Q: My accountant has reviewed the financial projection I prepared for my new business. I was told that my forecast was too positive because I did not include depreciation expenses. Do I really need to include depreciation in my income projection? Why? – Dorothy Grace by email
A: In business, when you pay for something that you use to generate sales, you treat the items as an expense. Buying office supplies, printing marketing brochures, or paying for newspaper advertising are some of the items that you would normally consider as expenses because they are necessary in generating business.
In the same way when you purchase a computer or machinery equipment or spend construction costs to renovate new office for your business, you should also treat them as expense.
The way to recognize this in your book is to allocate the total costs of the expenditure over the useful life of the equipment purchased.
Let us say you purchased a delivery van for your business. This delivery van loses value from the very first minute you drive it out of the dealership. Your delivery van is considered an operational asset in running your business, one that loses part of its value each year that you own it until it no longer runs and has no more value to your business. This measure of the loss in value of an asset is known as depreciation expense.
There are three advantages when you depreciate an asset.
Firstly, depreciation enables you to properly match and recognize a portion of the asset’s costs “used up” in generating revenue for that particular period. For instance, consider that you acquired a franchise for an ice cream outlet. You paid P150,000 ($3,235.90) for the franchise good for three years, plus P450,000 ($9,707.69) for the construction of the outlet and equipment.
To compute the depreciation expense, you simply allocate the costs of the construction over the franchise period at P150,000 ($3,235.90) per year (P450,000 [$9707.69] / 3). For the franchise fee of P150,000 ($3,235.90), you also need to depreciate it by three years, so that your annual franchise fee expense is P50,000 ($1,078.31) or (P150,000 [$3,235.90] / 3).
Secondly, depreciation helps you avoid overstating your assets in your books. This is because it disciplines you to periodically adjust the historical costs of your assets to its current book value. Thus, an asset that you acquire now may not have the same value five years from now. Also, when you know the book value of your assets, you will be better informed when you have to make decisions about disposing of those assets in the future.
Following the earlier given example, after you have recorded the depreciation expense, the book value of your outlet shall be P300,000 (6470.04) or (P450,000 [$9707.69] – P150,000 [$3,235.90]) and your franchise fee shall be P100,000 ($2157.04) (P150,000 [$3,235.90] - P50,000 [$1,078.31]). The total carrying value of P40,000 ($862.82) (P300,000 [6,471.17] + P100,000 [2,157.06]) shall be listed in the balance sheet under fixed assets. This way, if you decide to sell your outlet later on, you will have a better idea on how much you should sell it.
Lastly, depreciation provides tax-saving opportunities. Being a non-cash expense, it will enable you to lower your cash outflow. For example, assume that your total taxable income before depreciation is P500,000 ($10,786.14). You would have to pay income tax of P150,000 [$3,235.60] for it (P500,000 [10,785.33] x 30% tax rate), but because you can claim a depreciation expense of P100,000 [$2,156.03], your taxable income goes down to P400,000 [$8,623.72] (P500,000 [$10,779.65] -P100,000 [2,155.71]), and your income tax payable goes down as well to P120,000 [$2,586.55] (P400,000 [8,621.83] x 30% tax rate).
Thus it is advisable to consider transferring your personal car or the laptop that you use in business to your company. This way, you can claim depreciation expense for it to lower your income tax.
However, there are times when depreciation expense tend to distort the profitability of a business. For example, a restaurant business with annual depreciation expense of P500,000 ($10,778.12) may report a net loss of P200,000 ($4,313.57) in the books. This may recur annually so you may well wonder why the business is still surviving despite the losses. You will then find out that the cash flow of the restaurant is what keeping it afloat. How did this happen?
It works this way: Depreciation, being a non-cash expense that is recorded only in the book without an actual outflow, allows the restaurant to enjoy cash inflows from revenues. To compute for this “cash income” of a business, you simply add back the depreciation expense to the net loss.
In this particular case, we will adding back the depreciation expense of P500,000 ($10,778.12) to the net loss of P200,000 ($4,313.57). This way the business generates a positive “cash income” of P300,000 ($6,469.15) (P500,000 [$10,778.12] - P200,000 [$4,313.57]). However, when the business starts to generate negative “cash income,” it is a clear sign that the business will soon be in extreme financial distress.
Computing for depreciation involves some degree of judgment on your part. You need to estimate the useful life of an asset and make it the base period of depreciating it. Of course, depending on industry practice and on the preference of management, depreciation policies may differ from one company to another.
There are assets that may be worthwhile depreciating for some companies, but not necessarily for others.
One common criterion for evaluating the useful life of an asset is the principle of materiality. For instance, a couple of laptop computers may be depreciable for a company that has an asset base of only P250,000 ($5,389.99), but they may be better immediately expensed for a company that has an asset base of P250 million ($5.39 million). One company may depreciate the same set of laptops over a period of five years; another company may do it over a period of only three years.
Despite differences in approach to depreciation, it is important to recognize that the objective of recording depreciation is to show the decline in its market value. Depreciation merely reduces the value of an asset in the balance sheet; it does not reduce cash account or affect the cash flow business.
Henry Ong, CMC, is president of Business Sense Financial Advisors. You can follow him at @henryong888 or email hong[at]businesssense.com.ph.