Depreciation – What is it and why is it important to understand?
By: Alvin A. Rhoney CPA, CMC
Depreciation expense is largely misunderstood by many small business owners. Some believe that since it’s a “non-cash” item, it can be ignored when analyzing an operating statement. Others look at their net income and add back depreciation expense to arrive at their “real” net income.
The fact is that it’s very important to understand how depreciation must be considered in your financial planning process – especially in a company whose revenues are flat or growing at a slow rate.
But first let’s understand the general theory of depreciation – An example:
Let’s say that you use a machine to produce widgets and that machine will last five years before it will need to be replaced. Further let’s say that you paid $100,000 for the machine. The Federal Government says that you may not write off the full cost of the machine in the year of purchase. Why? Because that would allow you to pay less income tax and then they would have less of your money to spend. You see, depreciation expense has nothing to do with business and everything to do with tax laws. So Congress decided that if you use the machine to produce revenue over a five year period, then you must write the cost of that machine off (or depreciate it) over that same five year period. There are a number of depreciation methods that are acceptable for tax purposes. Some methods try to link the annual depreciation expense to the percentage of the machine cost that is “used up”. Other methods bear little relationship to the actual usage of the machine and are available simply because congress was lobbied to provide such alternatives.
When preparing company financial statements, an owner may use any systematic and rational depreciation method that he chooses. But when preparing a tax return, he must use a government approved depreciation method! Most small-business CPA’s simply use the tax-based depreciation method for book purposes as well. As a business owner though, it is your responsibility to carefully choose a method that best “fits” your business needs. Here’s why:
At the end of five years, you must replace that machine in order to continue to produce and sell widgets. A new one will likely cost more than the $100,000 that you paid five years ago. So if you don’t build the “real” cost of depreciation into your widget cost structure, then your price for your widgets will not include money for the machine replacement. So you’ll have to borrow the money for a new machine and pay interest on the borrowed money. The interest will cut into your profit margin because you hadn’t considered the interest as part of your cost structure so you’ll earn less net profit and wonder why.
If your company is growing in annual sales, then that sales growth will mask this problem. You’ll still have the problem but growing revenue dollars will lull you into thinking that all is well. The problem is still there, you just won’t see it.
But if your revenues are relatively flat, then the problem will become obvious very quickly. At that point the problem will become urgent.
The time to deal with issues of this sort is when they are important. That is, upon the initial purchase of the machine. Many owners fail to accept their management responsibilities of dealing with important issues until the issues become urgent.
If you would like a no-obligation review of your financial statements to identify important issues that need your attention now - before they become urgent, please call us today.
Financial & Management Systems, Inc.