Some Thoughts on Depreciation 



Robert L. Christensen 



Department of Resource Economics^ University of Massachusetts 



Depreciation may be the most misunder- 

 stood topic in financial management. It is prob- 

 ably the most complicated exercise in the devel- 

 opment of the business financial statement, and 

 it is a critical element in preparation of income 

 tax returns. In fact, the complexity of IRS rules 

 and some computational methods can obscure 

 the concept that underhes depreciation and lead 

 to a misunderstanding of true costs and busi- 

 ness profitability. 



Depreciation is an annual non-cash expense 

 that reflects the amount by which an asset 

 decreases in value due to use, age, and obsoles- 

 cence. It apphes only to assets like buildings, 

 machines, and breeding animals, as well as to 

 improvements hke roads, bridges, fences, and 

 drainageways that have useful hves of more 

 than one year. Depreciation recognizes the fact 

 that these assets can wear out with use. That is, 

 eventually they become so worn that they be- 

 come useless or repair costs become excessive. 



Depreciation also occurs through aging. 

 Even without use, wooden or rubber compo- 

 nents can rot, metal can rust or become brittle 

 and break, and plastic can lose strength and 

 crack. Assets also can become obsolete as new 

 technology is developed to perform the same 

 tasks more efficiently and at lower cost, or if the 

 asset is no longer relevant to the nature of the 

 business (e.g. , a mUking machine becomes obso- 

 lete if the dairy herd is sold). 



While depreciation is a non-cash expense, 

 there is a "day of reckoning" that comes when 

 the asset must be replaced. One might consider 

 the annual depreciation amounts as money to be 

 put in a reserve account to accumulate until the 

 day when the asset is replaced. In theory, the 

 business then will have the capital accimiulated 

 to replace the asset with little or no need to incur 

 new debt. More often, however, no such reserve 

 account exists. 



One sometimes observes situations where 

 the annual income statement of a business 



shows a low or even negative net income and 

 there is a suggestion of insolvency. One might 

 immediately ask how the operator can continue 

 in business and take care of family hving ex- 

 penses if net income is negative. One expla- 

 nation is that depreciation is subtracted as a 

 cost in the income statement. It's important to 

 recall that depreciation is a non-cash expense. 

 Since depreciation is a non-cash cost, that 

 amount actually is available from cash flow for 

 debt repa)rment, other business expenses, and 

 for family living costs. 



Another answer might be that past earnings 

 in the form of savings are being depleted in order 

 to meet costs and debt obligations. Still another 

 explanation could be that additional debt is 

 being incurred that allows the business to con- 

 tinue and family living expenses to be met. This 

 situation can continue untU the time of reckon- 

 ing when depreciable assets must be replaced. 

 Even though replacement might be possible 

 from borrowed funds, it may be difficult to con- 

 vince lenders that theyshould make the loan 

 when past income statements show low or nega- 

 tive net income. 



Comphcating the subject of depreciation are 

 the IRS procedures relating to depreciation. For 

 tax purposes, depreciation is a deductible ex- 

 pense of the business just as if it were a cash cost. 

 Regulations define what kinds of assets may 

 and may not be depreciated. They also establish 

 acceptable methods of calculating depreciation 

 and stipulate recovery periods (the number of 

 years over which different classes of property 

 may be depreciated). Once a particular method 

 has been established for an asset you cannot 

 change to another method, but you can use 

 different methods for different assets. 



It's not the purpose of this article to describe 

 depreciation methods and procedures. Rather, 

 only a few points will be made concerning depre- 

 ciation and tax liability. First, the amount of 

 depreciation taken on business assets can affect 



Fru'n Nous, Summer, 1994 



