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Depreciation & amortisation

How does it work?
Written by Max Valentine
Updated 7 months ago

Depreciation and amortisation are not always to go to topic of financial forecasting but they are definitely elements that are worth understanding.  To calculate depreciation, we first need to understand the concept of capital expenditure. Capital expenditure is the cost of any asset that meets the following criteria

  • the asset must have an economic life of greater than one year when purchased it is held for continuing use in the business
  • the asset must generate an accounting profit or economic return
  • the value of the asset when purchased must exceed a de minimis limit which varies from geographic region and accounting jurisdiction

The idea is that capital expenditure tends to be large one off cost and expensive e.g. acquiring a building or purchasing a fleet of cars and if these costs were recorded in one period, it would lead to horrific losses on the profit and loss account and would go against the accruals and timing accounting principles.  This because fixed assets have a useful and productive life longer than the period of the profit statement.  The accruals concept tries to match revenues to the relevant costs or costs the relevant time period and hence:

This problem is overcome by charging a proportion in each year of the expected useful life of the asset. 

Depreciation is the proportional cost of using fixed assets it is an accounting expense that reflects the usage wearing out or consumption of tangible fixed assets over time.

This proportion does not involve the movement of cash, it is a notional (paper) charge to the profit and loss account each year the profit is reduced by the annual depreciation.   

There are a number of ways to calculate depreciation which in practice differ between type of asset and company accounting policy (look in the Annual Report small print).  These include straight line, diminishing value, sum of digits and usage basis

With Numberslides, we use the most common approach which is the straight line method.  This is by far the most common method this approach linear portions that appreciable amount evenly over the remaining number of periods this is favoured by accountants and reporting for many industries

Let's work through an example: Let's just consider an item of equipment costing £250,000 with an expected useful life of five years the profit statement for each year would be charged with £60,000 (£250,000 / 5).  In reality, assets have a sell on (residual value) at the end of their life so this should be taken into account.

It is worth following depreciation through the financial statements - 

Balance sheet - you will see the value of the tangible and intangible (see amortisation) assets reduce by depreciation.  It can give you a feel as to whether the asset base is old or new.

Income Statement - you will see a depreciation cost to the business 

Cash flow - you will see deprecation added back, this is because it is not a cash cost but a notional cost.

Accounting policies are also important - If we compare two companies investing in a fleet of cars and the first company depreciates them at 5 years and the second at 3 years, the first company will show higher profits on the Income Statement but when you get into the cash flow this should be the same as the impact of depreciation has been removed. Depreciation can be quite a major factor in determining earnings.

The title does mention Amortisation as well.  This is the equivalent of depreciation but for intangible assets.  These assets include a company's brand (it has an economic value even though can be one word!) or intellectual property such as patents trademarks and copyrights.

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