What it means
When a business buys an asset that will last for years, charging the whole cost to the year of purchase would understate that year's profit and overstate every later year's, since the later years would use the asset for nothing. Accrual accounting instead capitalises the cost as an asset and charges it to expense gradually, over the years the asset is used, in a pattern that reflects how its benefits are consumed.
The charge each year is depreciation expense, and the cumulative charge to date is accumulated depreciation, which is deducted from the asset's cost on the balance sheet to give its carrying amount or net book value. The size of the charge depends on three estimates and a method.
The estimates are the asset's cost, its useful life to the business, and its salvage value at the end of that life; the method is the pattern in which the depreciable base (cost less salvage) is spread over the life. Straight-line charges the same amount each year and is used for most buildings, fittings and general equipment.
Declining balance charges more early and less later, for assets that lose value or usefulness quickly. Units of production charges in proportion to output, for assets whose wear depends on use rather than time.
Sum-of-the-years'-digits is another accelerated pattern. The method is a policy choice that should reflect the asset's use, be applied consistently, and be disclosed.
The accounting entry debits depreciation expense and credits accumulated depreciation. Where the asset is used in production, the expense is part of the cost of the goods made and flows through inventory into cost of sales when the goods are sold; where it is used in selling or administration, it is an operating expense.
Depreciation on idle assets is still charged, since time passes whether or not the asset is used. When the asset is sold or scrapped, its cost and accumulated depreciation are removed from the books and the difference between the carrying amount and the proceeds is a gain or loss on disposal, which is in effect the correction of the depreciation estimates made over the asset's life.
Depreciation has a distinctive relationship with cash. The cash was spent when the asset was bought and appears in investing cash flows in that year; the depreciation charges in later years involve no cash.
The cash flow statement therefore adds depreciation back to profit in arriving at operating cash flow, and measures such as EBITDA exclude it to approximate cash earnings. That does not make depreciation unreal.
It is the cost of using assets that must eventually be replaced, and a business that treats EBITDA as its profit and pays it all out will find itself unable to renew its equipment. Depreciation is also deductible for tax in most systems, often on a different basis from the accounts, so that it reduces cash tax: the tax saved is sometimes called the depreciation tax shield.
For readers of accounts, the depreciation charge and the policies behind it are worth examining. Useful lives that are longer than competitors' produce lower charges and higher profits; a change in lives or methods can move profit substantially with no change in the business; and a depreciation charge that is persistently below capital expenditure means the asset base is growing, while one persistently above it means the business is not replacing what it uses.
Comparing depreciation with capital expenditure, and with the depreciation policies of peers, is a standard analytical step, and the relationship between depreciation, cash flow and reinvestment is central to valuing any asset-intensive business.
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 4 years, and the combined charge of $3,200,000 is its largest non-cash expense.
Example
A delivery company's depreciation charge of $4,000,000 a year is close to its annual spending on replacement vans, which tells an analyst that the fleet is being maintained rather than run down.
Example
A company that changes the useful life of its machinery from 10 to 15 years reduces its depreciation charge by $1,500,000 and its auditors require the change and its effect to be disclosed.
Think of it
“Depreciation expense is this period's share of an asset's cost-the slice of depreciation hitting the income statement.
Formula
Calculation
Straight-line depreciation expense = (Cost minus Salvage value) / Useful life
Declining balance depreciation expense = Carrying amount at start of year x Rate
Units of production depreciation expense = (Cost minus Salvage value) / Estimated total units x Units produced in the period
Carrying amount = Cost minus Accumulated depreciation
Gain or loss on disposal = Proceeds minus Carrying amount
Depreciation tax shield = Depreciation deductible for tax x Tax rate
Worked example. A company buys equipment for $500,000 with a useful life of five years and an estimated salvage value of $50,000.
- Straight-line: depreciation expense = ($500,000 minus $50,000) / 5 = $90,000 a year
- Entry each year: debit depreciation expense $90,000; credit accumulated depreciation $90,000
- After three years: accumulated depreciation $270,000; carrying amount $230,000
- If the equipment is sold at that point for $200,000: loss on disposal = $200,000 minus $230,000 = $30,000; the entry removes cost $500,000 and accumulated depreciation $270,000, records cash $200,000 and the loss $30,000
Units of production alternative. If the equipment is expected to produce 100,000 units over its life and produces 25,000 in year 1: depreciation = $450,000 / 100,000 x 25,000 = $112,500, higher than straight-line because the first year was a busy one.
Cash flow and tax. The company's net income is $600,000 after the $90,000 depreciation charge. Operating cash flow before working capital movements = $600,000 + $90,000 = $690,000. If the $90,000 is deductible for tax at 25%, the depreciation reduces cash tax by $22,500 a year: the tax shield.
Effect of policy. If the company had chosen an eight-year life instead of five, the charge would be $56,250 a year and reported profit $33,750 higher, with no change in the equipment, its use or the cash spent on it.Case study
Seen in the real world.
A telecommunications company had built a network at a cost of $400,000,000 and depreciated it over eight years, $50,000,000 a year. Two years in, with $300,000,000 of carrying amount remaining over six years, the company's results were under pressure and the board asked the finance director whether the network would really be replaced in six years. The engineering team's view was that with upgrades the equipment would serve for ten more years.
The useful life was extended, the remaining $300,000,000 was spread over ten years, and the depreciation charge fell from $50,000,000 to $30,000,000. Reported operating profit rose by $20,000,000 in the year of the change, with no change in revenue, costs or cash, and the company's results release described an improvement in profitability.
Analysts were less impressed. The change was disclosed, as it had to be, and several analysts restated the company's profit on the old basis to compare it with prior years and with competitors, most of which used eight-year lives.
One noted that the company's capital expenditure on the network was running at $45,000,000 a year, which suggested that the assets were being replaced at something close to the original rate whatever the accounts now said. The company's share price did not respond to the "improvement", and its credibility with the analyst community suffered.
Four years later the network had to be substantially replaced to support new services, well before the end of the extended life, and the company recognised an impairment of $90,000,000 on the equipment that was retired early. The impairment was, in substance, the depreciation that the extended life had deferred, arriving all at once. The finance director's successor reverted to an eight-year life for the new network and, in the company's next results, drew the distinction between depreciation as an estimate of consumption, which should follow the engineering reality, and depreciation as a lever for reported profit, which the company had pulled once and would not pull again.
Watch out
Common mistakes.
- Treating depreciation as an arbitrary accounting charge that can be ignored because it is not cash; it is the cost of using assets that must be replaced, and a business that distributes its EBITDA cannot renew its equipment.
- Changing useful lives or methods to manage profit; the change must be disclosed, analysts will restate it, and the deferred depreciation returns as an impairment or as future charges.
- Not depreciating idle or under-used assets; depreciation runs with time (or, under units of production, with use as defined), and an asset standing idle still ages.
Questions
People also ask.
What is the difference between depreciation expense and accumulated depreciation?
Depreciation expense is the charge for one period, in the income statement. Accumulated depreciation is the total of all charges to date on the asset, deducted from its cost on the balance sheet to give the carrying amount.
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 left when the asset was bought and was shown as investing cash flow then. Adding depreciation back converts profit to a cash measure.
Is depreciation the same for tax as in the accounts?
Often not. Tax systems set their own rates and methods, frequently more accelerated than the accounts, to encourage investment. The difference between tax depreciation and accounting depreciation gives rise to deferred tax.
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