We start building the business case for our project by first understanding a few details that impact cash-flow analysis. One of them is depreciation, something we cover in detail in this lesson. Another is taxes, because everyone has to pay them, even businesses. The last one we'll look at is inflation. For this lesson, let's focus on depreciation or how the value of something changes over time. Let's get started. Depreciation is the process accountants use to determine the value of a tangible, physical asset over time. Remember the term asset? It's anything that has value to the company. When it comes to depreciation, it usually is related to some piece of equipment the company uses to run its business. Here's an easy example to make the point. You purchase a brand new pickup truck for your business. It costs $50,000 when you buy it. As you get in it to drive it to the office, it's worth $50,000. It hasn't lost any value yet. Of course, as you drive it off the lot, it loses some value. But that's another issue. Over time, the value of the truck decreases to maybe $20,000 after a few years. Accountants would say the truck has lost $30,000 in value from the time of purchase. Over and even longer period of time, the value of the truck decreases to zero. The only thing to do with it is to donate it to National Public Radio. Once again, from an accounting perspective, the truck has lost $50,000 in value from the time of purchase. Depreciation is effectively the process that tracks this reduction in value over time. Fair enough you say. Amortization is a similar concept. The process accountants use to determine the value of an intangible asset over time. What's an intangible asset? Anything of worth to the company that isn't a physical thing, such as intellectual property, patents, trademarks, copyrights and the like, and perhaps even the company's brand. Take this example. Your company was just issued a patent for a new technology your research group developed. Working with your accounting team. You value the patent at $500,000. How did you arrive at that number? It might be related to the profits on a product that uses that technology, or maybe what it's worth if you sold the patent to someone else. In any case, on the day the patent was issued, its worth $500,000. But perhaps after 10 years, it's only worth $250,000, meaning it's lost $250,000 in value. What happened? Well, the new technology is now 10 years old and maybe not so new anymore, especially when your competition has developed a competing technology. Once the patent expires, usually 20 years or so, what's it worth then? Nothing, not a zip, loss in value now, the full $500,000. The same basic idea here, an asset generally loses value over time. Depreciation and amortization are the ways accountants track that process. That's a critical point. Let's state that once again, depreciation is the financial measure of how tangible assets or physical assets such as equipment or vehicles lose value over time. Amortization is the same idea only now applied to intangible assets, such as intellectual property, which could include things like patents, trademarks, and copyrights. Here's a new term, accumulated depreciation, which is the total amount of depreciation and amortization, as it turns out, at some point in time, what do we mean by accumulated depreciation? Go back to our business truck example. When you first bought the truck, it hadn't lost any value at all. The accumulated depreciation is zero. After a few years when it's worth $20,000, it lost $30,000 in value. We would technically say the accumulated depreciation is $30,000. When the truck has lost all of its value, the accumulated depreciation is $50,000. Makes sense? Then let's keep going. While most assets are depreciated, not all of them are. For instance, in order to be depreciated, assets need to be used strictly for some business. Assets having a useful life of more than one year, can be depreciated too. As we've seen, depreciation occurs over a period of time, in most cases, several years. If assets have a useful life of less than one year, like a home inkjet printer that doesn't get depreciated. Items like this are expensed the year they are purchased. More on that later. Assets can be depreciated when their value decreases over time, simply because they wear out, they might become obsolete or it just as a physical thing that gets used up. That covers most assets of a company. Things like equipment, vehicles, buildings, furniture, computers, all sorts of things. But we can't depreciate land because as you can imagine, land never loses value. We can't depreciate the inventory in the warehouse, even though it too is an asset that can't be depreciated because it's generally sold within one year. But everything else is fair game. To see why we even worry about depreciation, consider the following. The table here is a typical income statement, also known as a profit and loss statement or P&L. If you want to fit in with the finance crowd. We're going to explore the income statement in much greater detail in the third course in the finance for technical managers specialization. We'll just cover the highlights for now. Any income statement begins with the company's revenues, what it made. In this case, in 2022, it looks like this company made one million dollars. The next term is known as the cost of goods sold or COGS. That relates to the cost of all the products sold, the raw materials, production labor, and those sorts of things, which we see was $600,000, and that leaves $400,000 in profit, or what is known as gross profit. Next up, are all the company's operating expenses, which includes R&D costs of $30,000, sales, general, and administrative costs, or SG&A of $170,000, and includes things like upper management salaries, the cost for sales, HR, finance, and the IT group, catch-all term. Next, we have the depreciation and the amortization expense for the year. This is related to the loss in value of the company's physical and intangible assets over the year. The company's total operating expenses are $230,000. Subtract this amount from the gross profit and you get income before taxes of $170,000. Taxes are based on this amount. As we'll see in future lessons, the corporate tax rate as of 2022 is 21 percent. Twenty one percent of $170,000 is $35,700 in taxes. Subtract that from the $170,000 and you had the company's net income or profit after tax, PAT of $134,300, otherwise known as the company's bottom line. A few key points to make here. The depreciation and amortization values depend on the value of the company's assets. The amount of tax owed by the company is based on the income before taxes. As depreciation and amortization are operating expenses, they have an important impact on everything that comes after them. For instance, the $30,000 associated with depreciation and amortization expenses are part of the operating expense and ultimately reduces the income before taxes by $30,000. As taxes are based on the income before taxes, reducing that by $30,000, just decrease the amount of taxes owed by the company by about $6,300, which comes from 21 percent of $30,000. Depreciation and amortization reduced the company's income before taxes and thereby, decreases the company's tax liability. In other words, they're like tax deductions. You know who gets involved whenever taxes are part of the discussion? You guessed it. The Internal Revenue Service, at least here in the United States. The IRS as it's called, is the US government organization responsible for collecting taxes from all of us, including businesses. They have a say in how this depreciation process is conducted, which begs the question, why is it necessary to depreciate assets anyway? There are several reasons, but here are a few important ones. The main reason assets are depreciated is simple. If you bought a piece of equipment for say, $100,000 and used it for a period of five years. The IRS wants you to spread that $100,000 over the time that equipment is used by the company as it more accurately reflects the cost of the equipment over its useful life. Because depreciation impacts taxes in the form of a tax deduction the IRS gets involved, or whatever the government tax organization might be where you live. Finally, the IRS wants to take all the guesswork on how to depreciate a company's assets. They have provided very strict guidelines on how to do this as we'll see later in this lesson. Let's see how this might work. Your company purchases a 3D printer for $10,000. Yes, I know a lot of 3D printer examples, but you can never have enough 3D printers. The way accompany might look at the value of a 3D printer and asset could be like this. Consider a plot of depreciation with the printer's value on the y-axis and the year on the x-axis. At time equals zero, the cost of the printer was $10,000. You believe it will have a useful life of five years, and at that point, you can sell it on eBay for $2,500, technically known as its salvage value. The straight line between the initial cost, and the salvage value over the printer is useful life of five years shows us how the printer is depreciated over time. What you see is the annual decrease in the printers value is the same every year, and it's called the annual depreciation expense. Well, that might make sense, but it's not the language the accountants would use to keep track of everything. To speak their language, let's see how they would describe this. The value of the equipment is known as the asset's book value, which we'll come back to in just a minute. The initial cost is known as the cost basis, and the useful life is known as the recovery period. Not too much of a language barrier. But why is the asset value called the book value? Because every year, the accountants would record the asset's value in the company's accounting books, and back in the old days, it was done with actual books. If you know the story of Ebenezer Scrooge, that's what he was doing, poring over all those accounting books at the end of the year. Of course, we can capture all this on a nice spreadsheet. What would the book value be for an asset initially valued at $10,000 depreciated over a recovery period of five years with a salvage value of $2,500. We'll assume its value decreases along a straight line like we did before. The spreadsheet layout should look familiar by now. The data input block is up top, and we have several columns below it showing the year from time equals zero to Year 5, the annual depreciation expense, the accumulated depreciation, and the asset's book value. The first thing to know, is as the value decreases linearly with time, the amount of depreciation each year is just the slope of the line, determined by the cost basis minus the salvage value, all of that divided by the recovery period, and that turns out to be $1,500 per year. At the end of the first year, the depreciation expense is $1,500, and the accumulated depreciation is also just $1,500 at this point. If the book value at time equals 0 is $10,000 and the book value at the end of year one is just $1,500 less than that, or $8,500. The same thing happens at the end of Year 2, the depreciation expense is another $1,500, and that makes the accumulated depreciation now $3,000, and the book value has dropped another $1,500 to $7,000. You can see how this works out. At the end of the fifth year, the depreciation expense is the same as before, but the accumulated depreciation is now $7,500, and the book value is just the salvage value of $2,500, and that's how the accountants would handle depreciation of an asset like this. Depreciation shows up on the income statement, the P&L, there would be a depreciation expense of $1,500 on the company's income statement. Every year for the five years the equipment is in-service. As we'll see in the next lesson, the accumulated depreciation shows up on the company's balance sheet. Another important financial statement. That's the basic idea behind depreciation. Let's wrap up with a few main takeaways. Depreciation is the process of determining the value of a physical asset over its useful life. Amortization is the same thing, only for intangible assets, such as intellectual property. Depreciation expense is the annual loss in asset value, and shows up in the income statement. Accumulated depreciation, is the total loss in value at some period of time, and shows up in the company's balance sheet. Importantly, depreciation and amortization expenses are tax deductible. They reduce the amount of tax owed for the year, and that means the IRS gets involved in the process. What we'll soon see is depreciation has a significant impact on a company's cash flows, and therefore, we must account for it in our project valuation analysis. We mentioned that depreciation and accumulated depreciation show up in the company's financial statements, specifically the income statement and the balance sheet, respectively. We're going to go over these in detail in the third course in the Finance for Technical Managers Specialization. But in our next lesson, we'll keep things simple, and just see where they show up on a company's financial statements. I'm Michael Orid and I'll see you next time.
