What it means
Accounting depreciation is a bookkeeping convention. A company decides an asset will last ten years, writes off a tenth of the cost each year, and the balance sheet shows a tidy declining figure that may bear little relation to what a buyer would pay.
Economic depreciation asks the harder question: what has this asset actually lost in value? That loss comes from physical wear, from technological obsolescence and from shifts in demand for whatever the asset produces, and it rarely falls in equal annual instalments.
The pattern is usually front-loaded for equipment and vehicles. A new machine can lose 20% to 30% of its value in the first year and much less thereafter, which is why straight-line accounting depreciation systematically overstates the book value of young assets and understates it for old ones.
The gap has real consequences. A company that carries assets at book values well above market value will report a loss on disposal, may find lenders discounting the collateral, and may underprice its services because the depreciation charge in its costing model is too low.
Some assets barely depreciate economically at all, and a few appreciate. Well-maintained property in a strong location, specialised tooling in short supply and certain aircraft have all held value while accounting rules wrote them down towards zero, which is one reason analysts adjust reported book values before comparing companies.
In practice
Real-world examples.
Example
A courier company runs a fleet of vans depreciated over eight years in the accounts. When it sells three vans after four years, each realises $9,000 against a book value of $14,000, and the $15,000 total loss prompts a review of the depreciation policy.
Example
A design agency buys $80,000 of workstations and writes them off over five years. A new generation of hardware arrives after two years and the second-hand market for the old machines collapses, so the economic value has effectively gone while $48,000 still sits on the balance sheet.
Example
A landlord holds a warehouse depreciated in the accounts towards zero over forty years. Local demand for distribution space rises and the building is independently valued 15% above its purchase price, so economic depreciation over the period has been negative.
Formula
Calculation
Economic Depreciation = Market Value at Start of Period - Market Value at End of Period
A packaging business buys a die-cutting machine for $250,000. One year later, comparable used machines of the same age and condition are selling for $190,000.
Economic depreciation for the year = $250,000 - $190,000 = $60,000, which is 24% of the original cost since $60,000 / $250,000 = 0.24.
For the accounts, the company depreciates the machine straight line over ten years with an assumed residual value of $50,000: ($250,000 - $50,000) / 10 = $20,000 per year.
The difference is $60,000 - $20,000 = $40,000 in the first year alone. The book value after one year is $250,000 - $20,000 = $230,000 against a market value of $190,000, so selling the machine at that point would produce a $40,000 loss on disposal even though nothing unexpected had happened.Case study
Seen in the real world.
Grantham Press is a fictional printing company used for this illustrative example. It costed every job using an accounting depreciation charge of $30,000 a year on its main press, spread evenly over a twelve-year life.
In reality the press lost value far faster, dropping roughly $95,000 in its first year and $70,000 in its second as digital alternatives improved. When the bank revalued the collateral before a refinancing, the press supported far less borrowing than the book value implied, and Grantham discovered a funding gap of just over $300,000 across its equipment.
The fictional finance director made two changes. Job costing was rebuilt around a replacement-cost view of the equipment rather than the accounting charge, which raised quoted prices on press-heavy work by about 6%, and the company began obtaining an independent valuation of major equipment every second year so that no future refinancing would be a surprise.
Watch out
Common mistakes.
- Treating book value as market value. The two are calculated for different purposes and can differ by a wide margin, especially for young equipment and for property.
- Assuming value falls evenly each year. Most equipment loses value fastest at the start, so a straight-line assumption misprices both early disposals and late ones.
- Ignoring obsolescence. An asset can be in perfect working order and still have lost most of its value because customers or technology have moved on.
Questions
People also ask.
Is economic depreciation ever recorded in the accounts?
Not directly, though impairment rules force a write-down when the recoverable amount falls materially below book value, which partly closes the gap.
Why do the two measures exist at all?
Accounting depreciation gives a consistent, auditable way to spread cost across periods, while economic depreciation reflects what the asset is genuinely worth today.
How can a business estimate it without a valuer?
Auction results, dealer listings and trade guides for similar assets give a reasonable working estimate for most vehicles and standard equipment.
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