Depreciation is a tax deduction which takes into account the decrease in the value of an asset over time due to wear and tear and through general usage. Depreciation aims to allocate the costs of assets to periods which the assets were used i.e. over the lifespan of an asset. Businesses use depreciation for tax purposes and it reduces a business's net income, allowing it to pay lower taxes.
As depreciation reduces net income, through the loss of value of an asset over a period of time, it does not impact a business's cash flow. There is no cash involved in a depreciation charge. Depreciation is therefore often added back to calculate a firm's exact cash flow for a period.
Firms which record large depreciation charges usually operate in industries that have large capital expenditures and assets that lose significant value over time. For example businesses in the real estate industry as the quality of the building decreases significantly over time and firms which operate in the oil & gas industry as machinery experiences wear and tear and record significant depreciation charges over time.
How to calculate depreciation?
There are three methods which firms can use to calculate depreciation. These methods include:
- Straight-line depreciation: This is when an asset is depreciated in equal amounts over the course of its life-cycle. It is generally considered the most common method for recording depreciation. The formula for calculating straight-line depreciation is: (Cost-Salvage value) / useful life
- Reducing balance: This occurs as depreciation expense decreases over the life-cycle of an asset. This method enables greater levels of depreciation to be charged in the early stages of an assets life cycle.
- Sum of the years': This involves depreciating an asset as a fractional part of the sum of its years of useful life. Similar to the reducing balance method, the sum of the year's method allows higher depreciation levels of an asset in the early years of an asset's life. This method is generally therefore only used with more valuable assets.
Conclusion
Depreciation is a key way for businesses to depreciate the assets of their useful lives. For you as an investor, it is crucial to understand exactly how firms are computing depreciation, to have the most precise and informed picture of the state of the company, which is practically possible.
