Chapter 7
Depreciation and loan amortization

Two of the hardest concepts for non-financial managers to grasp are depreciation and loan amortization. Each relates in some way to your largest capital expenses: The cost and financing of your fleet, buildings and other necessary equipment and facilities.

Depreciation expense is nothing more than an answer to the following question: If I buy something that will last several years and decline in value as I use it, how much of this cost do I allocate to each accounting year?

It makes sense, as we discussed earlier, to match costs with revenues in each accounting period. As you record revenue from hauling, you should deduct the cost of generating that revenue, including driver pay, fuel and wear and tear on the truck.

Wear and tear is represented as a cost by the decline in the truck’s value. Suppose you spend $60,000 in cash for a truck, which will be worthless in five years. One way to treat this item would be to allocate $12,000 each year ($60,000 divided by five years).

But you recognize that’s not what really happens; even heavily used trucks retain some value. That’s why we have the concept of salvage value — the estimated value at the end of the useful life. If the truck will be worth $10,000 at the end of the five years, then the depreciable basis, or amount we plan to charge off, is $50,000, making the annual cost of the truck $10,000 per year.
The formula for the calculation of depreciation is as follows:

Cost of the truck - salvage value	=	Depreciation expense per year
Number of years the truck will last

Now you see why it’s called an estimate. There are lots of variables that can affect what the expense should be each year.
So far, we have described the straight-line method of depreciation, which assumes steady depreciation in equal amounts each year.

In real life, of course, equipment doesn’t depreciate evenly. Everybody knows that once you drive a vehicle off the lot, you suffer a sharp drop in resale value. In addition, a new truck might log more miles in the first three years than in later years. As maintenance costs rise and the truck becomes less reliable, you might use it less.

Does it really seem fair, then, to charge an even $10,000 each year? Perhaps not. That’s why some clever accountants invented the concept of accelerated depreciation, under which you charge more off in early years than in later years. Some methods even calculate each year’s cost base on use. If you know the estimated total mileage over the life of a truck, you can deduct the cost by determining what percentage of the total you use in a given year. There are several methods, but it’s not important to know exactly how they are computed. Just realize that you can speed up the deduction.

How is all this recorded in the financial statements? Recall that the P&L shows revenues and expenses over a period of time and that the balance sheet shows financial position as of a date in time. This is how the individual financial statements record the truck during each of its five years’ useful life:

Note that the cost of the truck was written off on the P&L over five years. The balance sheet recorded the truck at original purchase price, and each year more depreciation accumulated, reducing the carrying value, or the net book value, eventually to the estimated salvage value.

Gain or loss on sale of fixed assets occurs on the P&L if you sell the truck above or below this $10,000 net book value. If, for example, this truck sells for $15,000, then the P&L will show a gain of $5,000 because you charged off too much in depreciation. Had the truck sold for $8,000, however, the P&L would show a loss of $2,000.

Tax depreciation almost always differs from book depreciation. The IRS didn’t want to fight with everyone over use of different depreciation methods, so Congress basically mandated the depreciation methods companies could use, classifying assets into groups by estimated asset life. Using this method, the expense is allocated each year based on a percentage of original cost. So a $60,000 tractor might depreciate $5,000 in the first year, $15,000 in each of the next three years and $10,000 in the fifth year. (Yes, sometimes the IRS ignores the salvage value.)

Bankers prefer realistic depreciation methods that attempt to track the actual decline in value — not what the IRS says it should be. Therefore, the bank may require your accountant to use GAAP methods for your annual reports and let your accountant worry about the proper amount for your tax return.

The same methods are used to allocate the cost of all your fixed assets each year, and the amounts are lumped together into the line called depreciation expense on your P&L. Your accountant probably has software designed to maintain your depreciation schedule. Only the useful lives and accelerated methods may vary. A sample of how your equipment might depreciate is shown on the next page.

Loan amortization has nothing whatsoever to do with depreciation. It relates to the method of accounting for the financing of your equipment, not how you charge the equipment’s cost to expense. Many people mistakenly believe otherwise.

Virtually all companies borrow to finance long-term equipment purchases, because rarely does anyone have enough money up front. It’s logical to spread cash flow out over the revenue-producing life of the asset. Banks are very careful not to let the financing period exceed the useful life of the equipment; otherwise they might have trouble collecting the loan. In fact, lenders rarely want financing terms to go beyond three to five years, even though the asset may hold value for a longer period.

You carry loans for trucks, trailers, office equipment and buildings on the books as long-term debt. The portion of the principal due within the next 12 months is classified as the current portion of long-term debt in current liabilities.

Of course, loans come with a cost: interest expense. You write interest off on the P&L in the year it is incurred — more in the early years when the balance is large, less as the principal balance declines. But most loans are amortized; even monthly payments are made over the life of the loan. Out of a $1,000 monthly payment, for example, the interest might be $600 and the principal only $400 in the first year. But by the fifth year, the interest may be $200 and the principal portion up to $800. This works just like a home mortgage.

The principal on a loan is not a cost; it’s simply the repayment of a loan. You’ll never see the full amount of loan payments on your P&L. The cost of anything purchased with the principal is allocated over the years using depreciation methods.

The cash flow on a truck purchase has nothing to do with the depreciation cost. Suppose you financed a $60,000 truck for five years at 9 percent with $5,000. Each payment would be $1,142 per month, or $13,700 per year for each of the five years. The depreciation calculation would be the same as shown earlier. The bottom chart on the previous page shows how the loan would affect your financial statements.

Note that the P&L writes off only the interest cost. The balance sheet recorded the truck at original purchase price. And each year, more of each year’s payments are applied towards the principal, reducing the outstanding loan amount eventually to zero.

In Summary
The method of depreciation is important, because it takes your largest dollar investment — in your fleet, buildings and other property — and spreads it over several years. The methods chosen should be the ones that best allocate this cost and match it with the revenue your trucks generate. Loan amortization or cash flow, while certainly important in managing the finances of the company, have nothing to do with depreciation.