Quick Technical Question!
Okay one thing I was hoping someone could clear up for me is how a decrease in depreciation affects the financial statements. I thoroughly understand how an increase of depreciation expense flows through the statements and all of the line items it changes, but I still haven't been able to get a definitive answer about any decrease.
Is that because there isn't one? Unless you're talking about a decrease in accumulated depreciation, say through a sale of a plant? If so, would it just boost NI/RE, increase cash from Investing activities and ultimately the ending cash balance? And finally would there be no net change in CA if you sold the item for book value?
Thanks in advance, this has been bugging me for a while.
Yes, the concept of a "decrease" in depreciation doesn't really exist. If depreciation was 20 in Q1 and then only 10 in Q2, you still have the 10 of depreciation affecting the financial statements in the same manner as before.
If you sell PP&E, net income only increases/decreases by the tax-effected amount of the sale price less book value (called Gain/Loss on Sale). Cash will go up regardless if you sell an asset (assuming it is unencumbered).
Thanks a lot, man. Appreciate it!
Short answer: A reduction in depreciation is positive for net income; generally negative for cashflow, ceteris paribus. However, if you SELL a capital asset, that's almost always going to be a positive cashflow, so a ceteris paribus is pretty tough here.
Let's take a step back and talk about what depreciation is and why we have it.
Pretty much every tangible asset except for land and maybe precious metals depreciate economically. Things rust. Roofs lose shingles, crack in the sun, and need to be replaced. Cars eventually break down after 15-20 years. Factory equipment also loses value over time and becomes obsolete. Patents, even copyrights have time limits and (I believe) must be written off over time. (I took a few Accy courses in undergrad, but I am not a CPA who does this professionally)
And that's why we have accounting depreciation. Something that you buy today, at least in a low inflation environment, probably won't be worth as much in ten years.
The problem is that accounting measures tend to be extremely conservative and often overestimate depreciation. And it can double-charge depreciation and maintenance up front. If I patch my roof so that it lasts for another ten years, that's a maintenance expense that's written off immediately, even though my roof is now more economically valuable. So depreciation on the balance sheet isn't genuine economic depreciation.
So many investors ignore depreciation or at least downplay its impact on the balance sheet.
Depreciation reduces net income and equity on the balance sheet. In a tax-free environment, it has no impact on EBITDA or cash flows.
However, in a taxable environment where depreciation can be written off and reduce tax payable, depreciation increases cashflows! You get a tax refund for an accounting (not economic) write-off!
Therefore, accounting depreciation is usually a good thing. Especially in high-interest environments. It eventually nets out over the life of the asset, but it's generally better to keep the money and invest it than to give the federal government a tax-free loan.
Most undergraduates- even (perhaps especially) at an Ivy League school- will take a long time to wrap their heads around the fact that accounting depreciation ain't economic depreciation; that economic depreciation is bad of course, but that has no bearing whatsoever on the goodness of accounting depreciation. If you can understand this difference, you can do well in a banking interview.
Hi there -- I see you helped out the OP but I am still a little lost... (I was asked the same question...what happens if Depreciation decreases by $10)
Essentially, I just walked him the "opposite" way if it was a decrease in Depreciation of $10
IE: I said Pre-Tax Income increases $10, Net Income increases $6 (assuming 40% tax rate), CFOperations decrease by $4, PP&E increase by $10 but Cash down by $4 so Assets up by $6, Net Income up by $6 = Balance....
Based on the information provided above, was that the right or wrong answer? (I believe my interviewer said that was the right answer)
It felt "weird" to me though because I have never seen that an Income Statement...do you know how it is written (ie when it is "bad" it is written as depreciation but when its "good" is it written as something else?)
Thanks for the help!!!
I assume from your question that the interviewer was implying that depreciation expense was $10 lower in the current period compared to the prior period (i.e. Depreciation expense on the P&L was $10 in 2013 and $0 in 2014).
If this is the case, your comments that Pre-tax income increased by $10, after tax income increased by $6, and cash flow decreased by $4 are all correct.
From a balance sheet perspective, the amount cleared to cash would be $4 lower, amount cleared to RE would be $6 higher, and $10 less is cleared to accumulated depreciation which walks the -4 in cash to the +6 in retained earnings.
The best way to understand the flow is to walk through the accounting logic. For example consider a period where depreciation expense was $10, income before tax was $100, and income after tax was $60. The net effect of all of this is total assets go up by $60 (increase to cash of $70, increase to contra asset accumulated depreciation account of $10) and Retained Earnings also go up by $60 (A = L + SE)
Original point was that higher economic depreciation = Bad, Higher Accounting depreciation (EG MACRS)= good.
Ok. Thanks for the help!
Thanks, man. I guess I did always view accounting depreciation as a bad thing, instead of a potential tax refund.
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