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Depreciation

WHAT IS DEPRECIATION?

Another accounting concept is the matching concept. This is the concept of matching income earned in a year to expenditure made in the same year. If you buy a machine that will make product for you for 10 years, then you need to match the running cost of the machine against what the machine produced.

Depreciation is the process of matching the cost of an asset in the years that it is used. So if an asset has a ten year life span, you charge 1/10th of the cost of the asset against profits as a cost.

AN EXPLANATION WITH NUMBERS
If the machine costs €10,000 and can produce 10,000 units per year for 10 years and you can sell the units for €0.50, then the machine, assuming it will last 10 years, will have its purchase price apportioned (depreciated) as follows and the profit calculated for each year will be shown to be steady in each year;

EXAMPLE - A
SPREADING COST OF MACHINE OVER 10 YEARS
Units Cost Cost Selling Price Profit Total
per unit per unit per unit Profit
Year 1 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 2 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 3 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 4 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 5 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 6 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 7 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 8 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 9 10,000 €1,000 €0.10 €0.50 €0.40 €400
Year 10 10,000 €1,000 €0.10 €0.50 €0.40 €400
Totals €10,000 €4000


If you chose to write off the cost in the first year, it would work out that you would show a big loss in year 1 and higher profits from then on. But the profit should be the same for each year.
Your cash flow will be different, as your cash will go down if you pay outright for the equipment (that is why the leasing of equipment is very good for cash flow)

EXAMPLE - B
COST OF MACHINE WRITTEN OFF IN FIRST YEAR
Units Cost Cost Selling Price Profit Total
per unit per unit per unit Profit
Year 1 10,000 €10,000 €1.00 €0.50 -€0.50 -€500
Year 2 10,000 €0 €0.00 €0.50 €0.50 €500
Year 3 10,000 €0 €0.00 €0.50 €0.50 €500
Year 4 10,000 €0 €0.00 €0.50 €0.50 €500
Year 5 10,000 €0 €0.00 €0.50 €0.50 €500
Year 6 10,000 €0 €0.00 €0.50 €0.50 €500
Year 7 10,000 €0 €0.00 €0.50 €0.50 €500
Year 8 10,000 €0 €0.00 €0.50 €0.50 €500
Year 9 10,000 €0 €0.00 €0.50 €0.50 €500
Year 10 10,000 €0 €0.00 €0.50 €0.50 €500
€4,000


The first year would be distorted and in example B you would not be in profit until the beginning of year 3. In Example B to make a profit in year 1 you would have to sell the goods at a price greater than €1 Euro, which would make your product unaffordable and uncompetitive.

Note: Cash Flow is not the same as Profit. You can have no cash and yet make a Profit! Cash flow forecasting is very different to Profit forecasting.
See chapter on Profit & Cash Flow.

WHAT DEPRECIATION DOES

It allows you to write off the cost of the machine over the lifespan of the machine, rather than charge it all in the first year when you buy it. Then the asset will be shown on your Balance Sheet at the purchase price less the depreciation, which is usually a figure close to the resale value of the machine, but not always.
What depreciation allows you to do is apportion the cost of the machine against the work done in the year. It matches revenue (income) to costs (expenses). When you buy a machine it might have a life span of 10 years.
Depreciation takes into account the wear and tear on the machine, and gives the machine an estimated value i.e. a resale value.

Cost of Machine €10,000
Lifespan of machine 10 years
Year Cost Depreciation Net Book
10% per year value
Year 1 10,000 1,000 9,000
Year 2 1,000 8,000
Year 3 1,000 7,000
Year 4 1,000 6,000
Year 5 1,000 5,000
Year 6 1,000 4,000
Year 7 1,000 3,000
Year 8 1,000 2,000
Year 9 1,000 1,000
Year 10 1,000 0



ANOTHER EXAMPLE OF DEPRECIATION

You buy a car for €20,000
You expect to get 5 years use from it
It will be worth €0 at the end of 5 years
5 years equals 20% deprecation per year (1/5 of the original cost per year)

Year Cost Depreciation Net Book
20% per year value
Year 1 20,000 4,000 16,000
Year 2 4,000 12,000
Year 3 4,000 8,000
Year 4 4,000 4,000
Year 5 4,000 0


The Depreciation charge is a fair way of charging against your Profits a cost of buying the car.

If you had rented the car for 5 years, you would have been charged a yearly rent. You would not have been charged for the full 5 years rental upfront at the beginning of year 1. Instead you would have been charged on a per year basis. So the charge would have been evenly spread over the 5 years.
Depreciation evenly spreads the cost of buying the car over the 5 years.