As explained above, provision for depreciation in a given period reflects the value of the wear on fixed assets resulting from their use during that period.
Depreciation expenditures are treated as expenditure in the profit and loss statement, although no cash actually leaves the company in the case of depreciation.
In other words, in the profit and loss statement, depreciation expenditures are an element of cost of sales, and decrease the company’s profit, although no cash is actually paid for them. Cash actually left the company when the asset was purchased.
Example:
Company A conducts all its transactions in cash, and has no depreciation expenditures. It earned a $10 profit in 2008, and therefore added $10 to its cash.
Company B also conducts all of its transactions in cash, but it has $1 in annual depreciation expenditures. The company also earned a $10 profit in 2008, excluding deprecation. Following provision for depreciation, however, its net profit fell to $9.
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Company A |
Company B $1 provision for depreciation |
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Added Cash |
Net Profit |
Added Cash |
Net Profit |
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$10 |
$10 |
$10 |
$9 |
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This dollar was a provision for depreciation |
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To summarize, every dollar that the company lists as a provision for depreciation in the profit and loss statement decreases the net profit by $1, without a corresponding decrease in cash. This will be demonstrated through a simple example, in which the activity of USA Toys Company in 2008 is analyzed.
Example:
The Balance Sheet of USA Toys at the Beginning of 2007 is as Follows:
USA Toys’ Balance Sheet as of December 31, 2006 ($)
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Assets |
Liabilities + Equity |
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Current Assets |
Liabilities |
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Cash |
50,000 |
Bank loans |
60,000 |
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Fixed Assets |
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Machine |
90,000 |
Equity |
80,000 |
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Total |
140,000 |
Total |
140,000 |
Activity in 2007:
Sales:
$80,000. Payment terms: Cash
Expenditures:
Raw materials – $30,000. Payment terms: Cash
Salaries – $10,000. Payment terms: Cash
Miscellaneous expenditures – $10,000. Payment terms: Cash
Depreciation:
$10,000 (10% of the $100,000 purchase price of the machine)
The company’s profit and loss statement for 2007 is as follows:
USA Toys’ profit and Los Statment for 2007($)
| Sales | 80,000 |
| Raw materials | 30,000 |
| Salaries | 10,000 |
| Miscellaneous expenditures | 10,000 |
| Depreciation expenditures | 10,000 |
| Total cost of sales | 60,000 |
| Net profit | 20,000 |
The Company’s Balance Sheet as of the End of 2007 is as Follows:
USA Toys’ Balance Sheet as of December 31, 2007 ($)
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Assets |
Liabilities + Equity |
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Current Assets |
Liabilities |
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|
Cash |
(1) 80,000 |
Bank loans |
60,000 |
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Fixed Assets |
Equity |
80,000 | |
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Machine |
(2) 80,000 |
Retained earnings |
20,000 |
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Total |
160,000 |
Total |
160,000 |
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(1) |
50,000 |
+ |
(80,000 |
– |
50,000) |
= |
80,000 |
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Cash – opening balance |
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Cash entering |
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Cash exiting |
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(2) |
90,000 |
– |
10,000 |
= |
80,000 |
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Machine- opening balance |
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Annual depreciation |
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The company’s cash flow includes $80,000 in entering cash (sales) and $50,000 in exiting cash (cost of sales, net of depreciation). The company’s cash from current activities therefore grew by $30,000. This cash flow can be shown as follows:
USA Toys’ Cash Flow Statment for 2007 ($)
| Cash Flow from current activity: | 30,000 | |
| Net profit | 20,000 | |
| Plus depreciation expenditures | 10,000 | |
| Cash flow investment activity | 0 – There was no activity in these spheres0 | |
| Cash flow from financing activity | ||
| Total increase in cash flow in 2007 | 30,000 | |
| Balance of cash at the begining of the period (January 1,2007) | 50,000 | |
| Balance of cash at the end of the period (December 21,2007) | 80,000 |
