What is depreciation? How does depreciation affect profit?

Depreciation is a term used to describe the way in which long term assets decrease in value over time, usually as a result of **wear and tear (but not always).

** Wear and tear refers to the gradual deterioration in a product’s quality when it is used normally and properly.

Depreciation refers to when the value of an asset decreases after the date it was purchased. It is the opposite of appreciation (when an asset goes up in value over time). A common example of depreciation is your car: as soon as you buy it, it starts dropping in value.

In business, depreciation has a more specific meaning, it has a direct impact on the profit figures of a company.

According to Cambridge Online Dictionaries, depreciation is:

“The amount by which something, such as a piece of equipment, is reduced in value in a company’s financial accounts, over the period of time it has been in use. The loss in value reduces a company’s profits, and the amount of tax it must pay.”

Car depreciationA brand new car depreciates the most on the day you buy it (because it is no longer a new car).

For example, lets say a company buys an asset worth 500,000 USD.

Accountants will view the asset and determine how long it will last, and make adjustments to the company’s profits, given that they have given it a 5-year life.

If the accountant believes the asset will last 5 years, then the 500,000 USD should be spread over the 5 years when deducting it from profits – as opposed to deducting the total asset value from profits when it is purchased.

If you divide 500,000 USD by 5 years you get 100,000 USD for each year. Every year this amount will be deducted from profits, and the value of the asset declines as each 100,000 USD charge against profits is incurred.

Company directors determine how long they believe the asset will be worth in the future. In this case, company estimates have a direct impact on the profits of a company.

Investors sometimes worry about how many judgments are made when determining depreciation – they want a harder profit figure.

How to calculate depreciation

The straight line depreciation method: divide the cost of an asset by its lifetime.

The declining balance depreciation method: the book value of the fixed asset multiplied by a factor based on the life of the asset.

Quotes by famous people

Warren Buffett, an American business magnate, investor and philanthropist, once said about people who hold cash equivalents:

“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”

‘To depreciate‘ is the verb of ‘depreciation’. As well as meaning to decline in value, to depreciate also means to disparage or belittle something (opposite of appreciate).

See this quote from Carl Jung (1875-1961), a Swiss psychiatrist and psychotherapist who founded analytical psychology:

“All the works of man have their origin in creative fantasy. What right have we then to depreciate imagination.”

Video – What is depreciation?