What it means
Buying a long-lived asset is an exchange of cash for future benefits. Charging the whole cost to profit on the day of purchase would make that year look terrible and the following years look better than they were, since they would enjoy the asset's output at no recorded cost.
Depreciation fixes the timing. It is the accounting expression of the matching principle: the cost of an asset is matched against the revenue it helps generate over its life.
Three estimates determine the charge. Useful life is how long the business expects to use the asset, which may be shorter than its physical life if technology moves on.
Residual value is what the asset is expected to be worth at the end of that life. The depreciation method describes the pattern.
Straight-line charges an equal amount each year and is used for most buildings, fittings and equipment. Reducing balance (or declining balance) charges a fixed percentage of the remaining value each year, front-loading the charge, and suits assets that lose value quickly or produce more in early years, such as vehicles and computers.
Units of production ties the charge to output and suits machinery whose wear depends on use. Land is not depreciated, because it does not wear out.
Depreciation appears in three places. In the income statement it is an expense, within cost of sales for production assets and within operating expenses for others.
On the balance sheet it accumulates in a contra-asset account, accumulated depreciation, which is deducted from cost to give net book value. In the cash flow statement it is added back to profit, because no cash left the business when it was charged.
Its exclusion from EBITDA is why that measure is popular for comparing businesses with different asset bases. Because the estimates involve judgement, depreciation is a lever on reported profit.
A company that extends the useful lives of its assets lowers its annual charge and raises profit with no change in the business. Standards require lives and methods to be reviewed each year and changed when expectations change, and analysts compare depreciation rates across competitors to spot unusually optimistic assumptions.
Tax authorities set their own depreciation rules (capital allowances in some countries), which often differ from the accounting charge and give rise to deferred tax.
In practice
Real-world examples.
Example
A hotel depreciates its building over 50 years, its furniture and fittings over 7 years and its computer systems over 3 years, each on a straight-line basis.
Example
A taxi operator uses reducing balance for its cars because they lose most of their value in the first two years.
Example
A quarry depreciates its crushing plant on a units-of-production basis, charging more in years of high output.
Think of it
“Depreciation is like acknowledging that your new car loses value the moment you drive it off the lot. Each year, it's worth a little less.
Formula
Calculation
Straight-line: Annual Depreciation = (Cost minus Residual Value) / Useful Life
Reducing balance: Annual Depreciation = Net Book Value at start of year x Depreciation Rate
Units of production: Depreciation per unit = (Cost minus Residual Value) / Total expected units; Annual charge = Units produced x Depreciation per unit
Worked example. A courier company buys a van for $40,000 with an expected life of five years and a residual value of $5,000.
Straight-line: annual charge = ($40,000 minus $5,000) / 5 = $7,000 each year. Net book value: end of year 1 $33,000; year 2 $26,000; year 3 $19,000; year 4 $12,000; year 5 $5,000.
Reducing balance at 35%: year 1 charge = $40,000 x 35% = $14,000 (NBV $26,000); year 2 = $26,000 x 35% = $9,100 (NBV $16,900); year 3 = $5,915 (NBV $10,985); year 4 = $3,845 (NBV $7,140); year 5 = $2,140, bringing NBV to $5,000 (the final year is adjusted to reach the residual value).
Units of production, if the van is expected to cover 200,000 miles: charge per mile = $35,000 / 200,000 = $0.175. In a year when it covers 52,000 miles the charge is $9,100.
All three methods charge $35,000 in total over five years. They differ only in timing. Under reducing balance, profit in year 1 is $7,000 lower than under straight-line and profit in year 5 is $4,860 higher.
Disposal: if the van is sold after three years for $21,000 under straight-line, the gain on disposal is $21,000 minus $19,000 = $2,000. Sold for $16,000, the loss would be $3,000.Case study
Seen in the real world.
Two regional bus companies of similar size reported operating margins of 11% and 6%. An analyst found that the first depreciated its buses over 15 years to a 10% residual value, while the second used 10 years and no residual. Restating the first company's depreciation on the second's basis added $4 million to its annual charge and cut its margin to about 6.5%; the two businesses were performing almost identically.
The first company's fleet was also older on average, and its maintenance costs were rising. Eighteen months later it announced a fleet replacement programme, shortened its depreciation lives to 12 years and recorded a one-off charge to catch up.
The analyst's report had anticipated both. Depreciation policy had been the whole difference between a company that looked superior and one that was not.
Watch out
Common mistakes.
- Treating depreciation as cash set aside for replacement. It is an allocation of past cost, not a fund.
- Setting useful lives once and never reviewing them, so that assets are fully depreciated while still in use or written off while obsolete.
- Comparing profit between companies without checking their depreciation policies.
Questions
People also ask.
Why is depreciation added back in the cash flow statement?
Because it reduced profit without any cash leaving the business in the period. The cash went out when the asset was bought.
What is the difference between depreciation and amortization?
Depreciation applies to tangible assets; amortization applies to intangible assets and to the repayment of loans. The mechanics are similar.
Can a fully depreciated asset still be used?
Yes. Its book value is zero (or its residual value), but it can continue in service indefinitely, with no further charge.
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