HOMESTEAD: A CPA's Views on Depreciation as Source of Cash-Pt I

["Norman G. Kurland" <thirdway@cesj.org>]

A CPA’s Views on Depreciation as a Source of Cash, Part I (Michael
Greaney
Response to Bill Ryan, Social Credit advocate, March 11,2002)

Dear Mr. Ryan,

I will not argue with your point that Say's Law will not work under
today's financial system.
The argument made by advocates of binary economics is that, under
Kelso's revision of
Say's Law, the purchasing power gap can be closed between aggregate
production (supply)
and aggregate consumption (demand).  Fortunately, the current issue of
the prestigious
Journal of Socio-Economics has finally made accessible to other scholars
around the world
and academia generally my paper, "A New Look at Prices and Money: The
Kelso Binary
Model for Achieving Rapid Growth Without Inflation" (see
http://www.cesj.org/binaryeconomics/price-money.html) to butress our
argument and subject
it to serious scholarly debate.  I feel heartened that other leading
binary economists have
praised my article as a major contribution to that debate.

In your last posting you challenged the proposition that depreciation
could be a source of
non-wage-based supplemental cash for closing the purchasing power gap
within a binary
economic system, a system which would also serve to close the gap by
expanding the base in
society who share supplemental ownership incomes in such
production-connected forms as
dividends, cash profit sharing and cash productivity bonuses.  That
purchasing power gap
can largely be traceable to the retention of earnings within productive
enterprises, a situation
that could be avoided if companies (1) paid out fully their pretax
profits as dividends to
people ready to consume what the economy produces and (2) the nation's
monetary
authorities and banking system would supply sufficient capital credit to
meet the economy's
overall needs for economically-feasible new capital formation reflected
in the form of
self-liquidating leveraged acquisitions of newly-issued equity shares
for workers and citizens
generally.  We also would argue that depreciation could also serve as an
alternative to
"creating money" disconnected with ownership rights under the National
Dividend Plan as
advocated by you and other advocates.

In response to your objections to our discussion of depreciation as one
possible source of
cash for increasing mass purchasing power, I (one trained merely in the
law and economics
program at the University of Chicago Law School with only a lawyer's
understanding of
accounting) have asked my colleague Michael Greaney, who is a CPA with
MBA
credentials) to address your points from his several decades of
professional experience.
What follows is a beautifully articulated scholarly lesson in basic
accounting that makes sense
to me and I hope will make sense to you, other Social Credit advocates,
and other
participants in the COG ownership discussions.

Norm Kurland
Center for Economic and Social Justice
Web site: http://www.cesj.org



8th March 2002

Dear Mr. Ryan:

Mr. Norman Kurland forwarded me your earlier comments
on the answer I gave to him concerning the effect that
timing of depreciation has on profits from an
accounting point of view.  Since you have requested a
direct response confirming that what you characterize
as "nonsensical gibberish" could proceed from someone
with a CPA and an MBA, please let me assure you that
yes, such "nonsensical gibberish" does, indeed, come
from someone who has earned a CPA and an MBA.
Further, I agree with ("sign off on") the quoted
sections in your missive, particularly in that, in
large measure, I wrote them.  You will find similar,
if not identical language in any beginning or
intermediate accounting textbook discussing
depreciation and its effects on profits.  My earlier
lack of response was due primarily to the fact that
your predilection for engaging in gratuitous insult
led me to believe that you were not serious in your
request for clarification.

In response to Mr. Kurland's request, I will address
your recent commentary.  To begin with, I must note
that the quote you discovered in an accounting
textbook to "prove" that depreciation is not a source
of working capital ("funds" or "cash") demonstrates
your complete misunderstanding of what the author
said.  First and foremost, in addressing a popular
misconception, the quote does not say what
depreciation IS, it says what depreciation is NOT:
Depreciation is NOT a fund for asset replacement.  If
you will read the quote more carefully, you will see
that is all the author said:

"...[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."

First, to understand what the author (and the
accounting profession) means by "depreciation" as a
source of working capital, you should read the book's
discussion of "cash," "working capital," "current
assets" or "funds." The discussion may be under any
one of these topics.  I have not seen the book, but
any basic accounting textbook will have this
discussion.  By the way, it would probably be useful
to find a more up-to-date source than one more than 40
years old.  There have been changes in terminology and
specific applications of certain principles, though
not in basic concepts, in the interim.

In that discussion, you will find a statement to the
effect that, "depreciation is a source of working
capital."  It might also read something along the
lines of, "depreciation is a source of cash."  "Cash"
is often understood as one way of referring to current
assets.  Current assets are assets that are either
cash now, or can reasonably be expected to "turn into"
cash within one year.  Another phrase often employed
is, "depreciation is a source of funds."  The precise
wording depends on the author, but the discussion will
be along the lines stated.

The author of the quote you used described the
relationship of depreciation expense (an "income
statement account") to cash (a "balance sheet"
account).  The income statement and the balance sheet
are profoundly different statements that, properly
used together, help give a picture of the financial
position of a company.  The income statement gives a
picture of the activity in which a firm engages over
time, usually a single accounting period, such as a
month, a quarter or a year.  The balance sheet gives a
picture of the position of the company at a specific
point in time, such as the end of a month, a quarter
or a year.  From a conceptual point of view (that is,
in accordance with the matching principle of
accounting), both should be prepared on the accrual
basis, not the cash basis.

The income statement (or "Profit and Loss Statement")
shows the revenues and expenses over a specific time
period.  Were the world run on the cash basis - which
it is not - every item on the income statement would
be traceable to a specific unit of currency received
or disbursed by the firm.  That the world does not run
this way appears to be your chief quarrel with the
accounting profession, CESJ, Norm Kurland, and, no
doubt, many others.

The world is run on the accrual basis.  That is,
persons (including artificial persons such as
corporations and the state) promise to deliver goods,
services or payment thereof at sometime in the future
or to recognize in the future the delivery of same in
the past.  The items on an income statement,
therefore, may or may not be traceable to specific
units of currency received or disbursed by a firm
during the same period.  Instead, items on an income
statement may, and usually do, consist of a small
measure of cash (including currency, checks and money
orders as "cash") attributable to current operations
and paid out and received by the company, and a large
measure of "accounts receivable" and "accounts
payable."  By far the greatest amount of actual cash
received and disbursed by most companies is the result
of operations in a previous accounting period.  Under
the accrual system, which runs on the assumption that
people's promises are good, the timing of the actual
receipt or disbursement of cash is, in a sense,
irrelevant.  What matters is when the cash is
RECOGNIZED as having been received or disbursed.

Your basic problem with respect to depreciation
appears to be that you overlook the fact that cash may
be received or disbursed at some time in the past or
future.  At the same time, cash may not be recognized
as having been received or disbursed at the time it
actually comes into or goes out of the company.
Depreciation expense - and the author of the quote you
selected makes this clear to someone who understands
the nature of accrual basis accounting - is a way to
recognize in the current period the disbursement of
cash that took place in a prior period.  This requires
an understanding of what happens when an asset is
purchased.

When a business enterprise purchases an asset, the
matching principle of accounting dictates that the
item is not expensed until and unless it is used in
operations or expended in some other fashion,
including damage or theft.  Certain items, such as
real estate, cash, and various kinds of investments,
are not considered "depreciable" at all, although
certain "fixtures" such as coal deposits or lumber on
(or in) land may be amortized or depleted.  Land qua
land, however, is not a depreciable asset, as it is
considered to have permanent value.

All other assets, however, are "used up" in
operations.  In accordance with the matching
principle, assets are recognized as being "used up"
(i.e., "expensed" or, in a non-profit, "expended") in
the period in which, as far as can be determined, they
are, in point of fact, "used up."  This recognition is
called "depreciation."  By means of "depreciation,"
the cash that went out of the company in some earlier
accounting period is "recognized" as going out of the
company in the current period.  An "accounts payable"
does the same thing for the purchase of an item that
depreciation does for its use.  That is, the cash was
recognized as "going out" of the company at the time
of purchase, even though the actual cash did not "go
out" of the company until a later period when the
company paid the invoice.

"Accounts payable" is a recognition by the company on
the balance sheet that the cash has not yet been
disbursed - although the disbursement has already been
recognized on the income statement.  Again, this is a
recognition of the difference between income
statement-type accounts and balance sheet-type
accounts.  Asset accounts and expense accounts, while
related, are profoundly different.  Similarly, an
"accounts receivable" is a balance sheet
acknowledgement that revenue recognized in a prior
accounting period has not yet been received in cash.
Similar to the way that a depreciation expense on the
income statement does not affect current asset
accounts on the balance sheet, the payment of accounts
payable or the receipt of accounts receivable does not
affect the revenue or expense accounts on the income
statement.

Some assets are of negligible value.  Relatively
speaking, whether they are expensed in the future
through depreciation (as would be proper) or expensed
in the current period (to save the trouble of
recording and tracking low value and numerous items,
such as waste cans and pencil sharpeners) is a
question not of compliance with the matching
principle, but of the concept of "materiality."  That
is, an item is so small in value that tracking it in
accordance with one principle adds costs that cannot
be justified by the other principle.  Therefore,
although not conceptually correct, many items of low
value (and "low value" can often be much higher than a
private person would consider "low") are expensed in
the current period rather than go through the time and
expense of keeping track of them and depreciating them
properly.  This distorts the expenses recognized in
current and future periods, but the distortion is
considered "immaterial," and therefore ignored.  It
also happens that most such items are purchased
regularly, so the effect in an on-going enterprise is
often virtually the same as if the items had been
depreciated.

Now we must recall the basic accounting equation:

Assets - Liabilities = Owners' Equity

The three accounts I have mentioned - depreciation
expense, accounts receivable and accounts payable -
all have a relationship to this equation.  Each one
covers one aspect of the timing of cash disbursements
and receipts from and by the company.  Taken together,
they represent the "universe" of the cash
relationships and timing within a business enterprise.
 We notice a difference, however.  Depreciation
expense is an income statement-type account.  Accounts
payable and accounts receivable are both balance
sheet-type accounts.

The relationship between the accounting equation and
accounts payable and accounts receivable should be
obvious:  accounts payable is a liability, while
accounts receivable is an asset.  This means that the
third account in this "triad," depreciation expense,
should, logically, relate to owners' equity - which it
does.  As an income sheet-type account, depreciation
expense "shows up" in the net profit or loss for a
period.  It relates to owners' equity by adding (or
subtracting) the periodic profit (or loss) to retained
earnings.  This requires some explanation.

If we understand the accounting equation properly, we
discover that the "most important" financial statement
is the Balance Sheet.  It is the embodiment of the
accounting equation with its division into assets,
liabilities and owners' equity.  While the balance
sheet is the "most important," however, other
statements are necessary in order to understand it
properly.  Most people outside business or the
accounting profession assume that "other statements"
refers exclusively to the income statement (or
"Statement of Profit and Loss" if you prefer).  That
is incorrect.  While essential, the income statement
gives only a part of the picture - the part that is
not given by the balance sheet.  The "problem" comes
in when we relate "activity" recorded on the income
statement with "amounts" recorded on the balance
sheet.  There needs to be some kind of reconciliation
between the two before the whole picture is presented
or understood. Two additional financial statements
provide this reconciliation.  These are the statement
of retained earnings, and the statement of sources and
applications of working capital (or "statement of
sources and applications of funds," or "statement of
sources and applications of 'cash'"; depending on the
terminology of a particular authority - it does not
change the function or the concept).

The statement of retained earnings reconciles the
effect of operations (profit or loss) on the income
statement, with owners' equity on the balance sheet.
That is, retained earnings is a part of owners' equity
and, under current methods of corporate finance, quite
often the most significant part.  The statement of
retained earnings begins with the prior period's
balance in the retained earnings account, adds (or
subtracts) the net profit (or loss) from operations
for the current period (including depreciation), and
deducts any distributions to owners (dividends).  The
result is the total amount of earnings retained by the
company, that is, profits that have not been paid out.

The statement of sources and applications of working
capital (or funds, etc.) would appear to be a critical
area of your misunderstanding.  The purpose of the
statement is to reconcile asset and liability accounts
(which are balance sheet-type accounts) with the
profit or loss from operations recorded on the income
statement.

Keep in mind that the function of accounts payable,
accounts receivable and depreciation expense is to
recognize revenue and expenses in the period in which
expenses were actually incurred and revenues actually
generated.  It does not matter when the actual cash
was paid out or received.  The typical statement of
sources and applications of working capital thus
begins with "net income."  Net income is a figure
taken directly from the income statement.  One manner
of presentation is to list all "sources" of working
capital (or "cash").  Beginning with "net income," we
then add all "sources" of working capital.  Among the
sources of working capital are the disposal of
long-term assets, an increase in accounts payable,
and, especially, depreciation expense.

Working capital is, effectively, the same thing as
current assets.  The difference is in orientation.
"Asset" and "liability" describe the thing.  "Working
capital" describes the use of the thing.  Current
assets less current liabilities gives "net working
capital."  That is, net working capital consists of
working capital to which entities outside the company
have no claim; the company can do as it pleases.  In
acknowledgement of how the term originated, the
company can use such "unclaimed capital" to carry out
current operations or "work" with it, so that the
"capital" becomes "working capital."

The company may choose to distribute such "excess"
working capital as cash dividends to shareholders.  As
you pointed out and supported by the section you
quoted from an accounting textbook, the working
capital freed up via depreciation is not a fund for
asset replacement.  It may therefore be used to reduce
retained earnings and put effective demand into the
hands of the people who own it and have a moral claim
on it - the shareholders.  This closes the purchasing
power gap caused by retention of net income within a
company as retained earnings.  How, though, does
depreciation "generate" cash for such a purpose (or
any other application of working capital)?

(Continued in Part II)