What is (Depreciation): A Guide to Business Asset Management

Understanding that depreciation is a key process is fundamental for good accounting. Whether you’re a business executive, investor, or accountant, terms related to reducing asset values will frequently appear in financial analysis.

Why Do Businesses Allocate Depreciation?

Before diving into what depreciation is, let’s understand why businesses need to report this expense. When a company purchases a fixed asset, such as a building, machinery, or vehicle, the amount paid isn’t an expense for just one year but a long-term investment recorded in the company’s books over several years.

Calculating depreciation helps to:

• Allocate the asset’s cost across the years it is used
• Reflect the true value of assets that are declining in financial statements
• Match expenses with the income generated from using those assets

What Does Depreciation Mean?

In fact, depreciation involves two simultaneous business phenomena. First, the physical value of an asset decreases over time due to usage, wear and tear, or obsolescence. Second, to comply with generally accepted accounting principles, the company divides the initial cost of the asset over its expected useful life.

Assets have an estimated lifespan, for example:

• Laptop: about 5 years
• Vehicle: about 5-10 years
• Commercial building: 20-40 years
• Office furniture: 7-10 years

In annual budgeting, depreciation is included as a fixed expense, unless using accelerated methods, which vary by year.

Understanding EBIT and EBITDA in the Context of Asset Depreciation

When discussing depreciation as a key component of financial figures, it is included in calculating EBIT (Earnings Before Interest and Taxes).

EBIT refers to net profit after deducting depreciation and other expenses but before interest and taxes. It starts from the profit before tax line and adds back all expenses deducted.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) differs because depreciation and amortization are added back into the figure. This provides a picture of operating profit unaffected by accounting policies.

This difference is crucial when comparing companies. Firms with many fixed assets tend to have higher depreciation, which can lower EBIT, but EBITDA shows the true operational profitability.

Assets That Are Depreciable and Non-Depreciable

Accounting distinguishes which assets can be depreciated to ensure depreciation is applied correctly.

Depreciable assets:

• Vehicles and transportation assets
• Buildings and structures
• Machinery and equipment
• Office furniture and fixtures
• Computers and electronic devices
• Certain intangible assets (patents, copyrights)

Conditions for depreciation:

• The asset is owned by your business
• Used in business operations or income generation
• Has a determinable useful life
• Expected to last longer than one year

Assets that are not depreciable:

• Land (does not deteriorate over time)
• Collectibles with value (artworks, antiques)
• Securities and financial investments (stocks, bonds)
• Personal property
• Assets with a useful life of less than one year

Four Main Methods of Calculating Depreciation

Choosing a depreciation method is a critical decision affecting financial statements. The four common methods are:

1. Straight-Line Method

The simplest and most widely used method. The same amount of depreciation is allocated each year over the asset’s useful life.

Example: A vehicle costing $100,000 with a 5-year useful life will have annual depreciation of $20,000.

Advantages:

• Easy to calculate and manage
• Suitable for small businesses with simple accounting
• Provides predictable and consistent expense figures

Limitations:

• May not reflect actual loss of value
• Does not account for higher usage in early years
• Ignores increased maintenance costs over time

2. Double Declining Balance Method

Also known as accelerated depreciation, it assigns more depreciation in the early years.

Concept: Calculate an accelerated rate (twice the straight-line rate) and apply it to the declining book value each year.

Example: Asset costing $100,000, useful life 5 years:

• Straight-line rate: 20%
• Double declining rate: 40%
• Year 1: $100,000 × 40% = $40,000
• Year 2: ($100,000 - $40,000) × 40% = $24,000
• And so on.

Advantages:

• Reflects faster loss of value initially
• Provides higher tax deductions early on
• Suitable for assets that rapidly depreciate

Limitations:

• More complex calculations
• May lead to lower book value than salvage value if not carefully managed

3. Declining Balance Variations

Other accelerated methods use fixed rates lower than double declining, providing a middle ground. Depreciation is higher in early years and decreases over time, aligning with certain asset usage patterns.

4. Units of Production Method

Depreciation is based on actual usage rather than time. If an asset is expected to produce a certain number of units over its life, depreciation per unit is calculated, and annual depreciation depends on units produced.

Example: A machine costing $100,000, expected to produce 1 million units, results in $0.10 per unit. If 200,000 units are produced in a year, depreciation is $20,000.

Advantages:

• Reflects actual wear and tear
• Useful for manufacturing assets with variable usage

Limitations:

• Requires detailed tracking of usage
• Estimations of total units may be inaccurate

What Is Amortization?

While depreciation applies to tangible assets, amortization is similar but for intangible assets and debt repayment.

For intangible assets: such as patents, copyrights, trademarks, amortization spreads their cost over the expected useful life.

Example: A patent costing $10,000 with a 10-year life results in $1,000 amortization per year.

For debt: amortization refers to paying off a loan in regular installments, which include both principal and interest.

Initially, more of each payment goes toward interest; over time, more goes toward reducing the principal.

Example: A $10,000 loan with annual payments of $2,000, where each payment reduces the principal.

Comparing Depreciation and Amortization

Understanding the differences:

Asset Types

• Depreciation: tangible assets (buildings, machinery, vehicles)
• Amortization: intangible assets (patents, copyrights) and debt repayment

Calculation Methods

• Depreciation: straight-line, declining balance, units of production
• Amortization: primarily straight-line

Asset Value

• Depreciation: considers salvage value
• Amortization: reduces asset value to zero over useful life

Useful Life

• Depreciation: economic lifespan
• Amortization: legal or contractual period

Impact on Financial Analysis

Why understanding depreciation matters for financial analysis:

Effect on Net Income

Depreciation is a non-cash expense that reduces reported net income, even though no cash is paid in that year.

Company Comparisons

Companies with many fixed assets will have higher depreciation expenses, lowering EBIT, but EBITDA may be similar, making EBITDA a better comparison metric.

Tax Implications

Depreciation reduces taxable income, providing tax benefits, especially when using accelerated methods.

Choosing the Appropriate Method

The choice depends on your business situation:

• Small businesses with simple accounting: straight-line
• Need high initial tax deductions: double declining balance
• Manufacturing or usage-based assets: units of production
• Large, diverse asset portfolios: a mix of methods

Summary: The Importance of Depreciation and Amortization

In conclusion, depreciation is a fundamental concept for accurate and comparable financial reporting. It applies to tangible assets, while amortization covers intangible assets and debt. These tools help to:

• Allocate costs fairly
• Reflect true asset values
• Enable investors to analyze and compare companies
• Inform tax policy decisions

Understanding asset useful life, calculation methods, and their impact on financial figures is essential for managers, accountants, and investors alike.