Part II – A CPA’s Views on Depreciation as a Source of Cash
Returning to the balance sheet, let us assume the
simplest case where all current assets are solely in
the form of cash. The question immediately arises: is
all that cash available for the purposes of the
company? The answer is, "not necessarily." A good
deal of the cash may already belong to somebody else,
even if it is sitting right there in the company's
checking account. For example, if the company stopped
paying its bills, it could build up a rather sizable
cash balance - but it would have no legitimate claim
on that cash. That is how an increase in accounts
payable is construed as a source of working capital.
Such an increase does nothing to increase the cash
actually held by the company, but it does allow cash
held by the company to be used for other things in the
interim before paying the bills.
The use of that cash may also have been allocated
internally - it may not be available for general needs
of the company. To determine whether the company may
legitimately use its cash for various purposes, we
need to look at other accounts on the balance sheet.
Since this is a "simplest case" scenario, there are no
accounts receivable. Accounts receivable is a current
asset, and, remember, all our current assets are cash.
We may, however, have some current liabilities, of
which the most significant is "accounts payable." We
may have a million dollars in cash in the company, but
if accounts payable are also a million dollars, we,
effectively, have no cash - all the cash on hand
belongs to the people to whom we owe the million
dollars.
Suppose, however, we have a million dollars in cash,
and "only" $750 thousand in accounts payable and other
current liabilities. Does that mean that we are free
to spend $250 thousand any way we like? Again, not
necessarily. We have to look at our long-term
commitments, that is, our long-term liabilities as
well as our responsibility to pay out dividends to
shareholders or use retained earnings to expand or
improve facilities (if we take the Henry Ford approach
and reject the possibility of external debt or equity
financing). Now we must return to the statement of
sources and applications of working capital to
continue our analysis.
On the "applications" portion of the statement of
sources and applications of working capital, we
discover that we have purchased long-term assets in
the amount of $100,000. This "removed" $100,000 from
current assets (cash in this case) by "reclassifying"
that amount of current assets as accounts payable.
Well, that was already taken care of in our review of
the balance sheet, but it shows where, specifically,
our cash has gone - even though it hasn't "gone" yet.
We are morally and legally obligated to pay $100,000
to our creditor in that instance, and not divert the
cash to our own use. Even though we have the cash in
our possession, it does not belong to us. It belongs
to the people to whom we owe it. This still leaves
unanswered the question as to where we "got" the
"additional" $250 thousand in cash.
Remembering for the sake of this example that all of
our current assets are in cash (i.e., no accounts
receivable, marketable securities, short term
investments, etc.), there is only one source for the
$250 thousand: depreciation expense. The working
capital thus "generated" may be used for any purpose
for which the company wishes to use its working
capital. "Recognized" would be a more accurate term,
as depreciation expense "frees up" cash instead of
physically generating it. The term "generation" is,
however, commonly used in accounting and considered
proper.
Such "freed up" working capital is, as the quote you
cited correctly states, not a fund for asset
replacement - although the company may decide to use
its working capital for that purpose, as well as for
the payment of dividends. Depreciation does not
result in one dollar more or less in the cash account,
again as the quote you cite correctly points out.
What depreciation expense does, however, is legitimize
the use of that cash for working capital purposes by
changing (reclassifying) the cash "tied up" in
long-term assets by expensing the long-term asset and
freeing up the expensed amount for other purposes.
Conceptually, depreciation does not bring actual cash
into existence. Depreciation tells where cash came
from.
In depreciation, therefore, you have at least three
timing issues involved. One, a long-term asset is
purchased, but cash is not paid over to the creditor
immediately. Instead, e.g., a 5-year note is signed,
thereby increasing long-term assets and long-term
liabilities in equal amounts. Ideally, the term of
the loan would be exactly equal to the life of the
asset, thus matching cash payments to the specific
periods in which the asset was producing and in the
same amounts. Don't ever expect to see this - most
lenders want their money as fast as they can get it,
and the term of a loan frequently bears no relation to
the useful life of the asset purchased. The term of
the loan versus the life of the asset is simply an
accommodation to reality.
Two, an asset is "used up" over its useful life. In
accordance with the matching principle of accounting,
this "using up" should be recognized in the period in
which the "using up" occurs. Depreciation expense is
an attempt to assign the cost of the use of an asset
to the period in which the cost is incurred,
regardless of when the lender demanded payment for the
asset.
Three (and this seems to cause you a great deal of
confusion), an asset is expensed at a time that does
not necessarily have any connection with when the
asset was purchased or paid for. It is important to
note that "purchase," "payment" and "use" are all
discrete concepts and distinct events. Depreciation,
accounts payable and accounts receivable, combined in
various ways on the four essential financial
statements, relate these three concepts and tie them
together into an integral whole.
Ideally, again, no one would pay for anything that he
was not purchasing at the moment of use. A company
would only pay for an asset as it was using it, and
only purchase it at the moment of use. A shopkeeper
would only be paid for the ingredients an individual
purchased to make dinner as the dinner was eaten. In
an absolutely ideal and perfect world, this would be
at the point where "title passes" (not to be confused
with legal conventions as to when title passes). That
is, "title passes" in a conceptual sense when
something is "used up," not necessarily when the law
says it passes.
As you can see from the above paragraph, refusal to
recognize depreciation as a source of working capital
(or "cash" if you prefer) not only gets you into areas
of such extreme triviality where business is
concerned, it disconnects you from reality. If
recognizing an expense in the period in which the
actual expense was incurred is a "trick" or is somehow
illegitimate, then credit itself must be called into
question. It also calls into question the legitimacy
of accounts payable and accounts receivable. When you
begin by questioning reality, you end by being
uncertain of everything based on reality, such as the
principles of accounting.
Depreciation expense is a way of accommodating the
recognition of revenue and expense, receipt and
disbursement of cash, with the real world. In the
real world, people are not paid immediately for their
work or their goods, and people take their time in
paying their debts as well as in using their assets to
generate production.
If I understand your objections to depreciation
correctly, you seem to demand instantaneous work,
production, payment and use. This is unrealistic, as
the world does not work that way. The basis of any
kind of credit, of money itself, requires that value
be transferred at some other point in time than when
the transaction "officially" occurs, whether in the
past (as with depreciation) or in the future (as with
accounts payable and accounts receivable). Your
quarrel would seem to be not with depreciation or even
the accounting profession, but with the whole idea of
credit, or, perhaps, the temporal nature of reality.
That being so, you will either have to change your
orientation and accept such basics as delayed payment
and recognition of expenses and revenues, or somehow
change the world to eliminate the concepts of money,
credit or time itself.
As a bit of friendly advice, you might in the future
want to modify your language somewhat when addressing
professionals speaking within their area of
competence. Regardless of your opinion of accounting
and the accuracy of your historical knowledge, your
mode of expression and choice of words seem more
calculated denigrate than to engage in serious
discussion or seek information. Since that,
presumably, is not your intention, your chosen manner
of communication is self-defeating. It tends to
alienate rather than inform, and to estrange potential
allies before you have given a fair or comprehensible
presentation of your ideas. After all, my lack of
response to your previous "challenge" was predicated
on the assumption that you could not be serious.
Individuals whose professional qualifications and
competence you have inadvertently called into question
would be disinclined to engage in discussion of any
kind with you. This has nothing to do with any merit
or lack thereof in the ideas you put forth. There is
profit to be found in discussing any idea
intelligently and with respect for the decencies of
debate and civilized behavior.
In closing, please let me reassure you that I stand by
my previous statements quoted by Norman Kurland, and
that the statements are in conformity with GAAP
("Generally Accepted Accounting Principles") as well
as accepted accounting theory and practice and current
tax law in the United States. If you find that you do
not understand some or all of this discussion, I would
consider providing more clarification if you could
specify the language to which you take exception and
the specific accepted principles of accounting you
believe I am violating.
Yours,
Michael D. Greaney, CPA, MBA
Director of Research
Center for Economic and Social Justice
__________________________________________________
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"William B. Ryan" wrote:
Norman Kurland,<?xml:namespace prefix = o ns =
"urn:schemas-microsoft-com:office:office" />
In further reply to your post under the above heading
archived at
http://www.geocities.com/socredus/kurland-12-14-01.htm
In continuation of
http://www.geocities.com/socredus/ryan-01-23-02.htm
which was in supplement to
http://www.geocities.com/socredus/ryan-12-17-01.htm
Of relevance to this discussion is this excerpt from
John-Baptiste Say regarding what has come to be called
Say’s Law http://www.geocities.com/socredus/say.htm
and the following excerpts from Douglas:
http://www.geocities.com/socredus/swanwick.htm
http://www.geocities.com/socredus/nature_of_price.htm
http://www.geocities.com/socredus/dickens.htm
1.You wrote:
“Under Say’s Law, purchasing power is assumed
only to the extent of production—not beyond or
addition to production.If production
increases, so does purchasing power.If
production decreases, so does the ability to
purchase that production…”
This we will not dispute.What we dispute is that
purchasing power increases or decreases
proportionately to production.The keyword here is
proportionately.We attribute this disproportionality
to a flaw or inadequacy in the financial system that
makes it incapable of rationally accommodating growth
vectors in population and technology
2.You wrote:
“Bill, you contend that ‘there exists,
however, no mechanism in double-entry
accounting to accommodate the parametric shift
of an increasing ratio of ‘B’ to ‘A’ flowing
from labor displacement...’ Again, for reasons
explained above, cash freed up by accounting
for depreciation can be used to close this
purchasing power deficiency...”
To repeat, depreciation does not free up cash.It
merely delays the expensing of a cash disbursement
from the present to the future.This is elementary
accounting 101, which is why I challenged you in my
last post regarding Michael Greaney. I would still
like to see his response.
The following is from “Accounting Principles,” by
Howard S. Noble, MBA, LLD, CPA and C. Rollin
Niswonger, PhD, CPA, a standard college text, which by
1961 had already gone through eight editions:
“…[A] common misconception is that
depreciation accounting provides a fund of
cash for the replacement of plant
assets.Expired portions of the cost of the
assets are periodically transferred to expense
by debits to depreciation expense accounts and
credits to accumulated depreciation
accounts.The cash account is not affected by
the entries and, of course, would not be
affected if the entries were omitted.The
confusion originates from the fact that
depreciation expense, unlike most expenses,
does not require an equivalent outlay of cash
in the period in which the expense is
recorded.”
Keep in mind we are interpreting purchasing power in
terms of it being effective demand.The expense charged
against current sales is what determines the rate of
profit and it is the rate of profit that is of
significance to the concept of effective
demand.Without profit the willing seller disappears;
without the willing seller production halts.
The fact that money may be pigeonholed somewhere from
past disbursement does not mean it is available as
purchasing power against current production. [*]And if
the money was used to repay a bank loan at some point
in its past disbursement it does not exist
anywhere.Yet it has been transformed into a cost that
is charged against sales.
[*} Money is a vector quantity.There is directionality
to production that I will explain in a future post.
3.You wrote:
“Social Credit, however, violates the basic
principles of accounting by adding to the
system on one ‘side’ without anything to the
other.That is, the amount of existing
production above a certain amount is declared
to be a National Dividend, and new money is
created and inserted into the system in that
amount.”
We are concerned not so much with existing production
but potential production--what can be made to
exist.For more than eighty years the slogan has been:
What is Physically Possible is Financially Possible!We
define production broadly to include the increase in
productive capacity, and consumption to include the
increasing option for leisure.It is the path toward a
sustainable world.Nothing has to be taken away from
anybody because what can be made to exist is so much
greater than what already exists.What can be made to
exist includes a great many intangibles.
I refer you to the diagram attached also archived at
http://www.geocities.com/socredus/baseline.jpg
Let me say parenthetically that the various “binary”
schemes seem to be inflationary to the extent they are
financed with “pure credit.”I have not found even a
single ESOP that did not entail the simple transfer,
or dilution in ownership, of already existing assets
from the already existing owners to the ESOP.There is
no net creation of wealth.ESOPs are often promoted as
the way for departing owners to “cash out.”Quite often
it has been the vehicle for the raiding of pension
funds and to force out unions by financially troubled
companies.The chief proselytizers for such schemes,
the most ardent “true believers,” seem to be lawyers
and financial agents whose business, the way they make
their! living, is to structure ESOPs.There is moreover
the matter of disproportionality that Social Credit
asserts.
Take a look at the diagram.The diagram depicts two
possibilities.In both the ‘A’ curve is diverging
exponentially from ‘A + B’ through time.In the first,
the ‘A” curve is held to be increasing linearly
through time.In the second, it is ‘A + B’ that is held
to be increasing linearly.
If we take ‘A + B’ to be the surrogate for the money
supply and by inference prices, and ‘A’ the surrogate
for its primary component, wages, and by inference
employment—the theorem becomes the analytical
confirmation of the empirically derived Phillip’s
Curve. There is a “trade off” between inflation and
employment.
If, as a matter of policy, in monetarist fashion, the
money supply is held to be increasing at some fixed
percentage per year, then employment must languish.
If, however, say from union pressure, wages are
permitted to rise commensurately with “productivity,”
prices must rise without limit.
The Social Credit solution is to moderate bank credit,
much as the monetarists do [*], but supplement it with
credit supplied “exogenously,” that is to say, not
costed into production so it does not appear in
prices—through the mechanism of rationally introduced
retail discounts and consumers’ dividends.The supply
and demand curves become “parallel.”Production rises
proportionately with demand.
[*] With of course some differences.
To be continued.
Bill Ryan