There’s a lot of confusion about what depreciation actually is. Some think it has something to do with an asset losing its value while others think that it’s a mechanism for a business to create a fund for the replacement of the asset when it’s no longer functional.
So, over the next few posts, let’s take a look at what depreciation really is, how it’s calculated and what impact it has on the income statement, the balance sheet and the cash flow statement.
In today’s post, we’ll define depreciation and clarify the concept.
Depreciation is a term used in accounting to spread the cost of a fixed asset over the span of its useful life. In this context, an asset’s useful life is the expected period of time over which it will contribute additional profits to the business through its use – that is, by being more productive either by increasing output or reducing the cost of production.
The “useful life” of fixed assets is often confused with the period of time that the tax authorities allow an accelerated tax deduction on the cost of certain types of fixed assets. This tax allowance is usually known as a “wear and tear allowance” or something similar. We’ll discuss this in detail in a later post.
It’s important to note that depreciation does not affect the actual (or market) value of the asset being depreciated; only it’s value on the statement of financial position.
Let’s give an example to make this point clear. Imagine that a business buys a piece of equipment for 100,000. That is the amount of the transaction that will initially appear in the accounts of the business. However, the business may have bought that equipment cheaply from another business that needed to raise some cash quickly. Let’s say that the equipment was worth 200,000, i.e. more than the business actually paid for it. In calculating the depreciation, the actual (or market) value is irrelevant – the equipment will be depreciated based on its cost (100,000), not its value (200,000).
Now imagine that the business depreciates the equipment over 3 years and at the end of the 3 years the equipment’s cost (100,000) has been fully depreciated and there is no amount attached to it in the accounts of the business. That doesn’t mean that the asset has no market value if the business wanted to sell it, only that its cost has now been fully depreciated. Because it was purchased cheaply, the equipment still has a market value after 3 years of 50,000.
So, in this example, the market value of the asset has not reduced to zero as a result of depreciation, it was simply an accounting procedure to expense the cost of the equipment over its useful life.
The key point to take away from this is that the value of an asset that you see on the balance sheet usually bears no relation to its actual value and in your analysis you should keep that firmly in mind and try to get actual assets values if you want to determine the true value of the business.
Next we’ll take a look at the 3 main methods of calculating depreciation.