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Bus 5111 Discussion Assignment Unit 2

Depreciation allows companies to write off the value of assets over time for accounting and tax purposes. It does not directly impact cash flow as it is a non-cash expense. Depreciation spreads the cost of an asset over its useful life rather than deducting the full amount in the year it was purchased. There are two types of leases: operating leases do not involve asset ownership so no depreciation is recorded, while capital leases are treated as purchased assets requiring depreciation to be recorded along with related assets and liabilities on the company's books.

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622 views2 pages

Bus 5111 Discussion Assignment Unit 2

Depreciation allows companies to write off the value of assets over time for accounting and tax purposes. It does not directly impact cash flow as it is a non-cash expense. Depreciation spreads the cost of an asset over its useful life rather than deducting the full amount in the year it was purchased. There are two types of leases: operating leases do not involve asset ownership so no depreciation is recorded, while capital leases are treated as purchased assets requiring depreciation to be recorded along with related assets and liabilities on the company's books.

Uploaded by

Sheu Abdulkadir Basharu
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Merritt (2019) describes depreciation as an accounting convention that allows a company to

write off an asset's value over time. All goods will decrease in value over time. “Businesses

depreciate long-term assets for both tax and accounting purposes. For tax purposes, businesses

can deduct the cost of the tangible assets they purchase as business expenses. Depreciation does

not directly impact the amount of cash flow generated by a business, because it is considered a

non-cash expense. When creating a budget for cash flows, depreciation is typically listed as a

reduction from expenses and so reduces the amount of taxable income reported (Finance for

Managers, 2012). Depreciation is the accounting treatment of the loss of value of capital goods.

This amount forms a cost item on the profit and loss account. The depreciation costs are

determined by reducing the purchase value with the residual value and dividing it by the

economic life. Depreciation is used with the view that assets will become worn out and lead to a

loss of value. “The net positive effect on the cash flow of depreciation is nullified by the

underlying payment for a fixed asset” (Merritt, 2019). It is obvious, by depreciating, a company

spreads the expense of assets over some time and therefore doesn’t have to make a huge

deduction in the year the asset is bought. The cash flow is the total amount of money that comes

in minus the amount of money that is spent. “Amounts that you may deduct from the profit

before amortization and depreciation are not cash shifts and therefore do not belong to the cash

flow. The cash flow is therefore the net profit plus depreciation. The cash flow is the

thermometer of the company. Financiers mainly look at the cash flow concerning other variables.

For example, cash flow concerning a debt or borrowed capital is very important” (Finance for

Managers, 2012).
Implications of a lease on depreciation.

There are two types of lease contracts, an operating lease, and a capital lease. An operating lease

involves the use of an asset without conveying ownership rights of the asset. Operating leases do

not have any depreciation, because the asset is not owned (Merritt, 2019). A capital lease is a

contract entitling a renter to the temporary use of an asset, and such a lease has the economic

characteristics of asset ownership for accounting purposes. The capital lease requires a renter to

book assets and liabilities associated with the lease if the rental contract meets specific

requirements. In summary, a capital lease is considered a purchase of an asset, while an

operating lease is treated like renting. A capital lease is a financing arrangement, a company

must break down its periodic lease payments into interest expense based on the company's

applicable interest rate and depreciation expense. An operating lease, on the other hand, does not

have any implications for the depreciation value, while a capital lease will increase the

depreciation expense. “We must also keep in mind that for a capital lease, only a part of its

periodic lease payment will be added to the depreciation expense” (Merrit, 2019).

References

Finance for Managers. (2012). Licensed under Creative Commons by-nc-sa 3.0.

Merritt, C. (2019, January 11). What Is the impact of depreciation expense on profitability?

https://smallbusiness.chron.com/impact-depreciation-expense-profitability-55349.html

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