More of this Feature • Introduction • Income Statement • Revenue / sales • Cost of Goods Sold • Gross profit • Gross margin • The first three lines • Operating Expenses • R&D Expense • SG&A Expense • Goodwill Charges • Extraordinary Events • Accounting for extraordinary events • Oper. income/margin • Interest income and expense • Interest coverage ratio • Depreciation expense • Accum. Depreciation • Straight-line Method • Accelerated and Sum of the Years' Digits Method • Dbl Declining Balance • Comparing Depr. Mths • EBITDA • Income taxes • Minority Interests - cost, equity, and consolidated methods • Unreported earnings • Continuing operations • Accounting changes • Preferred dividends • Net income applicable to common shares • Net profit margin • Basic vs. Diluted EPS • Hiding share dilution • Share repurchases • Return on Equity- ROE • Asset turnover • Return on Assets- ROA • Projecting earnings • Formulas & Calculations • Putting it together • Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

From Other Guides • EBITDA - Earnings before interest, taxes, depreciation, and amortization • Special Depreciation Allowance for your car

Elsewhere on the Web • Depreciation Expense Calculator • Depreciation Expense on the Income Statement • Why is depreciation dxpense included on the income statement?

Depreciation and Amortization
There are two different kinds of “depreciation” an investor must grapple with when analyzing financial statements, accumulated depreciation and depreciation expense. They are entirely different things, and are often confused with one another. In order to understand them, we must discuss them individually.
Depreciation Expense

According to Ameritrade, “Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. [emphasis added] Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred.”

An Example of Depreciation Expense

To help you understand the concept, let’s look at an example of depreciation expense:

Sherry’s Cotton Candy Co., earns $10,000 profit a year. In the middle of 2002, the business purchases a $7,500 cotton candy machine that is expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made $2,500 at the end of 2002 [$10k profit - $7.5k expense for purchasing the new machinery]. The investor would wonder why the profits had fallen so much during the year.

Thankfully, Sherry’s accountants come to her rescue and tell her that the $7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five [$7,500 / 5 years = $1,500 per year]. Instead of realizing a one-time expense, the company can subtract $1,500 each year for the next five years, reporting earnings of $8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is “depreciation expense”.

This presents an interesting dilemma; although the company reported earnings of $8500 in the first year, it was still forced to write a $7,500 check [effectively leaving it with $2500 in the bank at the end of the year [$10,000 profit - $7,500 cost of machine = $2,500 left over]. This means that the cash flow of the company is actually different from what it is reporting in earnings. The cash-flow is very important to investors because they need to be ensured that the company can pay its bills on time. The first year, Sherry’s would report earnings of $8,500, but only have $2,500 in the bank. Each subsequent year, it would still report earnings of $8,500, but have $10,000 in the bank since, in reality, the business paid for the machinery up-front in a lump-sum. Hence, if an investor knew that Sherry had a $3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of $8,500. In reality, the business would be $500 short.*

This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account. It shows how much cash was spent, at what time, and where. That way, an investor could look at the income statement of Sherry’s Cotton Candy Co. and see a profit of $8,500 each year, then turn around and look at the cash flow statement and see that the company really spent $7,500 on a machine this year, leaving it only $2,500 in the bank. The cash flow statement is the focus of Investing Lesson 5.

Accounting for Depreciation Expense in Your Income Statement Analysis

Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying $1,500 a year, so the company should have added those back in to the $8,500 in reported earnings and valued the company based on a $10,000 profit, not the $8,500 figure. This is incorrect. Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking.

*Depreciation expenses are deductible; Sherry’s would only pay taxes on $8,500 each year, spreading out her tax burden to the future. Some investors assume incorrectly that the business would pay taxes on $2,500 the first year and the full $10,000 each year after.

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