Lesson Corporate Finance: Depreciation - Basics

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Source code of 'Corporate Finance: Depreciation - Basics'

This Lesson (Corporate Finance: Depreciation - Basics) was created by by Shruti_Mishra(0)

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About Shruti_Mishra: I am a maths graduate from India and am currently persuing masters in Operations Research.

<A HREF=assets.wikipedia>Assets</A> such as buildings, factories, equipment, furniture, vehicles and computers last over several years but not indefinitely. The initial investment made in these assets gets used up over a period of time. The initial investment, thus seen as capital at that time, eventually becomes an expense. It is thus only appropriate to slowly convert this capital investment to expense gradually over the life rather than discarding it as an expense after its life is over. Thus during each <A HREF=accounting_period.wikipedia>accounting period </A>a portion of the cost of the asset is appropriated as an expense. Thus a portion of the asset gets transfered from the <A HREF=balance_sheet.wikipedia>balance sheet </A>to the <A HREF=income_statement.wikipedia>income statement </A>as depreciation expense every year during the entire life of the asset.

<A HREF=depreciation.wikipedia>Depreciation </A>can thus be simply defined as a non-cash expense which reduces the value of an asset over time as a result of wearing down or obsolescence.

<A HREF=cost_principle.wikipedia>Cost Principle</A>: This principle states that the asset amount reported on the <A HREF=balance_sheet.wikipedia>balance sheet</A> and the depreciation expense reported on the <A HREF=income_statement.wikipedia>income statement</A> should be related to the original cost of the asset (price at which the asset was purchased) and not to its present market value or cost of replacement. This ensures that the asset side of the balance sheet does not increase/decrease without equivalent effect on the liability side.

Some important points to note are:
1. Land is not depreciated as it lasts indefinitely
2. There are many methods used for depreciation, which can be grouped into two categories: <A HREF=straight_line_method.wikipedia>Straight Line</A> and <A HREF=accelerated_depreciation.wikipedia>Accelerated depreciation</A>. 
3. The assets are also referred to as Fixed Assets, Depreciable Assets and Property, Plant and Equipment.

Lets take a small example to understand the effect of depreciation on the balance sheet and the income statement. Suppose I bought an asset worth $10,000 and I depreciate it by $1000 next year. What will be the effect on the balance sheet and the income statement?

Answer: The value of the Fixed Assets would reduce by $1000, thus reducing the asset side of Balance Sheet by $1000. On other hand, the income statement would have a depreciation expense of $1000, which would reduce the net income and thus the <A HREF=retained_earnings.wikipedia>retained earnings </A>by $1000. This would in turn get reflected on the liability side of the balance sheet where the retained earnings would go down by $1000.

Depreciation differs slightly from <A HREF="amortization_1.lesson"> amortization </A>which is used to write off intangible assets or loans.