Finding ways to make more money is paramount to every business. Sometimes, that can be a tricky task and requires looking in unexpected places, through accumulated depreciation.
For the person who’s tasked with managing a business’s finances,the handling of assetsand how they depreciate is a complex one.
Of course, assets are an important component of money management because they help define the value of a business. But business assets lose value or depreciate over time.
So, how does a business account for that depreciation and what impact does it have on your business cash flow?
Not only does accumulated depreciation impact the value of an asset, but it also has tax implications for a business. Read on to learn more.
What Is Accumulated Depreciation?
Accumulated depreciation is an accounting term that refers to the total amount of depreciation accumulated over time on a tangible asset. It represents a decrease in the value of the asset due to wear and tear, age, or obsolescence, which eventually leads to its disposal.
The accumulated depreciation reduces an asset’s book value by subtracting it from its original cost. For wealth managers, accumulated depreciation can be an important consideration when deciding how to allocate assets for maximum benefit to their clients.
Warren Buffet famously said, “Price is what you pay; value is what you get.” Understanding accumulated depreciation allows investors to identify assets with value beyond their purchase price and thus obtain more from each investment.
Depreciation as an Expense
An asset has value to a business. Over time that asset depreciates causing a loss in value.
This depreciation is actually considered a non-cash flow expense. No cash leaves your business directly for this expense. Yet, it needs to be accounted for in the business finances.
But as the asset goes down in value or depreciates it has to reduce the business’s value in assets, but the business spends no actual cash on that expense. It just gets recorded as an expense for the business.
The depreciated asset does impact cash flow indirectly through taxes. More on this later.
Understanding Accumulated Depreciation
There are a few ways to understand and apply accumulated depreciation in a business.
A business will need to record the accumulated depreciation using the matching accounting principle calledgenerally accepted accounting principles(GAAP).
If you look at a single asset of a business, let’s use a bulldozer as an example; a company uses cash to purchase a bulldozer, which technically reduces its cash flow.
Yet, now they have the bulldozer as an asset that adds value back to the business. However, over time the value of the bulldozer decreases.
Accumulated depreciation is the total amount of depreciation that’s occurred up to that point for the asset.
A business can look at a single asset and keep track of its accumulated depreciation. It can also consider all of its assets collectively.
The accumulated depreciation is the collective depreciation amount up to that point of a single asset or all assets of the business combined.
Financial Modeling
Incorporating accumulated depreciation into a bottom-up financial model enhances its precision and reliability, providing a granular view of a company’s financial health and operational efficiency. This approach starts with the detailed analysis of individual assets and their depreciation schedules, allowing for a meticulous assessment of how these non-cash expenses affect overall cash flow and, consequently, the financial planning process. By accounting for the tax shield effect of depreciation, the model can more accurately forecast net cash flows. This is because the depreciation expense, while not a cash outlay, reduces taxable income, thus impacting the cash taxes paid by the company.
A bottom-up financial model, enriched with detailed depreciation inputs, enables a company to simulate various scenarios and investment strategies with a higher degree of accuracy. It allows financial planners to assess the potential cash flow benefits of capital investments by considering the tax savings associated with depreciation expenses. This level of detail aids in identifying which investments are likely to generate the most favorable tax-adjusted cash flows, aligning investment decisions with strategic business objectives.
Depreciation, Taxes, and Cash Flow
As accountants and business managers work on managing cash flow, depreciation doesn’t directly impact the cash flow. Again as an expense, it becomes part of the financial spreadsheet without cash flow being directly impacted.
However, when a business is ready to prepare its taxes, that same expense listed for the depreciating asset is listed as an expense and therefore lowers the taxable income.
In short, this accumulated depreciation can mean a lowered tax burden for a company and can indirectly mean more cash flow for a business from paying less in taxes.
Methods of Depreciation
There are several different accounting principles a business could use to calculate depreciation.
A business needs to know the method they want to use and use it consistently throughout the life of the asset. This is important for both tax purposes and the management of the asset.
Let’s take a closer look at the methods of depreciation that might be used for an asset.
Straight-Line Depreciation
Straight-line depreciation might be the simplest method used for calculating depreciation. Although, in terms of usable assets, it might not be the most practical.
First, you consider the value of the asset when new and the value of the asset at salvage time. Subtract those two numbers.
Then take that number and divide it by the predicted life span (probably in months) of the asset.
That number tells how much the asset would depreciate for each span of time you used in the calculation.
Double-Declining Balance Depreciation
Double-Declining Balance Depreciation (DBD) is a fixed rate method of accounting for assets used in businesses. In its simplest terms, DBD facilitates a faster depreciation of the asset’s cost than that allowed from straight-line depreciation methods.
This means the asset will depreciate most quickly during its earlier years of use and slowly over its later years. By capturing the accelerated depreciation in the early years, businesses are able to deduct more expenses from their taxes in those same earlier years.
Knowing proper depreciation schedules can maximize a business’ profitability and should be part of any financial plan for capital improvements. Double-Declining Balance Depreciation is an important tool for financial professionals who wish to maximize cash flow and tax savings for their clients.
You would use the same formula to calculate the depreciation amount as in straight-line depreciation. However, instead you subtract double the amount in the first half of the asset’s life.
Units of Output Depreciation
Some assets will depreciate based on their use instead of how long the asset is owned. This might be especially true of business equipment or machinery.
So, the depreciation is calculated based on its use time. The depreciation number is calculated, then subtracted as the asset is put to use.
Sum-of-the-Years Digits Depreciation
Another option for accelerated depreciation is sum-of-the-years depreciation.
In this model of depreciation, the asset gets more depreciated in the early years of its life span than later.
The business would need to decide the formula for this model and be consistent with it.
Return on Equity
Return on equity (ROE) is an important accounting principle for shareholders as it relates to assets.
Since the assets depreciate over time and for a group of assets you’d consider their accumulated depreciation, their value decreases and impacts the equity for shareholders.
In simple terms, this is why it’s important for businesses to constantly monitor asset value and track accumulated depreciation, so they don’t suddenly find they have less value.
EBITDA
EBITDA or earnings before interest, tax, depreciation, and amortizationis frequently used by accountants and business managers to consider overall cash flow.
Adding to net income, the interest, tax, depreciation, and amortization can help financial analysts have a more accurate picture of overall cash flow.
Understanding Accumulated Depreciation and Its Impact on Cash Flow
It’s important for a business to track accumulated depreciation with assets. While it might not directly impact cash flow, it can indirectly impact it through tax liability.
If you need financial advice or help with calculating depreciation to consider its impact on your cash flow, we can help. Contact us today so we can get started advising you.
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