Q: How is depreciation expense related to accumulated depreciation?
A: Depreciation expense is an accounting methodology used to charge the acquisition cost of fixed assets to earnings over the useful life of the fixed asset. Generally Accepted Accounting Principles (GAAP) and the IRS define the accounting useful life of various classes of fixed assets. If the company is using straight line depreciation, the purchase price, or cost, of the asset is divided by the number of years in the useful life of the asset class to determine the annual expense incurred and charged to earnings for the period.
As an example, assume the acquisition cost of a vehicle is $140,000. If its useful life is seven years, the annual depreciation expense is $20,000.
Accumulated Depreciation is the sum of all depreciation expense charged to earnings since acquiring the asset. Accumulated depreciation is presented as a contra account to fixed assets on the balance sheet. Fixed assets are presented at historic cost – the original purchase prices – which is reduced to the present book value of the assets by subtracting accumulated depreciation from the historic cost of fixed assets.
To refer back to the example above, after three years accumulated depreciation is $60,000 accumulated depreciation. The book value at the end of year three is $140,000 – $60,000 = $80,000.
Q: What is the reason(s) for correcting 2018 depreciation expense for Sequoia Properties? It seems that depreciation expense is a soft cost, so it doesn't seem to affect cash flow or debt service. Is this to figure out what actual tax liability is?
A: The quick answer in this situation is that the income statement is wrong as presented, and it is incumbent on us to work with accurate information in conducting meaningful analysis.
Let’s extend the conversation by citing the primary reason for making the adjustment. Doing so eliminates an understatement of 2018 expenses (even if a non-cash expense like depreciation) and eliminates a corresponding overstatement of 2018 profit. When this combination of understated expense and the resulting overstatement of profit occurs, lenders lose the ability to conduct credible analysis in areas other than cash flow. Every ratio or metric that relies on profitability in making the calculation is incorrectly stated if we fail to adjust the Sequoia Properties income statement. Leverage is the ultimate example of a key area impacted since equity is overstated in the absence of corrections to the misstated income statement.
Note also that traditional cash flow (Net Income + Non-cash Expenses) is the same before and after the adjustment to depreciation. That’s an important consideration in predicting cash flow using traditional cash flow as a proxy. Perhaps it is even more important to note that “real cash flow” as expressed in preparing the FASB Statement of Cash Flows is also unchanged by this correction.
Course overview: The Credit Write-Up and the CRE Analytical Process