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What Is Depreciation?
Depreciation is sometimes referred to as "non-cash expenses". Let us explain why, with an example:
⇒ On October 1st, 2015, you purchased equipment costing $10,500.
⇒ The estimated life of the equipment is 5 years.
⇒ At the end of its life expectancy, you expect to sell it for $500.
Now let's calculate your depreciation using the most common method called the "straight-line method".
Here, the actual cash paid for the equipment will occur as follows:
|Cost of Asset||$ 10,500|
|Expected Salvage Value||$ 500|
|Depreciable Cost||$ 10,000|
|Life Expectancy||5 years|
|Depreciation Expense Per Year||$ 2000|
If your company's accounting year ends on 31st March, then it will report the depreciation expense on the company's income statement as shown in the following depreciation schedule:
|Cash Paid||$ 10,500||$ 0||$ 0||$ 0||$ 0||$ 0|
Then, the actual cash paid by the company for this equipment will occur as follows:
|Depreciation Expense||$ 1000||$ 2000||$ 2000||$ 2000||$ 2000||$ 1000|
As you can see, you’ve paid $10,500 in 2015, but the 2015 income statement reports Depreciation Expense of only $1,000. (Because the asset was acquired on October 1, 2015, only half of the annual depreciation expense amount is recorded in 2015 and 2020.) In each of the years, 2016 through 2019, your company's income statements will report $2,000 of Depreciation Expense, thereby matching $2,000 of Depreciation Expense with the revenues earned in each of those years. However, the company will not pay out any cash for this expense during those years. The company's net income before income taxes will be reduced in each of the years, 2016 through 2019, by $2,000 — but the Cash account will not be reduced. This explains why Depreciation Expense is sometimes referred to as a “non-cash expense”.
What Is The Purpose Of Depreciation?
If your business uses an asset (machinery or equipment) that has a lifespan of more than a year, you’d need to match the cost of your productive asset to the revenues earned from using the asset. If these assets are regarded as a one-time expense, without considering its use, the records for your company will not accurately reflect its financial state. This is especially true for businesses that often invest in property they use for long-term, must pay for immediately
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