Depreciation
What is Depreciation?
Depreciation is an accounting method that measures how much value physical assets lose over time, which helps companies manage their money and financial accounts – it means ‘lower in price’.
We can broadly split depreciation into two parts:
- Physical assets – the value lost from things like machinery, vehicles or buildings
- Accounting – the way companies record any depreciation costs across their income statement, balance sheet, and cash flow statement.
- Tools
- Livestock
- Vehicles
- Computers
- Machinery
- Office furniture
- Buildings (used to produce income e.g. rental property or factories)
Companies can use depreciation to take more control of their financial accounts by spreading the costs out over time. It also offers the chance to take advantage of certain tax benefits.
Amortization is similar to depreciation, but for intangible assets. That’s things that have a value but can’t be seen or touched – a company’s brand or reputation for example.
Currency depreciation is when a currency‘s value falls against another currency – this is calculated based on any changes to exchange rates.
This doesn’t tend to impact domestically-focused companies – one’s that make their revenue on home soil. The same can’t be said for large international companies, though, as they make their profits from selling products and services globally.
A weakened currency in the country where the company is based could wash away some of their profits when converting back to home shores.
What does Depreciation mean?
Depreciation originates from the Latin word ‘depretiare’ which means ‘lower in price’.
You’ll probably be familiar with depreciation in day-to-day life. For example, your car probably isn’t worth what it was a few years ago. General wear and tear, and better technologies means things lose their value quicker than ever before.
It’s the same for companies and their assets. The value of a company’s assets largely depends on the number of things the machinery can make before it packs in. Just like a car, where the valuation is often based on how many miles you could drive in it.
Depreciation isn’t always about losing money though.
Depreciation accounting allows companies to spread out their spending over the useful or expected life of an asset. Spreading the costs over several years helps their annual results look a lot healthier year-to-year, rather than having hefty upfront costs which could impact overall profits for that year.
Depreciation also has its tax benefits. As it’s put down as a ‘cost’ to the business, this lowers the amount of company’s earnings that’s taxable, reducing the overall bill from the tax man.
Tax and depreciation laws vary between countries, sectors and products, so not all companies play by the same book.
What does depreciation mean for investors?
Depreciation is one of the metrics that allows investors to see beneath a company’s bonnet. Without this information, it’s difficult to work out how much a company is truly worth.
If you think about giant engineering or manufacturing companies that spend fortunes on high-tech machinery, without depreciation accounting, you could end up valuing the company highly, even if all their machinery was on its last legs.
Remember, understanding depreciation is all about the idea of ‘lower in price’. Companies highlight any depreciation costs in their financial reports each year, so it’s easy to see how it affects the business. Things are worth less as they get older and less productive – depreciation measures this change.
Examples of depreciation
Here are some examples of things that can be depreciated in business, we’ve organised them with the fastest depreciators, or shortest useful life, at the top.
How to calculate depreciation
There are a few different methods which businesses can use to calculate depreciation. Although there are regulations around which methods and assumptions can be used.
For example, the Internal Revenue Service (IRS) – the US’s equivalent to the HMRC – publishes guidance on the methods of calculation and the expected life for different property classes.
These are the most common methods:
Straight line depreciation
Straight line depreciation is the simplest method as it uses a steady rate of depreciation over the asset’s useful life.
The straight line depreciation formula is:
Depreciation example:
Company XYZ buys a lorry for £50,000 with five years useful life and a salvage value (expected future value) of £10,000. That means the asset will depreciate by £40,000 over five years, averaging £8,000 or 20% per year (£8,000/£40,000 = 20%).
Reducing balance depreciation
Reducing balance depreciation method is used for things that lose value quickly when they’re newer – car depreciation is a good example. Brand-spanking new cars lose a chunk of their market value as soon as they drive off the forecourt. Whereas second-hand cars hold onto their value a lot better - although they still do depreciate, it’s at a lot slower rate.
This depreciation calculator takes into account the current value of an asset, its cost and salvage value.
The Reducing Balance formula is:
Depreciation Example:
Using the same example as above, the lorry depreciated by exactly the same amount (£8,000 or 20%) in year one. However, in year two, deprecation fell to £6,400 or 16%. That’s because the calculation minuses any depreciation from previous years from the asset cost and highlights how things tend to depreciate at a slower rate over their lifetime.
Sum-of-the-Years’-Digits Depreciation
The Sum-of-the-Year’s-Digits (SYD) is an accelerated method for calculating depreciation. The SYD takes the assets expected life and adds a number for each year. An asset with a five-year lifespan would give 15 SYD (5+4+3+2+1 = 15 years).
Each number is then divided by the SYD to decide the percentage by which the asset should be depreciated each year, starting with the highest number in year 1.
The formula for SYD is:
Depreciation Example:
Using our lorry example, at the end of year one the depreciation cost will be £10,666.66 or 26.66% (4 years/15 years) x (£50,000 - £10,000). The cost at year two will be £8,000 or 20%: (3 years/15 years ) x (£50,000 - £10,000).