The Daily Technical #118: What is the relationship between depreciation and the salvage value assumption?

Good morning. Welcome to the 118th edition of The Daily Technical.

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OVERVIEW OF YESTERDAY’S QUESTION
How does buying a building impact the three financial statements?

Income Statement: Initially, there'll be no impact on the income statement since the purchase of the building is capitalized.

Cash Flow Statement: The PP&E outflow is reflected in the cash from investing section and reduces the cash balance.

Balance Sheet: The cash balance will go down by the purchase price of the building, with the offsetting entry to the cash reduction being the increase in PP&E.

Throughout the purchased building's useful life, depreciation is recognized on the income statement, which reduces net income each year, net of the tax expense saved (since depreciation is tax-deductible).

Common Mistakes

1. Misinterpreting how depreciation impacts the financials. Detail how depreciation reduces net income annually while being a non-cash expense that shelters taxable income, influencing cash flow indirectly.

2. Missing the tax benefits of depreciation can misrepresent net income impacts. Clarify how the depreciation deduction reduces tax expenses, thereby affecting cash flow over the building's useful life.

3. Assuming that buying a building immediately affects the income statement. Remember, the purchase is capitalized, so the initial transaction doesn't touch revenues or expenses. Focus on understanding how depreciation affects net income over time.

4. Forgetting to connect the building purchase to the cash flow statement. Ensure you capture the cash outflow in the investing activities section—this indicates how the transaction influences your cash position.

TL;DR

• IS: No immediate effect; purchase capitalized. Depreciation lowers net income yearly, factoring tax savings.

• CFS: Outflow in cash from investing due to purchase, reducing cash.

• BS: Cash decreases by the building's cost; PP&E increases equally.

• Depreciation gradually impacts IS, reducing net income, with tax benefits.

TODAY’S QUESTION
What is the relationship between depreciation and the salvage value assumption?

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