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FA Discussion Assignment 2

Depreciation expense has no direct impact on the cash flow of a capital project, as it is a non-cash transaction. However, it indirectly affects cash flow by reducing taxable income and taxes owed. There are two types of lease agreements - capital leases require recording the leased asset on the balance sheet and allow claiming depreciation, while operating leases expense payments and do not include recording the asset. Operating leases generally provide more benefits to companies through tax reductions and lack of ownership risks.

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36 views3 pages

FA Discussion Assignment 2

Depreciation expense has no direct impact on the cash flow of a capital project, as it is a non-cash transaction. However, it indirectly affects cash flow by reducing taxable income and taxes owed. There are two types of lease agreements - capital leases require recording the leased asset on the balance sheet and allow claiming depreciation, while operating leases expense payments and do not include recording the asset. Operating leases generally provide more benefits to companies through tax reductions and lack of ownership risks.

Uploaded by

Nestor Tsala
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Your Discussion should be a minimum of 250 words in length and not more than 450 words.
Please include a word count. Following the APA standard, use references and in-text citations for
the textbook and any other sources.

For this week's Discussion:

• Discuss the impact of depreciation expense on the cash flow analysis of a capital
project. Also, discuss the types of leasing arrangements and their pros and cons relating
to depreciation expense.

Department of Business, University of the People.


BUS 5111: Financial Management
2021-2022
-----

Introduction

Cash flow is the lifeblood of every economic enterprise. Items impacting cash flow, whether

negatively or positively, can make or break the business. This paper discusses the impact of

depreciation expense on the cash flow analysis of a capital project. Also, I examine the pros and

cons of lease contracts relating to depreciation expenses.

Depreciation & Cash flow of capital project

A capital project refers to a capital-intensive investment to construct or maintain

a capital asset. The total cost of the investment output is capitalized as an asset and depreciated

(Barone, 2020). Depreciation is a writing-off process of a fixed asset spread over its useful years

(Merritt, 2019). The income statement records the depreciation as an expense after operating

expenses. Moreover, the costs thus capitalized increase the asset side of the balance sheet as a

non-current asset. In the end, the cash flow statement will record the project's costs as an

investing activity.
2

In accrual accounting, depreciation has no direct impact on a capital project's cash flow

because it is a non-cash transaction (Merritt, 2019). However, as an expense, it indirectly affects

accrual income by reducing the taxes a company must pay.

Two types of lease agreements

A lease is an arrangement that gives the right to use an asset to a lessee for a pre-stated

period in exchange for payments (KAPLAN, 2019). In general, there are two types of

leases: capital and operating leases.

A capital lease refers to a contract agreement in which the leased asset is recorded in the lessee's

balance sheet (Hays, 2021). In other words, the lessee becomes the owner at the end of the

contract and may claim depreciation and interest expenses. Conversely, an operating

lease consists of a lease agreement not transferable to the lessee and therefore exempted from

being recorded in the balance sheet. Instead, it is expensed in the income statement as an

operating expense (Tardi, 2022), impacting the operating and net income.

Capital or Operating lease?

Arguably, firms may be better off entering an operating lease contract as it presents

more attractive advantages than a capital lease. The lessee pays interest on the leased asset in the

capital lease agreement because it is considered a loan. Consequently, depreciation applies,

recording the cash outflow over a period. Whereas for an operating lease, the lessee receives tax

cuts for the lease payments, bears no ownership risk, and can upgrade whenever the equipment is

outdated. (Tardi, 2022).

In conclusion, capital projects and leases receive similar depreciation treatment in

accounting. However, depreciation has no other impact on their cash flow than the items' initial

costs. Finally, firms should favor operating leases because of superior benefits.
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Words Count: #442

References
Barone, A. (2020, November 14). Capital Projects: What You Need to Know. Investopedia.

https://www.investopedia.com/terms/c/capital-project.asp

Hays, A. (2021, August 25). Capital lease. Investopedia. Retrieved from

https://www.investopedia.com/terms/c/capitallease.asp

KAPLAN. (2019). Acca applied skills. financial reporting (Fr): Study text - valid for September

2019, December 2019, March 2020 and June 2020 examination sittings. Kaplan Publishing.

Merritt, C. (2019, January 11). What Is the impact of depreciation expense on profitability?

https://smallbusiness.chron.com/impact-depreciation-expense-profitability-55349.html

Tardi, C. (2022, June 21). What is an operating lease? Investopedia. Retrieved June 26, 2022,

from https://www.investopedia.com/terms/o/operatinglease.asp

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