Depreciation

What does it mean

Depreciation is the recognition of the cost of a noncurrent asset across the useful life of the asset.  It is easiest to understand this by comparing it to something that only benefits a company for a short period of time (an expense).  When a business pays an employees wage, they are paying for the time given by that employee for a specific 2 week period of time.  Since the benefit of that employees work is fully realized during during that year, that money is listed as an expense on their income statement.  Let’s compare that to if the business purchased a piece of equipment, and that equipment had a useful life of 5 years.  If the business were to allocate that equipment’s cost as an expense, year 1 expenses would be overstated (which decreases income) and subsequent years expenses would be understated (which increases income) because all of the cost is recognized in a single year, but the benefits of having the equipment last the full 5 years.  To better allocate this cost to the years where the business receives the benefit, the equipment, instead of being expensed on the income statement, is listed on the balance sheet (fancy term would be “capitalized”) and a portion of that equipments cost is expensed each year over its useful life through the use of depreciation.  

Why does it matter

Depreciation matters to a banker for a few reasons.  The first reason is that depreciation has a direct impact on taxable income (and how much tax a business pays).  Anything that impacts taxes is important to a business owner; so it should be important to a banker as well.

Another reason depreciation should be important to a banker is because depreciation expense on the income statement is a “non-cash” expense.  What that means is that the expense included which reduces “taxable” income, but it is not like you write a check to someone for depreciation.  What that means is that the “depreciation” expense is still sitting in the borrower’s checking account, and it can still be used to pay our loans.  

Other Relevant Terms

• Income Statement
• Capacity
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