What is depreciation?
Depreciation is important to project managers because it has an effect on the overall justification of a project, equipment, and other capital assets that are used on projects and the profitability of projects to the company. Depreciation can make a difference between a project that is justified and one that is not. It can also influence the choice of equipment that is needed for a particular project.
Depreciation is an accounting method of deferring the expense of capital asset items so that the cost of an item is spread out over the useful life of the item rather than taking the full cost of the item in the year in which it is purchased.
There are two methods of depreciation: straight-line depreciation and accelerated depreciation. Straight-line depreciation spreads the cost of the asset evenly over its useful life while accelerated depreciation takes more of the cost of the asset earlier in its life rather than later.
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If we did not have depreciation methods to account for capital assets, it would be very difficult to make any sense out of a company's financial statements. Without depreciation methods, if a company purchased a large capital asset, it would have to recognize the cost of the asset in the year that it was purchased. Even though the asset had a life of several years, all of the cost associated with acquiring the asset would be recognized in the year it was purchased.
This recognition of all of the cost of the asset in the first year it is purchased would cause a company's financial statements to be irregular from year to year. Investors, seeing a reduction in profits, would not be able to tell whether the company had suffered a loss in business, which is bad, or simply purchased capital assets, which is generally good. For this reason we have depreciation.
Depreciation simply says that if we buy a capital asset that has a life of some years, we should distribute the cost of the asset over the years that are equal to its useful life rather than recognizing all of the cost in the first year of its life. This will also have an effect on the taxes the company pays.
For example, say a company purchased a machine for $100,000 and the machine had a useful life of ten years. Furthermore, the machine had a scrap value of $3,000. If we did not depreciate the machine, we would have to show an expense of $100,000 in the first year. This is an expense that occurs only once in ten years so once every ten years, the company's profits would be unusually low. For the other nine years there would be no machine expense, and the company would show an unusually high profit. A better way of accounting for this machine is to distribute the expense of the machine over the ten years of its life.
To use any of the depreciation methods, we need to know three things about the asset: the useful life of the asset, the original cost of the asset including delivery, installation, and start-up costs, and the scrap value of the asset at the end of its useful life. The depreciation expense is the amount of expense that is recorded each year during the life of the asset. This expense is the amount by which before-tax profit is reduced.
Perhaps a little accounting is in order to explain what is going on here. When a capital asset is purchased, the company pays for the asset with cash. The transaction reduces the company's cash assets by the amount of the purchase and increases the company's equipment assets by the same amount. There is no change in the company's total assets; there has been a trade between the two accounts. Each year the depreciation amount for the year is calculated, and the depreciation expense reduces the net profit before taxes by the same amount. At the same time, the asset account for the equipment is reduced by the same amount.
For the following examples we will use the same asset. The asset has a purchased cost of $39,000. The purchased cost of the asset includes shipping, installation, and start-up. Installation and start-up include the initial tooling that the equipment needs to make it function. It has a useful life of eight years and a scrap value of $3,000.