What you will learn
- Explain why the cost of a long-lived asset is spread over its useful life
- Tell the difference between depreciation and amortization
- Calculate straight-line depreciation
- Explain why depreciation is a non-cash expense and how it links profit to cash flow
When a company buys a machine that will last ten years, it would be misleading to record the whole cost as an expense in year one, because the machine helps earn revenue for a decade. Depreciation and amortization solve this by spreading the cost over the asset's useful life. In doing so they create one of accounting's most important quirks, which you have already met from the other side: a real expense that involves no cash.
Depreciation explained (The Finance Storyteller)
A simple intro to spreading an asset's cost over time. Watch for the key idea that the cash left at purchase, not each year afterward.
Two words for one idea
- Depreciation spreads the cost of tangible, meaning physical, assets like buildings, vehicles, and equipment over their useful lives.
- Amortization does the same for intangible assets like patents and certain licenses.
- The concept is identical. Only the type of asset is different.
Key terms
- Depreciation
- Spreading the cost of a physical asset over the years it is used.
- Amortization
- The same idea applied to intangible assets like patents.
- Matching principle
- The rule that costs should be recorded in the same periods as the revenue they help produce.
- Non-cash expense
- A cost that lowers reported profit but moves no cash in that period, like depreciation.
- Straight-line depreciation
- Spreading an asset's cost evenly, the same amount each year.
The matching principle
This practice comes from the matching principle, which says expenses should be recorded in the same periods as the revenues they help produce. Spreading an asset's cost across the years it is used matches the cost to the benefit, giving a truer picture of profit in each period than dumping the entire cost into a single year would.
Straight-line depreciation of a machine
A company buys a machine for 60,000 dollars. It expects the machine to last 5 years and be worth nothing at the end. Using straight-line depreciation, what is the yearly depreciation expense?
- Find the amount to spread. The full 60,000 dollars will be expensed, since there is no leftover value at the end.
- Divide by the useful life. 60,000 divided by 5 years.
- Solve. That is 12,000 dollars per year.
Why it matters: Straight-line depreciation is just the cost, minus any leftover value, divided by the number of years the asset is used.
Calculate annual depreciation
A delivery van costs 40,000 dollars, is expected to last 8 years, and will be worth nothing at the end. Using straight-line depreciation, what is the depreciation expense each year?
The non-cash nature
Here is the point that connects straight back to the cash flow statement. The cash actually left the company when the asset was purchased. The depreciation recorded each year afterward is a non-cash expense. It lowers reported profit on the income statement, but no cash leaves in that year. This is exactly why depreciation is added back in the operating section of the cash flow statement, and it is a major reason profit and cash flow can diverge.
Depreciation is the accountant's way of remembering that you already spent the money, spread across the years the asset earns its keep.
Depreciation vs amortization explained simply (Brian Feroldi)
Contrasts the two terms and reinforces the non-cash idea from an investor's point of view. Good before the goodwill exception below.
Methods and a key exception
The simplest and most common method is straight-line depreciation, which expenses an equal amount each year. Accelerated methods, like declining balance, front-load more of the expense into the earlier years. One exception is worth remembering: under current US rules goodwill is not amortized on a schedule. Instead it is tested regularly for impairment and written down only if its value has fallen, which is the goodwill write-down you met in the previous lesson.
Where does depreciation show up?
A company records 12,000 dollars of depreciation this year on a machine it bought two years ago. What happens on the statements this year?
Depreciation lowers reported profit but moves no cash this year, which is why it is added back in the operating section of the cash flow statement.Why not just expense it all at once?
Explain in a couple of sentences why spreading a machine's cost over ten years gives a fairer picture of profit than recording the whole cost in the year it was bought.
Write an answer before comparing it with the model response.
Model answer
The machine helps earn revenue for ten years, so charging its entire cost to year one would make that year look artificially unprofitable and the next nine look artificially profitable. Spreading the cost matches a piece of the expense to each year the machine actually helps generate sales, giving a truer picture of profit in every period.
You now understand a cost that reduces profit without touching cash. That sets up two of the most talked-about metrics in finance, which both try to see past this quirk: EBITDA next, and free cash flow after it.