Depreciation is an accounting measure used to take account of an asset's declining value over time. Depreciation costs reduce on-paper profits each year. Variations in calculating depreciation can make it more difficult to compare the profit between different companies.
When a business buys an asset such as a machine, it decreases in value over time. This reduces the company's overall assets at the end of the financial year when it draws up a balance sheet. Accounting principles mean that the changes in the balance sheets at the start and end of the financial year must correspond to the figures listed on the income statement (profit and loss account) for that financial year. (In other words, the amount a company makes or loses in the year will change its overall worth.) To make this work, accountants list the decrease in the asset's value as if it were an actual expense; in the accounts, this expense is titled depreciation.
To make depreciation work, when a company gets a new asset, its accountants decide in advance how long it will be economically useful: this period, the "lifespan," is purely for calculation purposes. The accountants also decide the value of the asset at the end of this period, sometimes called the scrap value. This could be a small sum (what the asset would fetch if sold second-hand at the end of the period) or could be zero, for example if it is expected to wear out beyond repair. The difference between the purchase price and the scrap value is the total depreciation amount. The accountants then list a proportion of this depreciation amount as an expense each year, spreading the entire "cost" across the lifespan of the asset.
The simplest way to calculate depreciation is to simply divide the total depreciation sum by the number of years in the economic lifespan, thus chalking up the same amount as a depreciation expense each year. This is known as the straight line method. Accountants may instead use the declining balance method, which doesn't list a fixed amount for depreciation each year, but rather uses a fixed percentage of however much of the total depreciation sum is left to be accounted for. The result is that more of the total depreciation is listed as an expense in the first few years. This may be more appropriate with equipment that quickly loses value. In some cases the accountants using double declining balance, which means the depreciation costs are even more "front-loaded." This could be done with computers, which tend to lose value extremely quickly.
Effects and rules
Because depreciation is listed as an expense, using differing depreciation methods (and this differing depreciation amounts each year) will change the profit figures for the company. This happens despite the fact that the actual money the company has earned and spent is unchanged. This can make it difficult to make comparisons between the business performance of different companies using different depreciation methods. To minimise this problem, most countries that have laws governing the way publicly traded companies prepare their accounts will have fixed rules about what depreciation method the company must use for each particular type of asset. Tax authorities will also have rules about how companies must calculate depreciation which affects their profit figure and in turn their tax liability. In some cases this may mean the company lists a different profit figure on its tax return than it does in its public accounts.
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