have had. The greater residual of funds is due solely to the allowance of depreciation as an expense before the determination of taxable income. T h e incremental increase in funds available is equal to 5 2 % of the de preciation charge, the additional tax which would have been paid if be fore-tax income had been increased by D. Residual funds available to a corporation are affected by de ductible depreciation charges in an economic system in which there are income taxes.
CF = annual cash flow to corporation
In a no-tax situation, depreciation expense would not affect funds within the corporation. Without taxes there would be no reason for government regulation. Enter Uncle Sam
Depreciation gains real importance to the corporation when there are in come taxes. Assuming a federal tax I/EC
Regulations
As might be expected, the Govern ment regulates the deduction for de preciation, as it directly affects in come, taxes paid by a corporation and corporate profits reported to stockholders. T h e Internal Revenue Service in its Bulletin F lists the av erage useful life of many items of equipment used by various industries.
W
ORKBOOK FEATURES
65 A
Straight-Line Method Sum of Years-Digits Method ο ο ο «/•
Straight Line Method
Corporation A Static Investment Rate
α> υ c σ
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