Depreciation... Why is this Non-Cash Expense so Critical?

This is a tough one... Depreciation?! Why the heck would any business owner bother wasting brain capacity into calculating this - it's a non-cash expense! It just makes an income statement look uglier, the calc. rules for CRA give the broad stroke % allowances to deal with at year end. Doesn't seem like anything we should be bothered with, right?

Well friends, it's actually a very important part of running a business that should ABSOLUTELY be taken seriously and factored into your business' profitability and other financial performance assessments. The only time you really get a chance to rightfully ignore it is when you are doing a Cash Flow Statement (more on those another time). Before I get into 3 reasons why Depreciation is more important than people give it credit for, let me explain more practically with 'real world' examples that will hopefully assist in driving the point home, with a slightly exaggerated tone, but underlying truth.

Example 1 - Bar Owner Brings the Stadium to the Patrons

Let's say you've just opened a nice new local sports bar, and business is going well, but it's mid-March and the NCAA basketball madness is kicking off and you're all of a sudden noticing the crowds aren't getting any better, in fact they're getting worse for those prime-time games. Other bars are drawing the crowds you want. They have the atmosphere. The stadium-type experience. One of your regulars works at an electronics store and has sold you on this incredible cinema-quality projector and screen so you can draw a buzzing crowd on game nights. Eeek it's $4,000. But wait, it's 4G! Plus, I think it can be capitalized, so it's not like our Income Statement takes a hit for March, plus it's an asset for when we sell this place in 4 years and it will draw in some business all year round for the 'big games.' Great, let's do it!

So December rolls around, you've had this asset for 9 months, the projector experience did well to ensure we kept pace with the other local establishments. Time to do taxes. The (traditional) Accountant tells me about the fact that I'll be paying less income tax than I initially thought by recognizing the capital cost allowance (CRA version of depreciation) on all my leasehold improvements, kitchen equipment, furniture, oh and that projector.

This is a gift that keeps giving! All it means is that my Income Statement gets this blow up of depreciation expense and I tell the government I made less than I actually did. Amazing. It's just a line on the statement, didn't actually change how much I made. I should go buy more assets! Multiple TV screens, fancy light show experience for goal celebrations, so many toys and so much business. Cue the shipping and installation costs, the repair guy expenses, the remote control replacements. And now you're in year 3 or 4, close to the time you originally planned to sell, and one by one, like clockwork, you literally find yourself replacing something that conked out on you or doesn't look as crisp and people are complaining. All of a sudden, you are spending who knows how much to replace all these toys, throw away the old one, and you're left with the same value of asset, ready to take on a new cycle of over-use and malfunctions. Now you truly have a regular cash expense on your hands, which could have been properly accounted for by just hitting the income statement with that constant depreciation expense each month and not ignoring it as a non-cash expense, but seeing it as a real expense that represents the cost of your business operation.

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Example 2 - The one-time purchase that keeps evolving

I'll make this one quick - so let's think about  a more predictable, less expensive piece of equipment. You decide less than a year into your bike repair business, which your'e running out of your garage, that you need a laptop for $1,500. Most laptops last you 3 years (if you're lucky) before you are ready to throw it out the window because it's not fast enough. You're looking at $7,500 within a 10 year span, and my guess is that wasn't part of any ROI you calculated for your business when deciding if you should invest $30,000 to outfit your garage for this business. And obviously $37,500 is a much different capital investment than $30,000 (25% extra to be exact, and that's nothing to roll your eyes at when making important business and life decisions).

Now that I have (hopefully) caught your attention, let me dive into those 3 Reasons why  Depreciation is more important than people give it credit for (some of which you may have pulled from the examples above).

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1. It's more of a cash expense than you might think

You better believe depreciation is a cash expense. Depreciation is simply the way we ensure your Income Statement properly reflects the cost of use of a particular asset you spent a boat-load of CASH on. Quite often, people get hung up on the fact that assets are just assets and not expenses. After all, we capitalize them AKA we tuck that hefty payment away to the Balance Sheet instead of allowing it to suck the life out of that month's Net Income via the Income Statement. Well, this bigger ticket item, which will often be referred to as a 'one-time' purchase, has a life span. Because no, the new car, the new furniture, the new computer... they don't have regenerating powers like geckos or iguanas (PS that's called Epimorphosis - educational blog alert). These items get damaged, they get over-used, accidents happen, they need to be replaced etc. And while it's not a monthly or even semi-annual expense, the one-time purchase turns into a two-time or three-time purchase in a short period of time when you consider the lifespan of a most successful businesses. So calculate your depreciation based on the usability and useful life of the asset, and don't just roll your eyes at the number that ends up hitting your Income Statement - it's just as important as those monthly cash expenses.

2. Owners are often shocked when actual ROI is far off base from their 3 to 5 year projections

In many circumstances, the results or realizations of not accounting for depreciation can occur years down the line, and typically more often in circumstances where there is a sole proprietorship, someone just looking to informally run a side business on their own so they can turn a profit for now - one day it could turn into something bigger. They will probably run some rough numbers slapped into an excel, just enough to decide if they are willing to throw some of their savings into this project rather than put it towards an RRSP. The ROI looks pretty good, so let's do this! Fast forward many years later, the lack of Accounting upkeep or Financial analysis of this small business, coupled with some additional bigger purchases that were made along the way without factoring any a) forecasted depreciation expense or b) part of the investment capital required for the business. After 5 years, possibly even more years, the individual is stuck wondering why they haven't doubled their savings account like they thought they would, yet the e-transfers into their bank account add up to far more than the receipts they kept for all the operational expenses over the years, as reported to the CRA for income tax calculations.

3. Clear the mud to focus on true monthly performance indicators

This is certainly lower on the list of critical reasons to be thorough with depreciation calculations. But it is still important to recognize the benefit of keeping things accurate when it comes to truly being able to run your business, especially when it is growing and you meed to make quick and informed decisions to promote that growth. When you have an applied methodology for calculating your depreciation on an ongoing basis, it's as simply as generating a recurring entry each month, and the only differences being when there are changes to your assets makeup. Excel is a powerful tool, and there are ways to make this incredibly intuitive with just a little upfront effort to think through the logic you want to apply (Carve is obviously here to help with that sort of thing!). My recommendation is that you maintain your books with your calculated depreciation accumulating month by month, ensure it is always a part of your ongoing financial position assessments (unless of course you are doing a strict cash flow assessment), and when it's time to apply CRA related rulings at year end, you capture this in a separate set of accounts. The sum of your managerial accounting depreciation and your CRA allowance differences will amount to the balance that will show up on your year end financials and submitted for legitimate income tax purposes, but internally speaking you can very easily omit the irrelevant CRA differences for your own decision-making purposes.