ENGG 401 X2 Fundamentals of Engineering Management Spring 2008 Chapter 3 (cont): Depreciation and Income Statements Dave Ludwick Dept. of Mechanical Engineering University of Alberta

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Disposal of Assets Lets just remind ourselves of some terms for reference –Book value: The original cost of an asset less the sum total of all the depreciation taken to date Book Value = Purchase Price – Accumulated Depreciation –Accumulated Depreciation the sum total of all the depreciation taken to date Depreciation Expense, Yr 1 + Depreciation Expense, Yr 2 + … Depreciation Expense, Yr N –Market value: The amount an asset can currently be sold for. It has no relationship to book value. Market value fluctuates with the market’s perception of the value of the asset

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Disposal of Assets When an asset is sold: loss on disposalloss on sale of assets –If the market value is less than its remaining undepreciated value (remaining book value), you record a “loss on disposal” or “loss on sale of assets” in other income $ Loss on Disposal Purchase Value Market Value Book Value

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Disposal of Assets (2) When an asset is sold: recaptured CCAgain on sale of assets –If the market value is more than its remaining undepreciated value, you record a “recaptured CCA” or “gain on sale of assets” as other income $ Recaptured CCA Purchase Value Market Value Book Value

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Disposal of Assets (3) When an asset is sold: recaptured CCAcapital gains –If the market value is more than its purchase value, you record a “recaptured CCA” and “capital gains” as other income $ Recaptured CCA Capital Gains Purchase Value Market Value Book Value

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Operating Income Interest is an “interesting” expense –Sometimes managers consider interest as directly related to the operations of the business, so it is included in the calcs for operating income –Other times, managers consider interest as separate from operations, so it is subtracted after the calcs for operating income –It must be subtracted to get Net Income, but depending on its purpose in the business Where does interest on long-term debt go? –If it goes into SG&A, then operating income measures the value created by the business as you have financed it. –If it goes into other income (as an expense), then operating income measures the value created by the business independent of the financing of the business. Either option is valid, you just have to be consistent.

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management More on Other Income Other income is where any one-time costs or revenue are listed. –This includes any costs and revenues not related to the core business activities. sale of parcel of land, one time sale of licensing rights, writedowns –Those costs and revenues need to be listed but would give distorted view of the company’s health if included in operating income.

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Cash versus Income Depreciation - a process of matching or allocating the cost of the capital assets over the time that the asset is used. Accounting is trying to use the matching principle to match the cost of the assets to the revenues they helped create. –Note that amortization is a process of cost allocation NOT asset valuation. –Amortization is not a measure of an asset’s declining market value –We only start recording asset depreciation once the asset is put into use Book break evenBook break even says that a business is generating enough income to replace its assets. Cash break evenCash break even says that a business can stay afloat. The difference is depreciation (and writedowns).

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Cash versus Income (2) Cash flow from operationsCash flow from operations measures whether the basic business is throwing off cash. It ignores the one time items in other income. operating income + depreciation –Is equal to operating income + depreciation –Remember: Operating Income = Revenue – Operating Expenses –Operating Expenses includes depreciation –We add depreciation back to operating income to cash flow since depreciation is a non-cash deduction Net cash flowNet cash flow or total cash flow includes all extraordinary items. It is the “acid test” for cash: does a company generate more cash than it consumes. net income + depreciation + writedowns –Is equal to net income + depreciation + writedowns Negative cash flow creates a crisis. –Vendors tend to stop delivering, and banks call loans.

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Cash vs Income – Problem #1 You borrow $3 million for a three year term and combine it with your equity to buy a business. The business is essentially debt free before you buy it and has a steady net income of $0.8 million/year. Depreciation runs at $0.4 million/year. Questions: –Can you repay the debt? –What condition must be met to achieve this?

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Depreciation and Cash vs Income – Problem #2 You study three companies: A B C Revenue$12.6 $12.6$12.6 – COGS $8.1 $8.1 $8.1 Contribution Margin = Contribution Margin $4.5 $4.5 $4.5 – SG&A excl. Deprec. $2.5 $4.7 $4.7 – Depreciation $3.0 $0.6 $0.6 Operating Income = Operating Income ($1.0) ($0.8) ($0.8) + Other Income ($0.5) - $1.8 Net Income = Net Income ($1.5) ($0.8) $1.0 Question: –Will these companies be OK in the short term? –Will these companies be OK in the long term?

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Operating Income versus Net Income Operating incomeOperating income looks at the underlying business. –It excludes “one time” or unusual items, and focuses on operations management (especially if interest on long term debt is excluded). Net incomeNet income is a measure of a business’s creation of value. –The Statement of Retained Earnings and hence the Balance Sheet –The Price/Earnings ratio (if publicly traded). You can do two things with net income: –Give it to the owners as a dividend. retained earnings –Keep it in the business as retained earnings

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Statement of Retained Earnings The statement of retained earnings records the value that has been kept within the business: Retained Earnings at start of the period + Net Income for the current period – Dividends Paid in the current period = Retained Earnings at end of the period For example: Retained Earnings, 31 Dec 2004$ Net Income in 2005$ – Dividends Paid in 2005$ = Retained Earnings, 31 Dec 2005$

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management The Art of Management RevenueExpenseNet Income Revenue ExpenseNet Income What we want: Up Down Up Advertise more Up Up ? Hire more sellers Up Up ? Cut staff Down Down ? Cut marketing Down Down ? Reduce quality Down Down ? Lower Price ? Nil ?