The Bottom Line Article 2 from International Beauty TV – Understanding depreciation
The Bottom Line – Article 2
Understanding depreciation
John Forbes
John is a Chartered Accountant, focused on his and clients Bottom Line! Founder and owner of Forbes, Chartered Accountants, based in Essex for the past 10 years; current Probiz sole Practitioner of the year. Probiz is a network of over 300 accounting firms providing specialist solutions and products to its members’ clients. John specializes in general accounting and strategic tax consultancy for owner managed business in Essex and Nationally. 20 years Industry experience as Group Finance Director, including mergers & acquisitions and Joint Ventures. Non executive director of small multinational. Wide international experience on a world wide basis. Experienced in acquiring, quick profit turnround and subsequent tax efficient sale of a significant accounting practice whilst continuing to run his own.
T: 01371 876640
Introduction
Another of those words that seem to baffle clients – they get it that a car goes down in value each year – it depreciates. So far, so good. But when we try to explain why profit is different to cash flow and depreciation is one of the reasons – they give up! So, I was asked to give some insight in this Article.
Depreciation – what is it?
What is depreciation? No, its not something only an Accountant would suffer from.
It’s a financial measure for the value of an asset used up in a period.
You buy a car for £10,000. After a year, its worth £8,000, after 5 years, nothing. Of course you don’t actually know what its going to be worth, so your Accountant will make an estimate using a standardized policy and charge a set amount against profits each year until you sell an asset, or its book value (cost less amounts set aside for depreciation) become nil.
If you sell it, any excess of the price you get over “book value” is called a profit on sale.
If you get less, its called loss on sale.
This applies to all assets you buy – furniture, equipment, computers. Now, you say, but I won’t ever sell that stuff and it doesn’t go rusty so it will last for ages. Yes, but not for ever. Eventually you will need to replace stuff.
Why is it important?
Because assets wear out, and have to be replaced. Or maybe the cost of repair is more than buying new.
What you make in profit, after paying tax, should be yours to spend. You may need to leave some in the business to finance growth and so on. And to pay for additional equipment. For many a small business they don’t need to leave money in for either of those most of the time. And they understand that they make a profit of lets say £20,000 a year, get to pay £4,000 a year tax on that therefore they need to put away £333 a month for tax and they can spend £1,333 a month.
If that was all then depreciation would not matter. But how are you going to replace the old equipment that has worn out, if you spent all the profit you made each year, as above?
This is what the depreciation provision is designed to do – make you retain some money in the business so you can replace assets when they are worn out.
A simplified example:
Jane Doe inherits £20,000 and sets up a business that sells widgets using a widget making machine. The machine can make 10,000 a year out of thin air, and Jane sells each widget for £5. Machine cost is £20,000, tax is magically zero, and other expenses are £20,000 each year
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Profit and loss |
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Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
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Sales |
50,000 |
50,000 |
50,000 |
50,000 |
50,000 |
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Expenses |
20,000 |
20,000 |
20,000 |
20,000 |
20,000 |
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Depreciation |
4,000 |
4,000 |
4,000 |
4,000 |
4,000 |
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Total costs |
24,000 |
24,000 |
24,000 |
24,000 |
24,000 |
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Profit |
26,000 |
26,000 |
26,000 |
26,000 |
26,000 |
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Owners drawings = profit |
- 26,000 |
- 26,000 |
- 26,000 |
- 26,000 |
- 26,000 |
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Cash flow |
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Money in |
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Sales of widgets
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50,000 |
50,000 |
50,000 |
50,000 |
50,000 |
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Money out |
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Purchase of machine |
- 20,000 |
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Expenses |
- 20,000 |
- 20,000 |
- 20,000 |
- 20,000 |
- 20,000 |
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Owners drawings |
- 26,000 |
- 26,000 |
- 26,000 |
- 26,000 |
- 26,000 |
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Total spent |
- 66,000 |
- 46,000 |
- 46,000 |
- 46,000 |
- 46,000 |
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Net cash (out) in |
- 16,000 |
4,000 |
4,000 |
4,000 |
4,000 |
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Cash at start |
20,000 |
4,000 |
8,000 |
12,000 |
16,000 |
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Cash at end |
£4,000 |
£8,000 |
£12,000 |
£16,000 |
£20,000 |
As you can see there is money left at the end to replace the machine
However, if we showed no depreciation, and the owner withdrew all the profit each year, then there would be no cash left at the end of year 5, and no business.
So what can we do about it?
Make sure you understand the cost of replacing your fixed assets – equipment, furniture, tools and cars, and think about how long they realistically last before needing replacement. And make sure your accountant provides enough depreciation! Good maintenance of assets can make them last longer of course, but there is always a limit.
But that’s looking back at your business and to know what you can spend each month you either need accurate management accounts, or a decent business plan – better still both. And you need to understand them, which is what we are trying to help you with in this series of Articles. These do not need to be complicated but you do need to use them to work out what you can spend and when, so you make sure you aren’t running out of money.
We at Forbes face this challenge for clients with a cut down spreadsheet we use to model their business easily – if only more of them would take the time to do this ….
For more information on how this all works and a free simplified break even calculator, do please check our website at http://www.forbesca.co.uk/common/calculators/break_even.html, and register for free to access all of the information available, get weekly newswires and further urgent updates from time to time.