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Depreciation is a non-cash expense that "uses up" the value of a revenue-generating asset over the lifetime of that asset.


Expanded Definition

When a company buys an asset, such as a delivery truck, to help it generate revenue, it either pays for it all up front as a capital expenditure (found in the investment portion of the cash flow statement) or it arranges some sort of financing such as a lease or loan. In any event, the value of the asset is put onto the balance sheet.

That expenditure to buy the asset, though, is not an expense. Thanks to the matching principle, expenses only occur as they are used to generate revenue. Since the lifetime of such an asset is longer than the current accounting period, the use of that asset must be spread out across those periods where it is used. This is called depreciation.

Suppose that a railroad freight car was purchased for $200,000 and was expected to last for 10 years, at which time it would be sold for $20,000. (This is called the "residual value.") The $200,000 is spent as cash and the Long-Lived Assets part of the balance sheet is increased by that amount. That balance is then reduced over the 10 years lifetime as the railcar is used to help generate revenue. At any given time, the value of the asset minus its total depreciation is called the carrying value or the book value.

Depreciation can be done in a few different ways:

  • Straight-line depreciation
  • Units of production
  • Accelerated depreciation

Straight-line depreciation

In this method, the amount to depreciate each year is the same and is simply the expected use value of the asset divided by the number of years it is expected to be used:

<math>Annual\ depreciation\ expense = \frac{Purchase\ price - Residual\ value}{No.\ of\ years}</math>

For the railroad car example given above, this would be:

<math>Annual\ depreciation\ expense = \frac{$200,000 - $20,000}{10\ years} = $18,000 / year</math>

Units of production

In this method, commonly used for manufacturing machines, the number of units that the machine can produce over its lifetime is estimated and the expense is the fraction actually produced during the accounting period. For instance, say a bottling machine is expected to bottle 10 million bottles over its lifetime. If, during the year, it bottles 350,000, then the book value of the machine is reduced by 3.5% of the original value less the residual value.

<math>Depreciation\ expense = \frac{No.\ units\ produced}{Total\ no.\ units\ expected} * (Purchase\ price - Residual\ value)</math>

Accelerated depreciation

In this method, we're going to end up at the same endpoint, the residual value, but we're going to start off more quickly and then slow down as time passes.

The consequence of using an accelerated depreciation method is that there is less net income in the early years of using the asset.

Double-declining balance

<math>Depreciation\ expense = 2 * \frac{1}{No.\ of\ years} * Book\ value</math>

to a limit of the residual value.

This is best shown with a table. Here is one using the railcar example from above:

(10% of (begin-salvage) each year)
(20% of book each year)
Year Depr Book Accum Depr Book Accum
0   $200,000     $200,000  
1 $18,000 $182,000 $18,000 $40,000 $160,000 $40,000
2 $18,000 $164,000 $36,000 $32,000 $128,000 $72,000
3 $18,000 $146,000 $54,000 $25,600 $102,400 $97,600
4 $18,000 $128,000 $72,000 $20,480 $81,920 $118,080
5 $18,000 $110,000 $90,000 $16,384 $65,536 $134,464
6 $18,000 $92,000 $108,000 $13,107 $52,429 $147,571
7 $18,000 $74,000 $126,000 $10,486 $41,943 $158,057
8 $18,000 $56,000 $144,000 $8,389 $33,554 $166,446
9 $18,000 $38,000 $162,000 $6,711 $26,844 $173,156
10 $18,000 $20,000 $180,000 $6,844 $20,000 $180,000


This is a less common method of accelerated depreciation.

The book value less salvage value is multiplied by the remaining number of years and divided by the sum of those remaining years. For example, if there were 5 years remaining, that sum would be 5+4+3+2+1 = 15. Mathematically, where N = number of years remaining, it is:

<math>Annual\ depreciation\ expense = (Book\ value - salvage\ value) * \frac{N}{\frac{N*(N+1)}{2}}</math>

Here is a table showing how this calculation differs slightly from the double-declining method illustrated above:

(20% of book each year)
Year Depr Book Accum Depr Book Accum
0   $200,000     $200,000  
1 $40,000 $160,000 $40,000 $32,727 $167,273 $32,727
2 $32,000 $128,000 $72,000 $29,455 $137,818 $62,182
3 $25,600 $102,400 $97,600 $26,182 $111,636 $88,364
4 $20,480 $81,920 $118,080 $22,909 $88,727 $111,273
5 $16,384 $65,536 $134,464 $19,636 $69,091 $130,909
6 $13,107 $52,429 $147,571 $16,364 $52,727 $147,273
7 $10,486 $41,943 $158,057 $13,091 $39,636 $160,364
8 $8,389 $33,554 $166,446 $9,818 $29,818 $170,182
9 $6,711 $26,844 $173,156 $6,545 $23,273 $176,727
10 $6,844 $20,000 $180,000 $3,273 $20,000 $180,000

Deferred taxes

The IRS allows companies to use an accelerated depreciation method for tax-reporting purposes, while the company can use a straight-line method for quarterly and annual reports to the investing public. At the end of the asset's lifetime, the total depreciation expense is the same, but the amounts recorded each year can differ quite a bit as the above tables demonstrate.

The reason a company would want to do this is to have a lower income tax payable in the early years of an asset's lifetime. The IRS allows this so as to keep more cash in the company where it, presumably, is put to work to the benefit of the company, employees, and customers.

The company therefore records a tax expense based on its shareholder accounting books, which commonly uses straight-line depreciation, but records a lower cash tax actually paid than that expense. This increases cash flow from operations as the difference is corrected for as a non-cash expense. It also creates a Deferred Tax Liability on the balance sheet to represent future taxes owed equal to the difference between tax expense and tax paid.

Changes in estimates

The estimated useful life of the asset and the estimated residual value are both estimates made by management. Management can change these estimates and thus affect the amount of the depreciation expense. (This only applies going forward, so past depreciation is not "corrected.")

For instance, if the estimated useful life is extended, the depreciation expense will be reduced, which will have the effect of increasing net income, all else being equal.

This is one way that management can manipulate earnings, so keep an eye on this expense line item and its trends over time. If capital expenditures go up, but depreciation expense stays the same or goes down, there might be something fishy going on.

Effect on cash flow

Depreciation is a "non-cash expense." The cash went out when the rail car was bought, but as outlined above, the value of the asset is "expensed" across time as it helps the company earn revenue (and the asset's carrying value or book value on the balance sheet is reduced).

When determining how much cash a company is bringing in, this expense must be added back to net income. Other non-cash events are adjusted for as well, but depreciation is usually the largest one, especially in an asset intensive business.

For instance, if net income was $20 million while the depreciation expense (listed as a part of operating costs) was $4 million, then that $4 million is added to net income so that (assuming all else is zero) the cash actually brought in by the company that period is $24 million. This is known as "cash flow from operations" and this is shown on the statement of cash flows.

Depletion and Amortization

Depreciation is the expensing over time of assets owned by the company. A similar process is used for natural resources, land, intangible assets, and other purchases.

Depletion is used to reduce the amount of natural resources that a company carries on its books.

Amortization is used to reduce the value of intangible assets such as patents. This is also used to reduce the value of leasehold improvements (such as improvements to leased office space, paid for by the company, but reverting to the building owner at the end of the lease).

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