In this episode of the I Hate Numbers podcast, we explain what depreciation is and its importance in business. Albeit often misunderstood,  it is crucial for accurately determining profitability. Essentially, we clarify that it is not merely a reflection of value loss but rather an allocation of the asset's cost over its useful life. Subsequently, we discuss how businesses categorize expenses into revenue and capital, identifying the latter as subject to depreciation. Specifically, we outline two primary methods of calculating depreciation: the straight-line method and the reducing balance method, offering practical examples for each.

Key Concepts

Revenue vs. Capital Expenses

Before exploring what depreciation is, we differentiate between revenue and capital expenses. Revenue expenses are daily operational costs such as hiring staff or buying food. Conversely, capital expenses include investments in infrastructure like equipment or buildings, vital for generating revenue but not intended for immediate sale.

What Depreciation Is

Depreciation involves spreading the cost of fixed assets over their useful lives, thus aligning expenses with revenue generation. Hence, we clarify that it is not about the asset's current market value but its cost allocation.

Calculation Methods

We explore two main methods:

• Straight-Line Method: Allocates depreciation evenly across the asset’s lifespan.
• Reducing Balance Method: Allocates more depreciation in earlier years, reflecting higher initial usage and diminishing benefits over time.

Impact on Financial Statements

Depreciation affects the income statement and balance sheet. However, it does not impact cash flow directly, though it is crucial for accurate profit reporting.

Conclusion

Overall, understanding what depreciation is helps in better financial management and accurate profit calculation. Therefore, it’s essential to grasp its role in aligning costs with revenue over time.

Listen to the full episode of the I Hate Numbers podcast to enhance your financial insights. Share your thoughts, and visit our online financial planning platform for additional resources.

In the world of business, across all sectors, depreciation is a term, is a concept that many people come across, not just accountants, but managers, staff, executives, directors, you name it. That word and concept will float around. Unfortunately, it's a term that's often misunderstood, even, dare I say, by some accountants.

In this week's I Hate Numbers podcast, I'm going to explain what depreciation is and what it isn't, its importance, its relevance, how we calculate it, and a couple of numbers in there by way of example.

Hi folks. My name is Mahmood. I'm a business finance fixer, accountant, educator, and author, and my mission is to help you get closer to your numbers and like them a little bit more. Let's crack on. Now, before we look at some terminology of what depreciation actually is, I think it's useful to take a step back and consider when businesses, when organisations spend money, we typically divide that into two big buckets, into two big categories.

Number one is costs that are incurred in relation to running the organisation, running the business, what we call revenue expenses as a collective term. So for example, a restaurant that's spending money on hiring staff, buying in food, paying the utility bills. Those would be examples of revenue expenses.

A theatre, for example, would also employ staff, people who are audience greeters, they'd be buying in items to sell on, they'd be effectively printing programs and the like. But those are also examples of revenue expenses. Now, the other category of expenses, and we accountants do like our categories, is what's called capital items.

Now that sounds very grandiose. Let me explain what I mean by that. Now, if we think about a business, whatever that business is, whether it's a humble market trader or whether it's a multinational company, there'll be items that have been acquired that are part of what I call the infrastructure of that business.

Those items represent the ability to support the business as well as generating direct revenue from those assets. So, for example, if we take the example of the restaurant, well, you need things like microwaves, ovens, fridges, to actually store the food to help prepare the food. Restaurants that acquire that equipment, those items, aren't intending to sell those items on. They’re part of the infrastructure,

they're part of the resources those businesses have to help generate the income to help generate profit. A theatre in the same token, when it puts on its performances, will have stage equipment, lighting, not for the intention of selling on again. It's part of the infrastructure, it's part of the way they generate their income.

So those generically are called capital items and we accountants love to have a variety of terms, we can also call them fixed assets, I've come across terms like CAPEX before. The more officious term is non-current assets, but whatever your preference is those are all examples of capital items. I'm going to call those fixed assets as a working term throughout this podcast. Now, that's the first thing to consider. It's the capital items, the fixed assets that are the ones that are subject to depreciation.

Number two, what actually is depreciation and what isn't depreciation? Now, many people understandably think that those items that I've mentioned there, like the ovens, the fridges, are items that tend to lose value over time. When we buy them, we take them out of the box, we have them installed, whatever we pay for them today,

we know that in a few months’ time, a year's time, whatever time in the future, they won't be worth the same value. And people mistakenly think depreciation is there to reflect that drop in value. However, that's not strictly speaking the answer. So, a bit of a spoiler alert, if we have things like buildings, buildings are also examples of fixed assets, but as a general rule, they tend to maintain their value as long as you look after them and they're in a good area, or they tend to go up in value, but buildings are still subject to depreciation.

So even though instinctively it feels like that's what depreciation actually is, in reality it's not. It's what's called an allocation exercise. Now, that sounds very weird and grandiose. Let me just expand on that a little bit more. Now, if we take our item, like the microwaves, the fridges, the stage equipment, the lighting, take your pick,

what we know is that those items, when we acquire them, generally speaking, will last for a reasonable length of time and we'll be using them not just in our current financial period, but hopefully beyond that as well. So, criterion number one is those items we acquire, they're part of the infrastructure, they're part of the way that we generate income.

Secondly, we tend, notice the emphasis on tend, to use that for more than just the current accounting period. Now, what we have to do is when we have this item called profit, when we calculate profit, what we have to do is to compare what we generate by way of income. And, we have to compare that to the cost, the revenue cost in that same time period.

And by the way, folks, it might be worthwhile, check out last week's podcast where the matching concept was the topic of conversation. So, to carry on with matching and accruals, that's the part that depreciation itself plays. Depreciation is effectively taking the cost of that fixed asset and spreading it over the period of time that we expect to use that asset.

In that way, we more accurately, and I use that term very loosely, we more accurately calculate the profit that we create. Let's throw in a couple of numbers here just to reinforce and help us connect with what's going on. So, let me take my theatre example. A theatre over a year generates a total income of a hundred thousand pounds.

Let's assume all its running costs, the cost of staff, the cost of printing, and stationary utility costs is also say 80,000 pounds. That's a 20,000 pound surplus. Now, in that same year, it's got items it's spent on stage lighting and equipment. And for argument's sake, let's say it spent 24,000 pounds on buying those items, and it's worked out that it's going to last it three years.

So what it will do, simplistically, it will take a third of that capital cost, 24 divided by 3 equals 8, subtract it from the surplus of 20,000 we had previously, and that gives us a 12,000 pound profit or surplus. In doing that, we more accurately calculate the profit for that one year. Think of the inequity that if we offset the entire cost against that income, that will give us a distorted figure for the profit that we generated in that year,

it may even turn into a loss. And next year, we've got nothing to offset against that income. So it has an element of equity about it. Now, what I want to look at now, folks, is the calculation methods. Now, we accountants, when a concept is created, we like to have a degree of flexibility because profitability is largely a judgment calculation.

Now in the world of depreciation, there are a number of methods of calculation the figure of depreciation. I'm going to flag up two of the main ones in current use. So if we stick to our theatre example, where we bought equipment to the value of 24,000, we're sitting in our office thinking, how do we calculate the depreciation?

And there are a number of methods, as I said, available to us. Now the first question is, is to consider three criteria. What did the item cost us? I said 24,000. And that will include the cost of purchase, the cost of delivery to our premises, the cost of installation, and let's assume all of that amounts to 24,000.

We then consider how long we expect to use that item for. Any look into the future is always going to be problematic, but let's say our experience suggests it's going to last three years. And the last consideration is to think going forward at the end of that three-year period, do we expect reasonably if we traded that item in and we've got rid of it, do we think we'll get anything for it by way of part exchange?

Any scrap value? For simplicity's sake, let's assume not in this example. So, the capital cost is the 24 grand minus zero for the scrap value, the expected lifespan is three years. So, our objective is over the three-year periods, we've got to allocate a proportion of that 24k in each year that we progress. Now, method number one is called straight line.

It's the simpler of the methods and it says take the capital cost, which in this case is 24, divide it by the useful life, which in this case is three years, and that's 8,000 pounds per annum. So in year one, 8,000 will be allocated against the revenue, another 8,000 in year two, and in year three, another 8,000. Method

number two, reducing balance goes a slightly different way. Conceptually it says, okay, you've got this item, you get most of the benefit of the item in the earlier years before it starts to get a bit depleted, starts to break down a little bit more, repair costs go up. So, actually what we'll do (a fairer method) is to allocate a bigger slice, a bigger portion in year one, a smaller portion in year two,

and a much smaller portion in year three. So of that 24,000, I might decide that I'm going to allocate 12,000 pounds in year one. That gives me another 12,000 to allocate. I'm going to allocate, let's say, 8,000 in year two. That's a total of 20,000. And lastly, the 4,000 goes in year three. I've got the same objective I'm achieving.

I've spent 24,000 over that three-year period, but I've done it in a slightly different pattern. Now, if you want to get into the nitty-gritty of the calculations, speak to your finance team and they'll explain it. What I'm trying to explain here is an overview and a framework. As I said, there are other methods available, but that's certainly two of the most common ones in circulation.

Now, what about the impact? Now these figures, profit is going to be shown in your income statement or your profit and loss or your income and expenditure statement. If you're a charity, you'll come across something called a sofa, and it's not a chair, by the way, or an accoutrement. And the secondary statement that we have is something called a balance sheet, which is a snapshot in time of the list of the company's and business's assets and debt.

So in our fictional example of our lighting equipment, year one, we sport the item for 24 grand, 8,000 was allocated against profit using the straight-line method. So that's a 16,000 pound, what's called a book value. In year two, another eight grand is allocated. The book value of the item dropped by another 8,000.

And in reality, the end of year three, on the records, we've got an asset in the business that, in the accounts, is recorded at nil value. And that's merely a historical record. Now, I mentioned at the beginning about when is depreciation drop relevant. Now, depreciation is a great concept. It reinforces the idea that we've got an item that we've acquired

so we need to reinforce the cost to our managing team, ourselves, the cost of using that CAPEX item. Number two, it calculates profit more accurately. If we disregarded those items that we've acquired, those fixed assets, well, if we're leasing an item or renting an item, we'd include that cost so you could produce an incomparable situation.

Now, the irrelevance of depreciation is when we look at things like cash flow. Now, cash flow is absolutely critical to a business. Without it, your business will not survive, let alone prosper. Cash flow is something we keep an eye on regularly, and as a heads up, folks, here, check out the show notes, by the way, for the link to our online financial planning platform, our cashflow platform called BudgetWhizz. Now, a cash flow statement is critical, but absolutely under pain of debt, depreciation should not enter that calculation.

Depreciation is not a cash flow. It doesn't appear on the bank statement. It's purely an accounting concept that's used for good reason, but it doesn't form part of the cash flow. So when you look at a company's profitability, when you look at your own profitability, ignore the depreciation to get a better idea of what the cash flow that's generated from the business is.

So what can we conclude, folks? Well, depreciation might seem like a bit of an abstract accounting concept. You may think it just relates to loss in value of items, but it doesn't. It reinforces the idea of what profitability truly is. And if we're going to apply this thing called matching or accruals accounting, it's critical that we

take on board depreciation. We get an idea that the cost of a fixed asset is not just the repairs and maintenance, the running cost of the item, but also the connected depreciation. It also reinforces the fact that when we look at profits in our business and we reflect how much depreciation is in there, it gives us a clearer, indirect way of keeping that money wrapped up in our company.

So, folks, I hope you found this recording useful. I'd love to know your thoughts. And until next week. Happy depreciating. We hope you enjoyed this episode and appreciate you taking the time to listen to the show. We hope you got some value. If you did, then we'd love it if you shared the episode. We look forward to you joining us next week for another I Hate Numbers episode.