In our last lesson, we looked at the concept of depreciation and how it's a measure of an asset's loss in value over time. We mentioned that both the annual depreciation expense and the accumulated depreciation show up on a company's financial statements, notably the income statement and the balance sheet. That is the topic for this lesson. Will be doing a deeper dive into financial statements in the next course in the finance for technical managers specialization. Our goal here is to show where depreciation shows up and why. Let's get started. Recall that depreciation is governed by the Internal Revenue Service requiring a company to spread out the value of any asset, both tangible and intangible over its useful life. While the company actually pays for the asset upfront, it's value, or more formally, its book value is recorded over the life of the asset in a way prescribed by the IRS. What that means is that depreciation and amortization for that matter are non-cash expenses. They don't represent any cashflow whatsoever. They are strictly used for accounting purposes to determine an asset's book value and for tax purposes to figure out the taxes owed during the year. As will see, the decreasing value, the book value of an asset, is recorded in the balance sheet, and the amount it decreases is recorded in the income statement. Let's look at some typical equipment purchases and see how a company might account for these. When companies buy equipment, they have two ways of accounting for them financially. They can expense it or they can capitalize it. Expensing it involves recording the entire cost of the equipment the year it was purchased. This is usually limited to smaller purchases, say, less than $1,000, which the IRS would consider having a useful life of less than one year. An example might be that you buy $500 weighing balance for your lab at work. In the operating expense section of the income statement, you would have an R&D expense of $500. For larger assets though, you need to go through the depreciation process. Technically, that means you capitalize the equipment expense. You purchased the equipment, but spread its value over its useful life. Each year you expense a portion of its value known as the depreciation expense. Imagine this scenario, you purchase a new microscope for your lab that costs $150,000. In the operating expense section of the income statement, you have just a portion of the initial cost listed as a depreciation expense, say $25,000. Let's see how these show up on the income statement. Here's the income statement we've been looking at so far, the P&L, if you will. For the $500 laboratory balance, we don't need to depreciate that. Therefore, we can expense it the year we purchased it, in this case, 2022. The full $500 which show up here in the R&D expense. From an accounting perspective, there is probably some line item in the R&D category for things like equipment in office expenses, where this would actually go. But will get into that later. Here is the same income statement now showing where the $150,000 microscope expense shows up. If the microscope was purchased in 2022 and depreciated over six years, then each year would have a depreciation expense of $25,000, assuming a linear decrease in value, as we've seen so far. That $25,000 would go in the depreciation expense section of the operating expenses as you see here. Now we have both types of equipment covered. But one more question, where is the $150,000 for the microscope? It turns out it's not on the income statement but elsewhere. This is where things can get slightly confusing. Yes. The company spent $150,000 to buy the microscope, but only 25,000 of that 150,000 shows up on the income statement. Technically, it shows up on what is called the statement of cash flows. A financial statement that outlines where the cash comes from and where it goes. But more on that later. It's only important for now to recognize there is a difference between a company's actual cashflows and what is recorded on the income statement. The balance sheet, one of the three important corporate financial statements would look something like this. It has three sections. One for the company's assets, one for its liabilities, and one called the company's shareholder equity. In basic terms, the assets column captures what the company owns. The liabilities column reflects what it owes to everybody else, and the shareholder equity is a measure of the company's overall net worth. We'll go over all of this in much more detail in the next course in the finance for technical managers specialization. But this will work for now. As depreciation has to do with asset values, let's focus on the asset column in the balance sheet, and in particular, the section called property, plant, and equipment, which by its very name, sounds like the place where all the depreciated equipment would likely show up. In this section, the company lists the value of all the land it owns, the value of all the buildings it owns, and the value of its equipment. This is also where the accumulated depreciation goes. Let's look at this more closely. The way the accountants keep track of the value for all of these assets is like this. The land, buildings, and equipment are first recorded at their historical costs. The accounting phrase, that means whatever the company actually paid for them and whenever the company actually paid for them. Remember, land is not depreciated as it never loses value, so we won't worry about that for now. The accumulated depreciation represents the total loss in value of the company's assets, notably its buildings and its equipment. Therefore, the current value of the assets on the year's balance sheet is just the original cost, less the total decrease in value over time or in accounting terms, the book value of the company's assets is equal to the collective cost basis of all the assets, less the accumulated depreciation of all the assets. Makes reasonable sense, even for us non accountants. How might this align with the purchase of our $150,000 microscope. If we bought the asset in 2022 and it is depreciated over six years in a linear fashion, had no salvage value, then the annual depreciation expense would be $25,000 each year. If the balance sheet reflected the company's financial position on December 31st,2022, the book value of the microscope would be $150,000. Then the next year, December 31st, 2023, the depreciation expense would be $25,000, and since it's the first year, the accumulated depreciation expense would be $25,000 and the book value of the microscope is reduced to $125,000. The following year, on December 31st, 2024, the accumulated depreciation increases another 25,000 to $50,000, and the book value on the microscope drops to $100,000. That goes on for a few more years. On December 31st, 2028, the accumulated depreciation increases to $150,000 and the microscope is now fully depreciated. Its book value is 0. For sure, when we look at a company's financial statements, it won't have microscope book value anywhere to be found. That will be buried in the company's internal financial records but the book value for all the company's assets are reflected in the balance sheet. Sometimes the balance sheet just shows the net property, plant and equipment, and not the accumulated depreciation as a separate line item. If you see that, all that means is the company has already gone through the calculation, taking the difference between the cost basis and the accumulated depreciation for all its assets. We'll understand more about this when we study financial statements in the next course but we're at a good point right now, so let's wrap this up with a few main takeaways. Depreciation is a non-cash expense used only for accounting purposes, mainly to determine the assets book value and to calculate taxes for the year. Purchasing an asset results in a cash outflow at the time of purchase but its value, or more specifically its book value, is spread out over time. Depreciation expense is the asset's annual loss in value and shows up on the income statement. Accumulated depreciation is the total loss in value up to some point in time and shows up on the balance sheet. Finally, an asset's book value is just a cost basis minus the accumulated depreciation. It's worth repeating that depreciation is a non-cash expense and therefore impacts a project's cash flows, especially if the project involves equipment or some other capital purchase therefore, we need to account for it in any project valuation analysis. I think we have a pretty good idea of depreciation and accumulated depreciation. In our next lesson, we'll see a few ways and how to determine the depreciation expense using the SL or straight-line approach and the DB or declining balance approach. The straight-line approach will definitely look familiar, so let's get right to it. I'll see you next time on finance for technical managers.
