Finance... Depreciation... in 90 seconds (or less)

While day to day costs are charged to the profit and loss account as expenses, purchases of equipment which will be used over many years are not. Even after purchase, something like a new kitchen has value and remains an asset for the business. Accordingly, it sits on the balance sheet as a fixed asset. However, over time it will lose value and over enough years will lose all value and itself need to be replaced. To recognise this, each year a proportion of the cost of the asset is charged to the profit and loss (P&L) account, this is called depreciation.

There are several methods of calculating depreciation but here we will just consider the 'straight line method', to see how depreciation works in practice. Say you bought a new kitchen at a cost of £160,000. For accounting purposes, you estimate that the kitchen has a useful life of 10 years. Each year then, you would charge £16,000 (=160,000/10) to the P&L as depreciation until the value of the asset reaches zero.

Critically however, while £16,000 is charged to the P&L as an expense, this is not a cash expense, this is purely an accounting entry. You cash outgoings were of course £160,000 when you bought the kitchen. In subsequent years, there is no cash outlay.

We said in the article on double entry book-keeping that each accounting event has two outcomes, not one, so while one outcome of depreciation is an expense of £16,000 to your P&L, the other outcome is a reduction in the carrying value of your fixed assets by the same amount. Accordingly, after one year, the value of the kitchen will show on your balance sheet as £144,000 being the start of year value (£160,000) less the depreciation charged (£16,000) which has reduced the value of the asset. It should be noted here that the value of the asset on your balance sheet is the accounting value and is not supposed to try to reflect its market value if you were to try to sell it on.

Finally, depreciation is the 'D' in EBITDA, that is Earnings Before Interest Tax Depreciation and Amortisation. But that's for another time.

That is depreciation, in 90 seconds or less.
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