Depreciation

Depreciation is the method of allocating the cost of a tangible asset over its useful life. In simpler terms, it’s a way to spread out the cost of an expensive item over the time it’s expected to be useful, rather than taking the hit all at once.

Here’s what depreciation typically applies to:

• Buildings

• Machinery

• Vehicles

• Furniture

• Computer equipment

👆 By the way, an interesting fact: While we typically think of depreciation as applying to physical things, there’s a similar concept for intangible assets like patents or copyrights. It’s called amortization. Same idea, fancier name!

Now, why does depreciation matter? It’s not just accountants playing with numbers. Here’s why it’s important:

1. It helps match revenues with expenses (a key accounting principle).

2. It can reduce a company’s taxable income (hello, tax benefits! 💰).

3. It gives a more accurate picture of an asset’s value over time.

4. It impacts both the income statement and balance sheet.

There are several methods of calculating depreciation, but let’s look at the most common one: Straight-line depreciation.

Straight-line Depreciation Formula:

Annual Depreciation Expense = (Asset Cost – Salvage Value) / Useful Life

Let’s break this down with an example:

Imagine you buy a delivery truck for your business:

• Cost: $50,000

• Expected useful life: 5 years

• Salvage value (what you think you can sell it for after 5 years): $10,000

Annual Depreciation = ($50,000 – $10,000) / 5 = $8,000 per year

This means each year for 5 years, you’ll record a depreciation expense of $8,000 on your income statement. On your balance sheet, you’ll reduce the value of the truck by the same amount.

Other depreciation methods include:

• Declining Balance Method (faster depreciation in early years)

• Units of Production Method (based on actual usage rather than time)

• Sum-of-the-Years’ Digits Method (another accelerated method)

Remember, depreciation is an accounting method, not a valuation method. Your asset might be worth more (or less) on the open market than its “book value” suggests.

Depreciation impacts financial statements in a few ways:

• On the Income Statement: It’s an expense, reducing profit.

• On the Balance Sheet: It reduces the value of assets.

• On the Cash Flow Statement: It’s added back in operating activities (since it’s a non-cash expense).

Understanding depreciation can help you:

• Better grasp a company’s true profitability

• Understand how companies manage their assets

• Spot potential red flags (like over-depreciation to manipulate earnings)