Depreciation

Expenses have primarily been categorized based on their function:
- Direct Costs (e.g., Cost of Goods Sold)
- Non-Direct Operating Costs (e.g., SG&A or R&D)
The income statement classifies expenses based on function.

An important accounting question:
- If a purchase generates revenue over several years, should the cost be expensed all at once or spread over the asset's useful life?
Accrual Accounting and the Matching Principle:
- Expenses must be spread evenly over the asset's useful life.
- This matching aligns costs with the revenue earned through asset utilization.
Depreciation: The annual expense recognized as a result of this matching principle.

Scenario: GE invests $30,000,000 in a new flow meter sensor intended to improve productivity.
- Useful Life: 10 years (asset will be scrapped, no salvage value).
- Instead of a one-time expense of $30,000,000, GE recognizes an annual depreciation expense of:
  ( rac{30,000,000}{10}) = 3,000,000
- This reflects the systematic decrease in value, matching expense with revenue generation over ten years.

Quantification of Wear and Tear: Depreciation measures the reduction in book or historical value of a physical asset over time.
Types of Assets:
- Fixed Assets: Assets with physical substance subject to depreciation.
- Intangible assets will be discussed separately.
Useful Life Estimates:
- Plants and Buildings: 15 to 40 years
- Machinery and Equipment: 3 to 20 years
- Furniture and Fixtures: 5 to 10 years
- Computer Software and Hardware: 3 to 5 years
- Land:
- Classified as a fixed asset but NOT depreciated due to the absence of expected value decline over time.

Identify which costs should be depreciated:
- Correct: Building cost of a warehouse, office furniture.
- Not Depreciated:
- Management compensation (annual expense, immediate recognition).
- Land used for the supermarket (fixed asset but not depreciable).
- Printing costs for marketing brochures (benefit within one year).
Key Point: Depreciation is recognized only when the useful life exceeds one year.

Depreciation is often NOT explicitly listed on income statements.
- Embedded within cost of goods sold (COGS) or SG&A based on asset's relation to manufacturing/procurement.
Visibility: Depreciation is disclosed on the Cash Flow Statement.
Example: Walmart recognized $8,000,000,000 in depreciation in 2012, identifiable through the cash flow statement.

Depreciation is a non-cash expense, impacting perceived profitability:
- Income Statement reflects reduced profits due to depreciation, while actual cash profits are affected only by cash payments for assets.
Example: GE's upfront cash payment of $30,000,000 does not appear to affect the income statement presentation repeatedly.

Straight-Line Depreciation:
- Most common method.
- Depreciable Cost calculated as:
  ext{Original Cost} - ext{Salvage Value}
- Annual depreciation expense remains constant across useful life.

Example modification: If GE's sensor has a salvage value of $2,000,000,
- Depreciable Cost becomes:
  30,000,000 - 2,000,000 = 28,000,000

Scenario: Tire maker spends $100,000 for manufacturing equipment expected over 5 years, $20,000 salvage value:
- Depreciable Cost:
  100,000 - 20,000 = 80,000
- Annual Depreciation Expense:
  rac{80,000}{5} = 16,000
- Each year, $16,000 recognized until the total depreciation equals $80,000.
- Balance Sheet Tracking: The value of the asset declines yearly:
- Initial value: $100,000
- Yearly depreciation: $16,000
- Final value (after 5 years, with debits tracked in accumulated depreciation): $20,000

Companies can opt for accelerated depreciation, which involves recognizing larger expenses in initial years:
- Common Methods include:
1. Declining Balance (specifically double declining balance)
2. Sum of the Years Digits
3. Units of Production
Most companies favor straight-line due to its favorable initial results (lower depreciation = higher apparent profits).