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What Is Depreciation and How is it Calculated

06 Mar 2023

For the key purpose of financial evaluation and reporting, plus tax liabilities, companies and businesses have to display how their assets may decrease in value over time. So, simply put, the answer to the question, “What is depreciation?”, is that it refers to a method of accounting that shows how any business’ asset value decreases over different periods. 

What is depreciation

Depreciation as a concept recognizes that assets may decline in value over time. Depreciation spreads the cost of any asset over its purposeful life. Let us say, you own a business and have invested in some advanced equipment to run your business. This piece of equipment comes at a cost to you and is useful to you. However, over time, although the equipment can be sold and new equipment can be bought, the value of the equipment you first bought will lose some of its value after some years of use. You could say that its value “depreciates”. 

What does this concept have to do with companies and their stocks? When you open a demat account to invest in the stock market, you wish to essentially invest in a company, a business. You should ask, “What is the meaning of depreciation,” simply to grasp what it is as it can have an impact on the value of stock of any company or business. 

Depreciation and its Impact

You should know that the opposite of depreciation is appreciation. Appreciation is when the value of any asset increases. If the value of the rupee falls, for instance, against the US dollar, it is said to depreciate. If it rises, it tends to appreciate. Therefore, in this very example, the concept of depreciation has an impact, negatively, in the currency market, as you have to trade using your currency to buy more foreign exchange. If you wish to invest in any securities, and assets, from stocks to gold and currencies to commodities, depreciation has to be understood well. 

Especially if you are looking to invest in an upcoming IPO, you should know about a company’s balance sheet and its business income. The financial effects of purchases of assets must be smoothed out, as well as its liabilities in terms of taxation, to know its true value. By simply knowing about what is depreciation in economics, you can learn about whether a company is overspending in terms of its assets and how this will impact its future debt and growth potential. 

Some Key Points to Begin With

“What is depreciation” is not a challenge to answer if you consider the following points: 

  • Depreciation is a process of accounting. It allocates the cost of fixed and tangible assets across a particular time frame that a business expects to benefit by their use. 
  • Many methods can be employed to calculate depreciation. Every method needs hard data and certain estimates. 
  • Companies and businesses use a variety of methods to make calculations about depreciation in order to make P&L (Profit & Loss) statements and for the purpose of taxation. 
  • Depreciation should be calculated precisely as it can affect a business’s financial data and results, plus its tax liabilities. 

How to Calculate Depreciation - Initial Thoughts

In terms of economics and financial markets, accountants define the word “asset” very specifically. This definition differs from the word as it is used in a common language. So, capital assets are those which have some future benefit, economically or financially, for a business and those which are under the sole control of the business in question. These assets are further classified as tangible, like infrastructure, buildings, and equipment, or intangible like trademarks and patents. 

The word “depreciation” applies to specific tangible assets. These are also known as fixed assets. Therefore, when you wish to invest in a business’s stock, the nature of assets that are fixed should be considered in terms of their service lives. Consequently, costs must be reflected across accounting periods when they are useful, and not just periods during which companies paid for them. This is an approach that displays the uses of assets by a company and offers a vivid picture of the performance of a business. When you invest in a company’s stock, business performance is a major deciding factor. 

Depreciation in Business - How is it calculated? 

One of the easiest methods that companies use to calculate depreciation is based on time. This is the “straight-line” method. It is commonly employed by companies and this is the formula in a nutshell:

(Cost - salvage value) ➗ expense predicted useful life = yearly depreciation

Knowing What is Depreciation in Business

What is the meaning of depreciation? You know this now, and can gauge its importance while thinking about its impact in a business’ life. A business can possibly depreciate any asset, but land. Assets may be large, such as windmills or airplanes. They may be small such as furniture or laptops. Depreciation is considered a large portion of the expense of any business. It is characteristically represented on profit and loss statements of all publicly traded firms and companies. For instance, in 2019, the Coca Cola Company recorded expenses from depreciation worth more than $1 billion. This was a deciding factor for many future investors at the time. 

Depreciation and Clues to Performance

Depreciation faced by many companies can give you a fair idea of a company’s performance, in terms of the profits it is making versus the depreciation expenses it is incurring. If you want to invest in an upcoming IPO, you may study the depreciation of a private company to give you a good idea about where it is headed. Investing in companies is easy and all you have to do is open a demat account with any reputable brokerage for starters. The part which is challenging is choosing the right companies to invest in. This is where depreciation expenses may help you to decide in an informed and calculated way. Stock investments need judgment calls, but these must be made after extensive study of any company. 

 

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