Depreciation

⏩Brief Explanation

Decline in asset value over time.

📔Glossary Definition

Depreciation is an accounting method used to allocate the cost of a tangible or physical asset over its useful life. It represents how much of an asset's value has been used up. Depreciation allows businesses to generate revenue from an asset while expensing a portion of its cost each year it is in use. This process helps companies account for the wear and tear on long-term assets like machinery, vehicles, or buildings. The depreciation expense is recognised on the income statement and reduces the value of the asset on the balance sheet.

🔢Worked Example: Ezee eBikes

Imagine our e-bike shop purchases a delivery van for £30,000 with an expected life of 10 years and a salvage value of £5,000.

Using straight-line depreciation, the annual depreciation expense would be:

Annual Depreciation = (Cost of the Asset − Salvage Value) / Life of Asset

Annual Depreciation = (£30,000 − £5,000) / 10 = £2,500 per year

So, each year, $2,500 is expensed as depreciation.

🗣️Usage in a Phrase

"The depreciation of our new delivery van affects our annual profit margin."

🥸Detailed Explanation

Depreciation is a fundamental concept in accounting and finance, particularly relevant for businesses that invest in long-term physical assets. Its primary purpose is to match the cost of a tangible asset with the revenue it generates over its useful life, adhering to the matching principle in accounting. By doing so, it provides a more accurate representation of a company's financial position and performance.

Methods of Depreciation:

Straight-Line Depreciation: This method spreads the cost of the asset evenly over its useful life, as seen in the example above. It's widely used due to its simplicity and ease of calculation.
Declining Balance Method: This method expedites depreciation in the earlier years of an asset’s life, with the expense decreasing over time.
Units of Production Method: Depreciation is based on the asset's usage, output, or units produced, making it ideal for manufacturing equipment.

Implications of Depreciation on Financial Statements:

Income Statement: Depreciation is listed as an expense, reducing the net income. This can lower taxable income, providing a tax advantage.
Balance Sheet: Assets are recorded at their historical cost and then reduced by accumulated depreciation. This shows the net book value of the assets.
Cash Flow Statement: Depreciation is added back to the net income in the operating activities section since it’s a non-cash expense.

Strategic Considerations:

Tax Implications: Depreciation can be a strategic tool for tax planning. Accelerated depreciation methods can reduce taxable income more in the earlier years.
Investment Decisions: Understanding depreciation helps in assessing the long-term value and return on investment of assets.
Budgeting and Forecasting: Planning for depreciation is essential for accurate budgeting and financial forecasting.

In conclusion, depreciation is not just an accounting exercise but a crucial element in strategic planning and financial analysis. For startups and small businesses like an e-bike shop, effective management of depreciation can lead to better financial health and informed decision-making.