An appreciation of depreciation
s we start the New Year, 2005 promises to be a
year full of exciting opportunities.Some of you will be
purchasing new equipment, opening drop stores, starting or
expanding routes, adding/promoting additional services such as
fire restoration, wedding gowns, alterations, etc. Others will
focus on their core business of drycleaning and will work on
improving the bottom line by becoming more efficient and
increasing prices.
 | ||
January is also the time of year when most
of us gather up all our financial “stuff” from last
year for our accountants.
That’s right — April 15 is
just around the corner and right now, many business owners are
holding their breath in anticipation of learning how much money
they made last year and in finding out how much money they owe
the IRS in income taxes.
The main reason owners are often surprised
to learn what their tax liability is at the end of the year is
that their accountants do not take the time to explain things
like cash flow statements and how/why it differs from your
profit and loss statement. There is also a great deal of
confusion about that mysterious line item
“depreciation.”
When you start planning the projects you
want to initiate in 2005 you must also look at what effect
those projects will have on profits and your cash flow. To do
that one needs some understanding of what the different
accounting statements are trying to tell us.
For the record, this article is about
management accounting and in no way is it intended to provide
tax advice. Always consult your accountant for tax advice.
There are two basic accounting formats for
reporting revenues and expenses: 1) cash basis and 2) accrual.
The most common method in the drycleaning
business is the “cash basis” of accounting. Under
the cash basis, revenues are recognized when you are paid, not
when you provide the service. Expenses are recognized as an
expense when you pay your bill not when you use the related
goods (hangers, poly, etc.).
Thus, in the cash method of accounting, if
you have customers that you bill at the end of the month, you
do not record the money they owe you as a sale. If you do the
work in December 2004 and they pay you in January 2005, that
amount will appear on your January 2005 income statement.
In the “accrual” method of
accounting, the work that you tag-in is recorded as a sale
(Please note: in the purest sense of accrual accounting the
work that is tagged-in should not be recorded as a sale on your
income statement until the finished garments are racked).
The accrual method is designed to measure
the profitability of the “economic activities
conducted” during the accounting period, which is usually
a month. Accrual accounting is a necessity for companies that
have work that takes months to complete (construction,
manufacturing), but the cash method works fine for drycleaning.
Many CPAs insist on using the accrual
method for drycleaners. Several of my clients have family
members who are CPAs who do their books. These CPAs favor the
cash method because it takes less time to compile.
No matter what accounting method you use
— cash or accrual — at the end of the year you will
still have the ubiquitous line item called
“depreciation.”
In accounting terms depreciation means the
“systematic allocation of the cost of a depreciable asset
to expense” over the asset’s useful life.
Depreciable assets are physical objects which retain their size
and shape but which eventually wear out or become obsolete.
These assets are not consumed like supplies.
Once again, from an accounting point of
view, the depreciation is used to offset a reasonable portion
of the asset’s cost against the revenues that the asset
helped generate during that accounting period. Depreciable
assets are items such as your boiler, drycleaning machine,
presses, etc.
For their internal financial statements,
most large companies determine depreciation expense by the
straight-line method.
To calculate straight-line depreciation,
you divide the total cost of the asset by the asset’s
useful life. If you bought a $30,000 piece of equipment that
you expect to last for five years, the depreciation expense
would be $6,000 per year for five years, or $500 per month for
60 months.
Please note: your depreciation expense has
no connection to how you pay for that equipment.
For tax purposes, most companies will use
an alternative depreciation method — one that will reduce
their income tax liability for that year. The method most
commonly used is “accelerated depreciation.”
With accelerated depreciation, you can
expense up to $100,000 for tax year 2004. Once again, there is
no relationship between depreciation and the way you pay for
the assets.
If all this isn’t confusing enough,
let me add that you never write a check or make a payment to
“depreciation.” Because you don’t actually
pay for depreciation, we add the total amount of depreciation
back to profits (thus increasing profits) or add it back to
losses (thus reducing losses).
So, how does depreciation really affect
your cash flow? Other than how it affects your income tax
liability, depreciation has no affect on cash flow.
How does purchasing assets affect cash
flow? That depends on how you pay for the asset.
Example #1
You purchase a $50,000 piece of equipment
and pay for it at the time of purchase. You take advantage of
accelerated depreciation and reduce your income by $50,000.
Dollars spent = $50,000
Depreciation = $50,000
2004 Income Statement =
<$50,000>
In this example, you reduced the amount of
income for which you must pay income taxes by the same amount
of money you spent.
Example #2
You purchase a $50,000 piece of equipment
and pay for it at the time of purchase. In this example, you
decide to use straight-line depreciation over five years.
Dollars spent = $50,000
Depreciation = $10,000
2004 Income Statement =
<$10,000>
In this example you spent $50,000 but you
have only reduced the income on your income statement by
$10,000. Thus, you will pay income taxes on the $40,000 that
you spent on the equipment above what you depreciated.
Example #3
You purchase a $50,000 piece of equipment
and pay for it over a period of five years with no money down.
In this example, you take accelerated depreciation at $50,000.
Dollars spent =
$10,000 (plus interest)
Depreciation = $50,000
2004 Income Statement=
<$50,000>
In this example, you only spent $10,000 in
principal payments plus interest (which is tax deductible), but
you were able to reduce the amount on which you pay income
taxes by $50,000. What about the next four years? For the next
four years you will be paying an income tax on the amount of
money you pay back the lender for principal (Please note, with
installment loans you pay more for interest and less in
principal in the early years, which will makes the principal
payment vary over the life of the loan).
As you make your plans for 2005, write
down what you think everything will cost you and how long it
will take to meet your objective. Next, sit down with your
accountant and ask for advice before you decide what to buy and
how to pay for it.
Be sure to ask the following: “How
are we going to handle depreciation and how will it affect my
income taxes and thus my cash flow over the next five
years?”
Make these professionals who work for you
explain what they are doing and why. Never be embarrassed to
say, “I don’t understand. Please explain it to me
again.”
Planning costs time and money, but that
sure beats those unpleasant (and costly) surprises we have all
experienced over the years. Wishing a happy, healthy and
prosperous New Year to all!
In the game of business the more you know
the better you can play the game.
Alan Robson is a private consultant
dealing with the specialized needs of the drycleaning industry.
Contact him by telephone at (941) 408-8819 or send e-mail to
him at: alan@bizbuilderonline.com or visit the Biz Builder web site: www.bizbuilderonline.com.
 |
