Depreciation is the process of accounting for the cost of wear and tear of an asset on a company’s financial statements. Companies use different methods to determine annual depreciation costs, which reduce the value of an asset on the balance sheet and are noted as expenses on the business results report. Depreciation expenses have a negative impact on the company’s net income.
Depreciation allocates the full price of long-lived assets, which are assets that are expected to have a useful use period of more than one year for the duration of use. For financial reporting purposes, companies use depreciation to match the duration of the asset cost with the revenue it generates. Instead of recording the full cost of the property at the time of purchase, this expense is spread out during the expected usefulness of the property. Depreciating assets include items such as equipment, homes, furniture, and machinery. The land is not devalued.
The straight line depreciation method is the most common method used to depreciate assets for financial reporting purposes. Annual depreciation expense in a straight line equals the depreciation cost divided by the useful use period or the expected number of years of use. The depreciation cost equals the total price of the asset minus the remaining value or expected value at the end of its useful use period. For example, an asset with a depreciation cost of $100,000 and a 10-year useful use period has an annual depreciation cost of $10,000: $100,000 divided by $10 equals $10,000.
Impact on net income
The total depreciation in the accounting period is recorded as the depreciation expense on the business results report. This reduces net income, also known as final profit. Net income equals revenue minus expenses. Higher depreciation costs contribute to an increase in total costs, resulting in lower net income. Companies with most of the old assets have been depreciated, and companies with few long-lived assets benefit from low depreciation costs and higher net income.
Analysis of non-depreciation income
Depreciation expense is considered a non-cash expenditure, which means there is no actual cash flow. Analysts and investors often evaluate a company’s earnings without the influence of finances, taxes, and non-monetary expenses, such as depreciation. A calculation known as “earnings before interest, taxes, depreciation and amortization” or EBITDA, is often used for this. It is calculated by adding interest, taxes, depreciation and amortization to net income. EBITDA provides a clearer picture of a company’s core operating results, which can be used to compare its performance with that of other companies.