What is depreciation?

Imagine a small manufacturer buys a packing machine that will last for many years. If the full price is booked as a cost in the year of purchase, that year looks poor and the years after look too good. By depreciating, the business spreads the cost over the period in which it uses the machine, and the yearly result gives a fairer picture.

The calculation uses the cost of the item, its expected useful life and often a residual value, which is what it is expected to be worth at the end. With straight-line depreciation the amount is the same every period. Other methods charge more at first and less later. The right choice depends on how the item wears out in practice and on what the tax rules allow, so agree it with your accountant.

Every depreciation charge is a posting. One side is a cost in the profit and loss account. The other side lowers the book value of the fixed asset on the balance sheet. Many companies post it every month or quarter, often as a recurring journal entry, and in doing so keep the assets side of the balance sheet up to date.

What goes wrong? In a loose spreadsheet, an asset that has been sold or fully written off can keep running, or a new purchase gets forgotten. The result is then wrong and the balance sheet drifts away from reality. Also watch for the difference between depreciation in your books and depreciation for tax. The two do not have to be the same.

Land is usually not depreciated, because it does not wear out. And an item that is hardly used any more may lose value faster than the plan assumes, so check from time to time that the useful life is still right.