Depreciation expenses in capital projects and leasing arrangements

Treating depreciation expenses in capital projects and leasing arrangements can be a confusing task for student of managerial accounting. It is an expense that affect income statement but it is not a cash flow. This article will try to address the confusion and provide a simple and straightforward information about the issue.

The impact of depreciation expense on the cash flow analysis of a capital project

A capital project is a capital-intensive and long-term project intended to build upon or improve a capital asset (Barone, 2020). For instance, companies may spend large financial resources to acquire equipment or new office project. If the large cost is expensed immediately, it can considerably hurt the financial performance. Expensing the large cost over future periods reduces this impact significantly (Hayes, 2021b).

The practice of expensing the cost of a capitalized asset over time is called depreciation (Petryni, 2017). While the asset purchase will be reported in the investing activities section of the cash flow statement (CFS), the purchase will not be reported in the operating activities section. Instead, it will be expensed through depreciation as the carrying value of the asset dropped over time.

Depreciation expense has a direct effect on the income statement (IS), but since it’s a non-cash expense, it doesn’t affect the company’s cash (Merritt, 2019). However, depreciation must be used to adjust the net income to a cash basis in the operating activities section of the CFS. The net income can not be used directly as net cash change in operating cash flow. It must be adjusted with depreciation, as well as other adjustments (Parker, 2021). In the IS, depreciation is subtracted to calculate net income, but the journal entry will show that no cash was involved, thus, depreciation should be added back to adjust the accrual net income to a cash basis (Dauderis et al., 2021).

Types of leasing arrangements and their pros and cons

There are various types of leasing arrangements, but the most common in a corporation are operation lease and capital lease. An operating lease is a lease contract that allows asset utilization without transferring ownership (Tardi, 2021), while a capital lease is a lease contract that has the economic characteristics of asset ownership (Hayes, 2021a).

An operating lease is treated like true renting, hence, the payments are considered operating expenses. The assets being leased are not recorded on the balance sheet and the depreciation expenses can not be deducted. On the contrary, a capital lease treated the asset as being owned by the lessee. The assets are recorded on the balance sheet, hence the assets depreciate over time and incur interest expenses (Hayes, 2021a).

Both have pros and cons regarding depreciation expenses. The difference in treatment for both leases in the US GAAP can have a significant impact on businesses’ taxes (Tardi, 2021). Capital lease payments are not tax-deductible expenses. However, the lessee can claim depreciation on the asset to reduce taxable income (Anikso, 2022).

For an operating lease, accounting tends to be easier (Anikso, 2022). The unrecorded asset can also provide a lower debt-to-equity ratio. Moreover, the company is free of the ownership risk, as it is the burden of the lessor.

To better understand how to treat depreciation expenses in capital projects and leasing arrangements in terms of financial accounting, real world experience will be really helpful. This is why I encourage students to analyze real financial statements from real companies. The information is usually available for public. In the US, the information can be gathered from the SEC website here.

References

Anikso, E. (2022). Capital Lease vs. Operating Lease: Which Should You Choose? Seek Capital. https://www.seekcapital.com/blog/capital-lease-vs-operating-lease/

Barone, A. (2020). Capital Projects: What You Need to Know. Investopedia. https://www.investopedia.com/terms/c/capital-project.asp

Dauderis, H., Annand, D., & Jensen, T. (2021). Introduction to financial Accounting. Lyryx Learning Inc. Licensed under Creative Commons BY-NC-SA 3.0. https://lyryx.com/introduction-financial-accounting/

Hayes, A. (2021a). Capital Lease Definition. Investopedia. https://www.investopedia.com/terms/c/capitallease.asp

Hayes, A. (2021b). Capitalization: The Whys and Hows. Investopedia. https://www.investopedia.com/terms/c/capitalize.asp

Merritt, C. (2019). What Is the Impact of Depreciation Expense on Profitability? Small Business - Chron.Com. https://smallbusiness.chron.com/impact-depreciation-expense-profitability-55349.html

Parker, J. (2021). How Does Depreciation Affect Cash Flow? Investopedia. https://www.investopedia.com/ask/answers/080216/how-does-depreciation-affect-cash-flow.asp

Petryni, M. (2021). The Difference Between Capitalization & Depreciation. Bizfluent. https://bizfluent.com/info-12063680-difference-between-capitalization-depreciation.html

Tardi, C. (2021). What Is an Operating Lease? Investopedia. https://www.investopedia.com/terms/o/operatinglease.asp

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