Depreciation is the accounting method that spreads the cost of a physical asset like machinery, vehicles or IT kit over the years it is used. Instead of expensing the full cost on day one, a portion is charged to the income statement each period.
It is a non-cash expense. The cash went out when the asset was bought. Depreciation allocates that historical cost to the periods that benefit from using the asset, and it reduces the carrying amount of the asset on the balance sheet over time.
Where depreciation shows up in the accounts
Depreciation affects three core statements:
- Income statement: a periodic expense that lowers operating profit. Many companies present EBITDA, which excludes depreciation and amortisation, to show earnings before these non-cash charges.
- Balance sheet: assets are shown at cost less accumulated depreciation. The net figure is the carrying amount, often called net book value.
- Cash flow statement: under the indirect method, depreciation is added back in operating cash flow because it reduced profit but did not use cash in the period.
In the ledger this is typically recorded as debit depreciation expense and credit accumulated depreciation, a contra asset account that sits against the fixed asset. For investors, this accounting plumbing matters because it shapes profit, asset book value and reported cash flow.
Which assets are depreciated and which are not
Depreciation applies to tangible fixed assets with a limited useful life. Common examples are plant and equipment, vehicles, furniture, servers and buildings. Land is not depreciated because it is usually considered to have an indefinite life.
Intangible assets such as software and licences are not depreciated but amortised, which is the similar cost allocation for non-physical assets. Natural resources like mines or oil fields may use depletion to allocate cost as the resource is extracted.
Assets acquired through long term leases can create a right-of-use asset that is depreciated over the lease term or useful life, depending on the contract and accounting rules. Low cost or short lived items might be expensed immediately rather than capitalised and depreciated. The line between what is expensed and what is capitalised can vary by policy and regulation, and it links directly to a company’s capital expenditure decisions.
Common methods and the basic maths
Different methods allocate cost in different patterns. The total cost allocated over the full life is the same, but the timing varies.
- Straight line: charges an equal amount each period. Simple and widely used when the asset provides even benefits over time.
- Reducing balance: applies a fixed percentage to the reducing carrying amount, front loading the expense. A common variant is double declining balance.
- Units of production: ties depreciation to usage such as hours run or units produced, useful when wear and tear tracks activity rather than time.
The core inputs are cost, useful life and residual value. Depreciable amount equals cost minus expected residual value at the end of life. Annual straight line charge is depreciable amount divided by useful life.
Example: A company buys a machine for £100,000, expects to use it for 5 years and sell it for £10,000 at the end. Depreciable amount is £90,000. Straight line depreciation is £18,000 per year. After two years, accumulated depreciation is £36,000 and the carrying amount is £64,000.
Under a reducing balance method at, say, 40 percent, year 1 expense is £40,000 on the £100,000 cost, year 2 is £24,000 on the £60,000 carrying amount, and so on, stopping when the carrying amount reaches the estimated residual value. Units of production would instead compute a per unit rate, for example £90,000 divided by expected total output, then multiply by actual units produced in each period.
Companies also handle part year ownership with pro rata charges, for example half a year’s depreciation if an asset is bought mid year. Practices can vary by standard and policy.
Useful life, residual value and revisions
Useful life and residual value are management estimates informed by past experience, manufacturer guidance, warranty terms, maintenance plans and expected usage. They are not fixed forever. If expectations change, depreciation schedules are usually revised prospectively from the date of change.
Suppose after year 2 the machine above is expected to last 7 years in total with no residual value. The new depreciable base becomes the current carrying amount spread over the remaining 5 years. The past charges are not restated, but future annual expense falls because the life is longer and the remaining amount is being spread over more years.
Changes in method can also occur if a different pattern better reflects how benefits are consumed, though standards normally require consistency and justification for switches.
Impairment, repairs and componentisation
Depreciation is systematic allocation, not a direct reassessment of value. If an asset’s recoverable amount falls below its carrying amount because of damage, obsolescence or weaker cash flows, an impairment may be recognised. That is a separate charge that reduces the carrying amount immediately, and future depreciation then runs off the lower base.
Regular maintenance is usually expensed as incurred. Major overhauls that extend life or improve capacity may be capitalised and depreciated over the period of benefit. Policies differ, and accounting standards give criteria for when costs are treated as repairs versus improvements.
Some complex assets are decomposed into significant parts with different lives, known as componentisation. An aircraft’s airframe and engines, for instance, may be depreciated on different schedules that reflect their distinct wear and replacement cycles.
Why investors care: margins, cash and tax
Depreciation affects performance metrics. Heavy depreciation can depress operating margin and net income even when cash generation is healthy. That is why measures like EBITDA are often discussed alongside EBIT and net profit. Depreciation also feeds into return ratios: higher asset bases and larger charges can lower return on assets in capital intensive sectors.
On cash, the expense itself does not consume funds in the period, so it is added back in operating cash flow. The real cash impact appears when a company spends on new assets or replacements, visible as investing cash outflows for property, plant and equipment. Comparing depreciation with current period capital spending can hint at whether a business is investing above, at or below maintenance levels, but the comparison is imperfect because asset lives are long and projects are lumpy.
Tax treatment often differs from book accounting. Many jurisdictions allow accelerated or other prescribed methods for tax depreciation, creating timing differences between accounting profit and taxable profit. The rules vary by country and can change, and nothing here is personal tax advice.
For valuation, analysts may model separate schedules for depreciation and capital expenditure, test sensitivity to useful life assumptions, and watch disclosures about methods and changes. A firm with ageing assets and low current depreciation might face higher replacement spend later. Conversely, a recent investment cycle can mean high depreciation today with capacity to drive revenue in future.
In short, depreciation links what a company owns to how it earns. It translates yesterday’s investment into today’s expense and tomorrow’s replacement needs, shaping reported profit, asset values and the path of cash through the business.