Lisa, a teenager, was eager to attend the museum’s open house event with her friend. However, her budget-conscious parents had recently expressed concern about her spending habits. They challenged Lisa to find “non-cash activities” – activities not requiring cash – for the entire month. Determined, Lisa approached her parents with a proposition.
“Mom, Dad, may I please go to the free day at the museum tomorrow?” Lisa asked.
Her parents exchanged skeptical glances. “How will you get there?” her father inquired.
“I’ll take the train,” Lisa replied confidently.
Her mother raised an eyebrow. “You won’t use any money for the train?”
“Nope!” Lisa assured them.
Intrigued by this apparent cost-free outing, her parents agreed to let her go. That evening, when Lisa returned from the museum, her parents were curious about the free travel opportunity she had uncovered.
“So, how did you get that free train pass?” her father asked. “Was there some kind of promotion for students attending the opening?”
Lisa looked confused for a moment, then realization dawned on her face. “Oh, I didn’t have a free pass,” she explained. “I used my 10-ride card.”
Her parents’ expressions changed from curiosity to disappointment. “But you told us you wouldn’t spend any money,” her mother pointed out.
“Well, I didn’t need any money today,” Lisa argued. “I already had the card.”
Lisa revealed she had purchased the 10-ride card two months ago for $100. Her parents felt misled, believing Lisa had implied the trip bore no costs – at any time. Lisa felt she was following their desire – she had all the resources for her outing and spent zero cash (anytime this month) to get there.
This scenario raises an important question: Was Lisa being deceptive, or was she simply operating under a different understanding of expenses?
The Teen was Right!
Lisa’s interpretation of a “non-cash activity” mirrors a common misunderstanding in the business world regarding depreciation. Lisa considered her train ride “free” because she didn’t spend cash that day. Lisa’s understanding of “non-cash activity” mirrors depreciation’s categorization as a “non-cash expense”. Both Lisa’s train ride and depreciation involve cash outlay (at some point). The term “non-cash” is misleading, as some interpret this to mean no cash was spent at any time. Lisa’s parents, like many business owners, thought (misunderstood) that the term “non-cash expense” meant depreciation never involved any cash payments.
Depreciation Misunderstandings in Business Examples:
- The “Tax Loophole” Illusion: A prevalent belief that depreciation is simply a clever accounting trick to lower taxes, rather than a reflection of genuine asset value reduction over time.
- The “Two-for-One” Fallacy: Some incorrectly assume that depreciation allows them to claim the cost of an asset twice – once at purchase and again through depreciation – misunderstanding the purpose of spreading the expense over time.
These misconceptions stem from a fundamental misunderstanding of how expenses are recognized in accounting. To unravel this confusion and shed light on the true nature of depreciation, explore a core principle that governs financial reporting: the matching principle.
An Origin Story…The Matching Principle
This misconception about the timing of cash payments and the timing of the depreciation expense leads to a fundamental principle in accounting: the matching principle. Understanding this concept is crucial for grasping why depreciation, despite being labeled a non-cash expense, represents a genuine financial cost to a business – one that requires or will require a real cash payment at some point in time.
The concept of depreciation is rooted in the matching principle, a cornerstone of accrual accounting. The principle dictates that expenses should be recognized in the same period as the revenue the expense helped generate, which may not be the same as the period when the expense was paid.
The matching principle is crucial to present a business’s profitability over time. It ensures that financial statements reflect the true cost of doing business in each period, rather than distorting results based on the timing of cash flows.
Assume Patty’s Pet Grooming has annual revenue of $100,000 and operating expenses (excluding depreciation) of $60,000 each year. Patty purchases a van in Year 1 for $60,000. Assume the van has a 3-year useful life. Consider treatment of the van under two scenarios, with and without the matching principle.
| Matching Principle | ||||||
| Year | Revenue | Expenses | Depreciation | Total Expenses | Profit | Profit (%) |
| 1 | $100,000 | $60,000 | $20,000 | $80,000 | $20,000 | 20% |
| 2 | $100,000 | $60,000 | $20,000 | $80,000 | $20,000 | 20% |
| 3 | $100,000 | $60,000 | $20,000 | $80,000 | $20,000 | 20% |
| No Matching – Expensed in Year Purchased | ||||||
| Year | Revenue | Expenses | Van Purchase | Total Expenses | Profit | Profit (%) |
| 1 | $100,000 | $60,000 | $60,000 | $120,000 | -$20,000 | -20% |
| 2 | $100,000 | $60,000 | 0 | $60,000 | $40,000 | 40% |
| 3 | $100,000 | $60,000 | 0 | $60,000 | $40,000 | 40% |
The Observations about the tables support reasons for the use of the matching principle in internal reporting.
Key Observations from the Tables:
- Three-Year Average: Over the three-year period, the average profit remains consistent at 20%, regardless of the method employed when considering the van.
- Tax Implications: For tax purposes, expensing the entire amount in the first year can provide immediate tax advantages, potentially reducing tax liability in that year.
- Management Tool: When using financial statements as a management tool, the matching principle offers significant benefits for decision-making.
- Consistency and Comparability: Allocating the expense over time enables business owners to compare financial performance more accurately from period to period.
- Alignment with Revenue: The steady expense recognition aligns with the asset’s contribution to revenue generation, providing a clearer picture of ongoing operational performance.
- Trend Analysis: This approach allows for more accurate trend analysis and forecasting, crucial for strategic planning and resource allocation.
- Balance: While tax implications are important, the value of reliable, consistent financial reporting for internal decision-making should not be underestimated.
Costs of Not Understanding Depreciation
Misunderstanding depreciation can have several significant consequences for small business owners. Some examples of potential consequences include the following:
- Inaccurate profit assessment: A business owner might think they’re more profitable than they really are if they don’t account for depreciation. This could lead to overspending or overestimating how much money is available for other business needs.
- Poor pricing decisions: If the cost of equipment is not properly factored into pricing through depreciation, products or services might be underpriced, leading to reduced profitability or even losses.
- Misguided investment choices: A business owner might make poor decisions about when to replace or upgrade equipment, potentially spending money unnecessarily or hanging onto inefficient assets too long.
- Cash flow surprises: If an owner doesn’t plan for eventual asset replacement due to misunderstanding depreciation, they might face unexpected cash flow problems when equipment needs to be replaced.
- Obscured business patterns: When asset costs are not properly matched to revenue through depreciation, it becomes challenging to identify important trends in the business’s financial performance. This distortion can mask underlying patterns crucial for making informed decisions about the company’s direction and health.
Depreciation: A Matter of Timing, Not Absence of Cash
In Patty’s Pet Grooming, it was assumed the payment for the van occurred in a single period. Frequently, payments for an asset purchase occur across multiple periods. It’s important to note that depreciation can still be termed a “non-cash expense” even when a cash payment occurs in the same period. This classification is based on the nature of the expense rather than its timing relative to the cash outflow.
A more accurate understanding of depreciation as a “non-cash expense” is “cash-used at-some-point expense”.
It’s crucial to remember that calling depreciation a “non-cash expense” does not mean that cash was never involved. The term can be misleading. In reality:
- Cash was spent: The asset being depreciated was purchased with real money at some point.
- Timing mismatch: The expense (depreciation) recorded on financial statements may not align with when cash was paid or how much was paid in a given period.
- Spread-out cost: Depreciation spreads the asset’s cost over its useful life, regardless of when payments were made.
- Financial snapshot: It helps provide a more accurate picture of how much the asset’s use “costs” the business in a given period.
In essence, depreciation is about when a business recognizes the cost of an asset over the useful life of the asset. This matches the asset’s cost to the periods in which it supports revenue generation. Depreciation is classified as a non-cash expense, which can be misleading. The term “non-cash” simply indicates that the depreciation expense does not necessarily match a cash outflow in the same amount or same period it’s recorded.
