Why Is Depreciation a Non Cash Item?

Depreciation allocates the cost of fixed assets, such as factories, over many years.

Fixed assets, or long-term economic resources, constitute a substantial portion of corporate balance sheets. In fact, investments in plants and equipment -- to name a few assets -- are important for corporate leadership to consider when making long-term strategic decisions. Depreciation helps companies recover asset costs over a period of time.

Identification

Depreciation expense is a charge that a company records to spread the costs of its assets over several years. Simply put, depreciating an asset means recording a portion of the asset's value over its useful life. Useful life is the estimated number of years over which a firm intends to use an economic resource in its operating activities. Although it reduces corporate income and tax liabilities, depreciation expense is a noncash item. Companies do not pay for depreciation, unlike other general and administrative charges, such as salaries, rent and insurance. Yet firms benefit from the lower taxes that result from increased expenses and reduced operating income.

Significance

Depreciation is a key operating expense, especially in industries that require significant capital investments. "Capital asset," "fixed asset" and "long-term asset" are identical terms. Without depreciation rules, investors and business owners would be reluctant to commit substantial amounts to long-term projects. The fact that companies do not disburse cash in depreciation activities remains an important incentive in corporate long-term investment initiatives.

Time Frame

Organizations allocate the costs of operating assets at the end of each month, quarter or year. There is no time requirement for asset depreciation, as long as firms conform to Internal Revenue Service rules. In addition to IRS directives, corporate fixed-asset managers also ensure that depreciation entries adhere to generally accepted accounting principles and international financial reporting standards.

Illustration

A tire manufacturer purchases new equipment valued at $1 million. The corporate controller wants to depreciate the asset over 10 years. As a result, annual deprecation amounts to $100,000 ($1 million divided by 10). To record the transaction, the controller debits the depreciation expense account and credits the accumulated depreciation account. No cash is involved, but the company benefits fiscally from the entries. If the company's tax rate is 30 percent, it will save $30,000 ($100,000 times 30 percent) at the end of the year.

Financial Reporting

Depreciation activities involve two types of accounting statements: balance sheet and income statement. As an expense, depreciation reduces a company's net income. An income statement lists corporate expenses and revenues and is also known as a statement of profit and loss. Accumulated depreciation is a balance sheet component. Also known as a statement of financial position or statement of financial condition, a balance sheet sheds light on a company's economic health. The report indicates corporate assets, debts and equity capital.

References

• Accounting Coach: Depreciation Expense
• Accounting Study Guide: Depreciation Methods
• Solution Matrix: Depreciation / Depreciation Schedule