Page 99 - Finance for Non-Financial Managers

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Finance for Non-Financial Managers
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Depreciation The amount of expense that a company
charges against earnings to write off the cost of a capital
asset over the time it will benefit the company, without
regard to how it was paid for and after coinsidering age, wear, obsoles-
cence, and salvage value.
There are various methods of calculating this expense, most origi-
nating from favorable tax laws. If the expense is assumed to be
incurred equally over the life of the asset, the method of depreciation
is straight line. If the expense is assumed to be incurred in decreasing
amounts over the life of the asset, the method is accelerated.The
straight line method is more common: the total cost of the asset is
divided by the number of months it will be used and the result is
charged to expense each month until the asset is retired or sold off.
cash payments and the periods benefited more into alignment.
It might finance a machine over five years and depreciate it
over the same five years. For many assets, this is helpful but
doesn’t solve the problem entirely, as financing periods are
often shorter than the useful lives of the assets being financed,
e.g., a factory machine might last seven to 10 years or more,
yet few banks will finance such purchases for longer than three
to five years. Thus, even in this seemingly ideal scenario, you
will still have a disparity between the cash disbursement and the
recording of depreciation expense.
Another example is the area of prepaid expenses (discussed
in Chapter 3), which are amortized. An example might be an
insurance policy on which an annual premium is paid in
advance. When you buy insurance and pay the premium, that
policy provides protection for a year. Proper accounting treat-
ment says that the premium benefits all 12 months and should
therefore be charged to profits over the benefit period, not just
the month in which you paid the premium. So, you write your
check in January 2003, but you record as expense only 1/12 of
the check amount each month during the next 12 months, the
period of coverage. Cash flow and expense are reflected totally
differently in this example.
As you can see, some of these examples describe transac-