Depreciation is another idea that does not seem to be considered holistically from a cash flow perspective when calculating profit. As a result, it fails to provide proper cash flow information when considering the transactions that involve depreciation. Let’s say you buy a piece of equipment for $100,000, and let’s assume you pay cash for it. You will now be $100,000 poorer from a cash flow perspective. This $100,000, however, doesn’t make it to the income statement as a $100,000 cash transaction even though that is how you paid for it.
From an accounting perspective, that asset you purchased must now be depreciated. Let’s say the equipment is depreciated equally over five years at $20,000 per year. The $20,000 goes onto the income statement and is involved in calculating profit. This creates an interesting scenario. First, the $20,000 has nothing to do with how you paid for the equipment. Second, and even more troubling, is that depreciation is considered a non-cash entry. This makes sense from the standpoint of it being an arbitrary number, but it also should represent what you paid for the equipment if profit truly represents cash flow. You are out $100,000 and that number does not show up as such on the income statement.
As a result of all this, with anything you buy that is depreciated, there’ll be a difference, sometimes a significant difference, between the cash used in the transaction and how it is reported on the income statement. This issue can be manifested in several ways. The first is when you pay cash at one time and depreciation takes place over a longer time. It also happens when you’re paying for the objects over time. The timing of the payments will be different from the depreciation schedule (Exhibit 9.1). You may pay off a loan in four or six years but have a five-year depreciation schedule. Finally, there may be a difference between the payment schedule and the dollar values for depreciation. The amount that you pay based on the terms of the loan may be very different from the dollar values that are used on the income statement,
Exhibit 9.1 Your income statement sees your depreciation schedule. This rate can be very different from the cash you use to pay off any money you may owe
Depreciation enters into profit your profit calculations, but it is not based on your cash flow dynamics; it is determined by the choice and application of an accounting rule, so it becomes another source of why profit isn’t an effective proxy for cash flow.