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Depreciation is an important concept in accounting. This is because it is a non-cash expense and normally should not have any significance on the cash flows. Since the amount of depreciation never really leaves our bank accounts in the way of expenses, we still have it in cash. While determining the net income in the income statement, depreciation is subtracted. Then again, it is added back during the calculation of cash flows, thus nullifying its effect. However, depreciation affects cash flows in an indirect manner and its effect has been described in this assignment.
Depreciation is an accounting method of assigning the cost of a physical asset over its useful life and is used to account for deteriorations in value over time (Parker, 2018).
Depreciation is expressed in four ways, either as a straight-line depreciation, units of production, double declining balance and sum of years digits method (CFI, n.d.).
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Depreciation spreads the expense of a fixed asset over the years of the valuable life of that asset. For example, assuming your company decided to embark in a project in which it bought a new truck for its business. That truck is a physical asset and a capital project for the company, hence, the company doesn't report the full cost as an upfront expense. This is because accounting rules require that the expense be spread over the useful life of the asset which is achieved through depreciation (Parker, 2018).
If the cost of the new truck is $100,000 in cash, and your company establishes that the truck has an estimated useful life of 10 years.
Under the usual method of depreciation - the straight-line method, your company will report no upfront expense rather a depreciation expense of $10, 000 annually for 10 years. In this way, your overall profit will reduce by $100,000 over time. Assuming your company was accounting for the truck using cash accounting method, it will show a $100,000 expense when you bought the truck and no expense at any time afterward. In both cases, you have a $100,000 outflow of cash at the beginning and no outflow afterward. However, the everyday effect is on cash flow.
However, depreciation helps firms to avoid making huge deduction in the year the asset is purchased, but allows firms to receive revenue from the asset (Management Study Guide, n.d). Just like the above example, all of the money was gone as soon as your company bought the truck. It spent the money upfront. But in your profit-and-loss calculations, you didn't lose anything (Parker, 2018). Instead, you just traded $100,000 worth of cash for $100,000 worth of truck. As time passes and you "gain back" that value by using the truck, and turn the cost into an expense through depreciation. Still, depreciation has an indirect impact on cash flow, in that depreciation reduces the amount of taxable income for a company if it is allowed to be a tax-deductible expense (Merrit, 2019). And with the company paying less in taxes, net income would be higher. And you know that net income is used at the starting point for calculating cash flow, net income will be higher as a result of the tax benefit deduction of depreciation, reducing the cash outlay for a company's taxes (Merrit, 2019).
A lease is a contract in which one party (lessor) approves to transfer an asset to another party (lessee) in exchange for periodic payments or a safe continuing debt. With an operating lease, the lessor keeps ownership of the hired asset (Codjia, 2017). While in a capital lease, the lessee owns the asset when the leased assets' payment is completed (Codjia, 2017). When firms need capital assets such as buildings, vehicles or heavy equipment, sometimes they prefer lease to buying. Leasing involves less cash upfront, provides flexibility in payments and, often can keep assets and liabilities off the balance sheet. Lease payments usually appears on your income statement as expenses, but exactly how they appear centers on how you categorize the lease (Lumen, n.d).
In accounting, an operating lease is not reported as an asset or a liability i.e. not shown in the balance sheet, and is expensed via the income statement as payments are incurred (Lumen, n.d). A capital lease, on the other hand, is recognized and recorded as an asset and liability calculated, as the present value of the cumulative rental payments (Lumen, n.d). However, leasing activities will make depreciation of capital assets have different tax and financial reporting behavior from ordinary business expenses. And lease payments will be considered expenses rather than assets, which can be set off against revenue when calculating taxable profit at the end of the appropriate tax accounting period (Codjia, 2017).
Depreciation is a very good tool in the accounting process to take care of the cost of a physical asset over its useful life and is used to account for declines in value over time as well. This will help companies use up or gain maximum value off assets. They have incurred without having direct impact on cash flow. More so, Lessee and Lessors will also have balanced benefits via leases which in-turn will affect how much taxable profit is available in each financial period.
Depreciation in Accounting. (2019, Nov 24). Retrieved from https://studymoose.com/depreciation-in-accounting-essay
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