False profits due to hidden expenses like depreciation

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‪#‎professionalizeyourbusiness‬ series: False profits due to hidden expenses-Part 1

When I set up a business or a company’s accounting and financial management system, I also advise them on best practice or point out some of the issues they need to put into consideration. What I discover is that there are some expenses that are ‘hidden’ because cash does not flow out from the business and therefore easily forgotten . The 1st one in this series is depreciation.

I computerized the accounting system for a client and in the process I advised the accounting personnel that they have to include depreciation on the fixed assets as an expense in their accounts. At the end of the exercise, the income and expenditure statement indicated that the business had made a loss. The Boss/Owner insisted that the business could not have made a loss because the sales had gone up than the prior year.

When we went through the report in detail, we came across depreciation as the one that tilted the scales. She had made a profit of Ugx20 million before depreciation. However, based on the fixed assets the depreciation charge for the year was Ugx25 million which meant a loss of Ugx5 million.

They had made a new purchase of a motor vehicle of Ugx80M to be used for distribution of there products. This was not in their fixed assets register in the previous year but it resulted to Ugx16M depreciation expense charge in the financial year.

Depreciation is a method of allocating the cost of a tangible (fixed) asset over its useful life. For accounting purposes, depreciation indicates how much of an asset’s value has been used up.

Revenue and Expenses to GDP 1993-2007
Revenue and Expenses to GDP 1993-2007 (Photo credit: Wikipedia)

Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for Ugx10 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense Ugx1 million (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year.
The learning point is that the higher the value of your fixed assets the higher the annual depreciation charge over its useful life.

For example: If Business A buys a Motor Vehicle at 80M which they anticipate to use over 5 years, the annual depreciation charge will be 16M.

If Business B buys a Motor Vehicle at 40M which they anticipate to use over 5 years, the annual depreciation charge will be 8M

Have you considered depreciation in your business?

February 25, 2019

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