Q&A - What is depreciation?

Depreciation is a tricky concept to understand and often confuses business students. It is a cost that is recognised in the income statement, but it does not involve a cash flow! How does this happen?

Let’s look at a simple example.

A business buys some factory machinery for £100,000 and expects the machinery to last for 10 years before it will need to be replaced. In the accounts, the original purchase amount of £100,000 would be treated as an increase in non-current assets in the balance sheet (not as a cost in the income statement). So the balance sheet value of Property, Plant & Equipment would rise by £100,000, offset by a reduction in cash of £100,000.
There is no change in net assets – all that has happened is that £100,000 of cash has been replaced by £100,000 of new machinery. The machinery is set to work for the long-term in the business.

Now this factory machinery will not last for ever. The business knows that the machinery will need to be replaced. So it is sensible to make an allowance in the financial statements for the reduced value of that machinery. That is where depreciation comes in.

Depreciation is an estimate of the fall in value of a fixed asset over time

There are various ways of calculating depreciation, but one of the most common is to simply reduce the original purchase cost of the fixed asset in line with its expected useful life.

In our simple example, the machinery was bought for £100,000 and is expected to last ten years. So each year, the asset value of the machinery is reduced by £10,000 (£100,000 spread over 10 years) – that becomes the depreciation cost in the income statement each year for that asset.

The total depreciation cost in the income statement each year is the total depreciation allowances for all the fixed assets that are shown in the balance sheet.