Scary Jargon For Project Managers, Part 1 Of An Occasional Series: Depreciation

[This is the first of an occasional series to help demystify some of the Scary Jargon Terms that get banded around an organisation, and which project managers may come across from time to time. Managing budgets and finances is an integral part of the project manager's role, but relatively few project managers will have received any formal financial training during their careers.

Consequently finance and financial terms can start to develop a mystique, and it's a brave person that will stick their hand up in the middle of a meeting and ask "excuse me, what's 'return on net assets' mean?" The idea of this series is to explain in language that I could understand what the jargon is all about.]

DEPRECIATION

As anyone who has bought, then subsequently sold a car will know, things aren’t necessarily worth what you paid for them. This can be because the item is less attractive to the market than it once was - think unpopular stocks - but more likely in a project situation, it’s because the item has deteriorated in some way. In the case of a car, think of wear and tear, the availability of newer models, trends in automotive fashion - all of these will combine to make the vehicle worth less now than when you paid for it. This concept is vital to understanding the value of a business, so read on to find out more.

In financial terms, we’re talking about DEPRECIATION. The value of an asset - a car, say - will DEPRECIATE over it’s lifetime until some point where it’s worth effectively nothing. This has an important impact on an organisation’s financial results, because the value of its assets is an important measure of overall financial health.

So in project situations, it’s reasonable to assume that the value of the new systems that you’re implementing will be less at the end of the financial period than they were worth at the start. And somehow, that has to be accounted for.

To do this, accountants will take the original value of the asset and reduce (or DEPRECIATE) it by an amount in each financial reporting period - to make things easier, we’ll talk about a year. So the BOOK VALUE of the asset is what’s left after you’ve DEPRECIATED it. How much you knock off the value of each asset every year will depend on the DEPRECIATION METHOD.

STRAIGHT LINE depreciation means that you take the same amount off the book value each period until the value reduces to zero. Let’s assume that we normally keep PCs in the business for 3 years, and then replace them. At the end of 3 years, we have to pay to get rid of them, so they’re effectively worth nothing. So to depreciate the PCs on a straight-line basis, we’ll need to knock off a third of the value each year - so at the end of year 1 they’ll be worth 66% of what we paid for them, 33% at the end of year 2 and nothing at the end of year 3. The depreciated amount is recorded in the balance sheet as the value of the asset at the end of the accounting period.

Another way of calculating depreciation is the REDUCING BALANCE method - this usually involves knocking off a fixed percentage of the asset’s value each year.

There are various different methods of depreciation, depending on how you think the value of the asset will change. This can have a significant impact on the financial health of the organisation, so there are numerous rules surrounding how and when to depreciate - and accountants spend much of their time working out the hows and the whens. All this means that it’s unlikely that you’ll need to worry about which way is the best way to depreciate your assets, but it’s important to which method you’re supposed to use.

A couple of ‘gotchas’ to be aware of. Firstly, the accounting lifespan of an asset can differ from its useful working life. Even though a PC may be worth nothing to the financiers, it can still be in perfect working order and playing a vital role. And secondly, land and buildings tends to be treated differently - usually land is accounted for at cost, which means that over time it will tend to under-estimate the actual value.

Under UK accounting regulations, the depreciation method has to be stated in the organisation’s accounts - it’s normally included as a note to the balance sheet.

FURTHER READING:

There’s no shortage of books that attempt to explain finance in words of less than one syllable - here are a few that I’ve used in the past and found reasonably accessible:

Finance for the non-financial Manager - John Harrison (Thorsons, 1989)- UK-centric, and getting a bit old now - but clear and reasonably easy to follow. Covers budgeting and cost accounting.

The Fast Forward MBA in Finance - John A. Tracey (Wiley, 1996) - more US-centric, and covers a wider range of topics including investment.

Interpreting Company Reports and Accounts - Geoffrey Holmes (FT Prentice Hall, 2002) - the standard tome for my MBA Finance module. More concerned with reading between the lines of an annual report (hence the title), but useful nonetheless.

Key Management Ratios - Ciaran Walsh (FT Prentice Hall, 1996) - does exactly what it says on the cover, with a very clear explanation of how numbers are crunched and arrived at. If you’ve got no understanding of finance at all, this is probably a good one to start with.

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