What is
Depreciation?

Depreciation refers to the reduction in value of an asset over time due to wear and tear, aging, or obsolescence. It is a non-cash expense that allocates the cost of an asset over its useful life. Depreciation is recorded as an expense on the income statement and is deducted from the asset's book value on the balance sheet.

Key takeaways

Non-cash expense

Depreciation doesn't involve actual cash outflows but reduces taxable income.

Asset allocation

Depreciation spreads the cost of an asset over its useful life.

Impact on financial statements

Reduces the value of assets and affects net income through expense recognition.

Tax benefits

Depreciation helps reduce tax liability by lowering taxable income.

Why depreciation matters

Depreciation is important for several reasons:

1. Tax advantages: Depreciation allows businesses to reduce taxable income by recognising asset costs over time.
2. Accurate financial reporting: Proper depreciation ensures that the value of assets reflects their actual worth.
3. Expense management: Spreading asset costs over time provides a more accurate picture of a company’s financial health.
   
   Types of depreciation methods There are several methods for calculating depreciation, each with its own application depending on the asset’s usage and expected lifespan:
   1. Straight-line depreciation: Spreads the asset's cost evenly over its useful life. Commonly used for assets with a uniform wear pattern.
   2. Declining balance depreciation: Accelerates depreciation in the early years of an asset’s life. Common for assets that lose value quickly, such as vehicles and technology.
   3. Units of production: Depreciation is based on the asset's usage, production, or activity level. Used for machinery or equipment in manufacturing.
   4. Sum-of-the-years’-digits: A form of accelerated depreciation that depreciates more in the earlier years of the asset’s life.

The depreciation process

Asset purchase

The company acquires an asset, which is initially recorded at its purchase cost.

Estimation of useful life and residual value

The company estimates how long the asset will be in service and its residual value at the end of its life.

Depreciation calculation

The company chooses the appropriate depreciation method and calculates the depreciation expense for the asset.

Expense recognition

The calculated depreciation expense is recorded on the income statement annually.

Adjustments

The asset's book value is adjusted over time as depreciation is deducted.

Depreciation impacts both the income statement and the balance sheet

Income statement: Depreciation reduces taxable income by recognizing depreciation as an expense.

Balance sheet: Depreciation reduces the value of assets on the balance sheet, reflecting the asset's net book value over time.

The role of depreciation in financial analysis

Depreciation plays a key role in financial analysis:

• Profitability: Depreciation reduces a company's net income, affecting profitability ratios.
• Cash flow: While depreciation reduces income, it does not affect cash flow. It can improve cash flow by reducing taxes.
• Asset management: Tracking depreciation helps companies manage their assets and plan for replacements or upgrades.

Real-world examples

Case study: Tata Motors’ depreciation strategy

Tata Motors, an Indian multinational automotive manufacturing company, has a fleet of vehicles and machinery used for production. The company uses straight-line depreciation for its buildings and declining balance depreciation for its vehicles. As a result:

The company reported significant savings on taxes in the early years of vehicle purchase.

Accurate depreciation calculations helped Tata Motors allocate funds for vehicle replacements, ensuring their fleet was always up-to-date and in optimal working condition.