Depreciation is a term we use to describe how long-term assets decrease in value over time. Depreciation usually means a decline in value as a result of wear and tear. However, wear and tear is not always the culprit.
‘Wear and tear’ refers to the gradual deterioration in a product’s quality when we have used it normally and properly.
The term refers to when the value of an asset decreases after the date when we bought it. It is the opposite of appreciation, i.e., when an asset goes up in value over time.
A common example is your car. As soon as you buy it, it starts dropping in value.
Depreciation in business
In business, the term 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 decline in value of a company’s assets reduces its profits. If profits go down, so does the amount of tax it must pay.
Depreciation affects profits
Let’s suppose that John Doe Inc. buys an asset worth $500,000.
Accountants will view the asset and determine how long it will last. If the asset has a five-year life, the accountants will subsequently make adjustments to the company’s profits.
The accountants will spread the $500,000 over five years when deducting the amount from profits. They do not deduct the whole amount on the day of purchase.
If you divide $500,000 by five years, you get $100,000 per year. Every year the company deducts $100,000 from profits. The asset’s value declines by $100,000 each year.
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 the directors make when determining depreciation. Investors want a harder profit figure.
How to calculate depreciation
With the straight line depreciation method, we divide the cost of an asset by its lifetime.
With the declining balance depreciation method: we multiply the book value of the fixed asset by a factor based on the life of the asset.