Depreciation is such a wacky concept it deserves its own page. Now, for those of you who like to be tested, here's a question:
Depreciation is:
- A means of accounting for wear and tear on fixed assets
- Something accountants dreamed up to fit purchases made over one time period to fit accounting over other time periods
- A great way of avoiding taxes
- Further evidence that accounting and necromancy are one and the same
- The punch line of a stupid jock joke you heard in a bar
- All of the above.
If you chose anything but number 6, you should probably reconsider your career choice. Perhaps something in the automotive safety testing industry would suit you better?
NOTE: Depreciation comes in other flavors, notably amortization and depletion, but they are all pretty similar from a modeling perspective.
Depreciation works like this. Say you buy a Lear Jet for $1 million. You deduct $1 million from cash flow as an investment and it goes on your balance sheet for $1 million. However, you have a busy year and fly all over the world. Your daughter holds her sweet sixteen party in it and a bunch of your son's friend puke during a kegger he has in it. Your Lear jet is no longer worth $1 million. It has depreciated in value. So who gives a flying hedgehog turd if it went down in value?
Well, there are many reasons why you might want to accurately reflect the new value on your balance sheet. One of the best reasons to account for depreciation is, drum roll please... taxes. Since the value of something you own has declined, you have lost money. Businessmen since the dawn of time have always held that you should be able to deduct losses from taxable income. Therefore, they record depreciation as a loss on their income statements. But since it's not real money that's been lost, just value of an asset being held, something you already bought and accounted for, it's a non-cash charge against earnings.
So let's say your Lear Jet declined in value by $100K. You can put an expense item called depreciation on your income statement and reduce your profit by $100K. You just reduced your taxes! By buying a Lear Jet! Whooeee!
In fact, the more expensive the thing you buy, the longer and greater you can reduce your taxes by the amount of the depreciation. This is why the rich continually get richer and the poor get poorer. Life is good.
So how do I model depreciation, you ask?
So like this, I answer.
To model this, I use an IF statement. I know, IF statements are getting close to computer programming and that makes you want to poop in your pants. But it's really easy. Look:
You don't have to use the IF statement, but it'll make dragging/copying cells easier since if the value at the beginning of the period is zero, it won't give you a negative number for value at the end, it'll give you a zero.
The key is realizing that depreciation is related to all three financial statements. The beginning values and ending values of the asset being depreciated affect the balance sheet. The depreciation itself is subtracted from the income statement and added back on the cash flow statement.
Depreciation rates are set by the IRS, since depreciation's entire existence is perpetuated by the tax benefits that one derives from it. I don't know all the rules, but I figure 3 years for high technology, 7-20 years for plant and equipment and 30 years for buildings. You are not supposed to depreciate land, which is why so many companies will value land low and buildings high. Those tax cheats! Go ahead and make up your own rules if you're too lazy to ask an accountant. You're going to make up half the fucking numbers anyway, you lazy good-for-nuttin!
I put depreciation on a separate worksheet, usually.
OK, here's the cool thing about depreciation if you are modeling an industrial company, say for ten years. Depreciation measures wear and tear on equipment. So if the company is a paper company, for example, and has $25 billion invested in plant and equipment in the form of paper machines and box factories and whatnot, then the depreciation figure will be fairly significant.
But this is how you figure out how much the company is spending on repairs and maintenance for its factories. Just plug the annual depreciation back into the cash flow statement as an investment in plant and equipment. This won't always work, but there is some logic that a company should be spending at least its depreciation on upkeep of its hard assets. This doesn't work for goodwill that's being amortized or forest assets that are being depleted or other things. It probably doesn't work on Lear Jets, but you have to figure your repair bill on your Lear Jet is going to be some function of the depreciation on the Lear Jet. You have to use your head. Your big head. The one on your shoulders.