Explain the concept of depreciation and its impact on financial statements
Theme: Accounting, Financial Statements Role: Accountant Function: Finance
Interview Question for Accountant: See sample answers, motivations & red flags for this common interview question. About Accountant: Manages financial records and ensures compliance with regulations. This role falls within the Finance function of a firm. See other interview questions & further information for this role here
Sample Answer
Example response for question delving into Accounting, Financial Statements with the key points that need to be covered in an effective response. Customize this to your own experience with concrete examples and evidence
- Definition of Depreciation: Depreciation is the systematic allocation of the cost of an asset over its useful life
- Purpose of Depreciation: Depreciation is recorded to match the cost of an asset with the revenue it generates
- Types of Depreciation: 1. Straight-line depreciation: Allocates the cost evenly over the useful life. 2. Declining balance depreciation: Allocates higher depreciation expense in the early years. 3. Units of production depreciation: Allocates cost based on the asset's usage or production
- Impact on Financial Statements: 1. Income statement: Depreciation expense reduces net income. 2. Balance sheet: Accumulated depreciation reduces the carrying value of the asset. 3. Cash flow statement: Depreciation is added back to net income as a non-cash expense
- Effect on Profitability: Depreciation reduces net income, which in turn affects profitability ratios such as return on assets and return on equity
- Tax Implications: Depreciation expense is tax-deductible, reducing taxable income and lowering the tax liability
- Capital Expenditure Planning: Depreciation helps in evaluating the economic viability of investments by considering the asset's useful life and expected cash flows
- Financial Reporting Compliance: Depreciation must be recorded in accordance with accounting standards (e.g., GAAP or IFRS) to ensure accurate and consistent financial reporting
Underlying Motivations
What the Interviewer is trying to find out about you and your experiences through this question
- Knowledge of accounting principles: Understanding the concept of depreciation and its impact on financial statements demonstrates knowledge of accounting principles
- Analytical skills: Explaining the impact of depreciation on financial statements requires analyzing the effects on assets, expenses, and net income
- Attention to detail: Discussing the accurate recording and calculation of depreciation highlights attention to detail in financial reporting
- Financial analysis: Understanding the impact of depreciation helps in assessing the financial health and performance of a company
Potential Minefields
How to avoid some common minefields when answering this question in order to not raise any red flags
- Lack of understanding: Not being able to explain the concept of depreciation accurately or confusing it with other accounting concepts
- Inability to explain impact: Failing to articulate how depreciation affects financial statements, such as income statement, balance sheet, and cash flow statement
- Limited knowledge of methods: Not being familiar with different depreciation methods, such as straight-line, declining balance, or units of production
- Ignoring tax implications: Neglecting to mention the impact of depreciation on taxable income and tax liabilities
- Overlooking asset value: Not recognizing that depreciation reduces the value of assets over time and affects their book value
- Neglecting financial ratios: Failing to mention how depreciation affects key financial ratios, such as return on assets or debt-to-equity ratio
- Lack of real-life examples: Not providing practical examples or scenarios to illustrate the concept of depreciation and its impact on financial statements