When you buy assets that are intended to last longer than one year, such as real estate, vehicles and equipment, you don't write off the whole acquisition cost in the year of purchase. Rather, you allocate or depreciate the expense of an asset's cost over its useful life. Depreciation affects the company's income statement and balance sheet. It also has an effect on the company's cash flow, albeit indirectly.
Whenever you buy assets that you're going to use for longer than one year, depreciation comes into play. Depreciation simply means spreading the cost of an asset over the number of years you'll be using it. The reasoning here is that the asset will generate revenues for your business for years into the future. Charging the entire acquisition cost upfront doesn't reflect the asset's revenue-generating potential. It's much more realistic to record a percentage of the asset's expense at the same time as you are recognizing the revenue that the asset is generating for your business.
There are various ways of allocating depreciation. Most businesses use the straight-line method, which writes off the expense at the same rate for each year of the asset's useful life. So, if Smalltown Company buys a van for $20,000 and plans to use the van for five years, it would write off the cost at $4,000 per year over a five-year period. There are two basic journal entries here:
- In the income statement, debit the Depreciation Expense account by $4,000 every year.
- In the balance sheet, credit the Accumulated Depreciation account by the same $4,000.
Over time, the accumulated depreciation balance increases as you add more depreciation. Eventually, this figure will equal the original cost of the asset. In the case of Smalltown's van, this will happen after five years. Smalltown must stop recording a depreciation expense at this point because the cost of the asset has essentially been reduced to zero.
Since depreciation is an expense, it has a direct effect on the profit that appears on a company's income statement. Profit, or net income, is all of the company's revenues minus the cost of doing business, which can include expenses, interest, taxes and depreciation. So, when Smalltown records a $4,000 depreciation expense, what it's actually doing is reducing net income by $4,000. The larger the depreciation expense in any accounting period, the lower the company's profit.
Accumulated depreciation is shown on the asset side of a balance sheet. You increase it with a credit because it essentially is a substitute for reducing the cost of an asset as it loses value over time. This is a better approach than crediting the asset account directly, since it separates depreciation out from the asset valuation change that would occur if the company had disposed of the asset.
For example, when Smalltown has a fully depreciated van, the net asset value would be zero – the cost of the asset minus the value of its accumulated depreciation. But instead of showing that Smalltown has no vehicles on hand, the accumulated depreciation account entry lets you see that Smalltown does, in fact, own vehicles and that the vehicles are fully depreciated. This information is helpful since you can see at a glance what assets the company owns and that the vehicle is reaching the end of its useful life.
There's obviously a real-world impact on cash flow when a company buys an asset. However, in accounting terms, depreciation is a non-cash expense. You don't have an outflow of cash every time you record a depreciation expense, so depreciation does not directly impact the company's cash flow. There is, however, an indirect effect. When you prepare your tax return, you'll list depreciation as an expense. This will reduce the amount of taxable income, which in turn reduces the amount of tax you owe. Thus, depreciation affects cash flow by reducing the amount of cash you must pay in taxes.