In this post we will answer two questions:
- How does the purchase of a piece of equipment for $1,000,000 affect the financial statements?
- How does an increase in depreciation flow through the financial statements?
For the purpose of this exercise, assume a useful life of 10 years, and that the purchase is made in cash.
Note: Too often this question is phrased by asking what happens when depreciation expense increases or decreases. While depreciation schedules can change, I thought it would provide helpful context to include the source of depreciation in the question.
First let’s start with the purchase of equipment. The company makes the purchase with cash on the balance sheet. This means that everything takes place on the asset side of the balance sheet:
- Increase in Assets: Equipment
- Decrease in Assets: Cash
Dr. Equipment $1,000,000
Cr. Cash $1,000,000
FINANCIAL STATEMENT IMPACT: Excluding the related depreciation expense, which we will address in part two.
Balance Sheet: Cash is reduced by the amount of the purchase, and PP&E is increased by the amount of the purchase.
Cash Flow Statement: The purchase of equipment appears as a cash outflow under Cash Flow from Investing Activities.
The input that will cause this change to be reflected in a three statement model will most likely be located on the PP&E Schedule under “Capital Expenditures.” The PP&E Schedule will link to PP&E on the balance sheet causing the $1,000,000 increase. The PP&E schedule will also link to capital expenditures under cash flow from investing activities on the cash flow statement. Recall that cash on the balance sheet is the sum of the prior period’s cash balance and the current period’s cash flow, the latter coming from the cash flow statement. By reducing cash flow for the period by the amount of the purchase, the balance sheet remains balanced. (For more information on PP&E Schedules follow this link
(Note: For a quick refresher on how the supporting schedules link to the three primary financial statements please watch Overview of the Process.)
NOW we own the asset.
Second let’s look at the impact of an increase in depreciation expense associated with this purchase.
We have assumed a useful life of 10 years, which (conveniently) means that depreciation expense increases by $100,000 in each period. (Please see the video on the Income Statement
if this does not make sense.)
FINANCIAL STATEMENT IMPACT:
Income Statement: Depreciation related to equipment used to manufacture a product will fall under Cost of Goods Sold (COGS). So the first thing you will note is that COGS increases by $100,000 (because it includes depreciation). This reduces taxable income by $100,000. If you assume a 20% tax rate, then the tax payment is reduced by $20,000 and net income is reduced by $80,000 (note: this is why depreciation expense is often referred to as a “tax shield”).
Balance Sheet: PP&E is reduced by the amount of depreciation. Retained earnings is reduced by the change in net income (-$80,000). The change in cash will be described in the next step.
Cash Flow Statement: We start at the top with a lower net income (reduced by $80,000). We then add back depreciation expense of $100,000 because it is a non cash item. This increases cash flow from operations by $20,000.
Financial Model: In summary, the balance sheet remains balanced because…
- Cash (Asset) is increased by $20,000;
- PP&E (Asset) is reduced by $100,000;
- Retained Earnings (Stockholder’s Equity) is reduced by $80,000.