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What is Depreciation?

Depreciation is the accounting process of allocating the cost of a tangible fixed asset — a vehicle, machine, or building — across its useful life rather than expensing it all in the year of purchase. Each period a portion of the cost is charged to the income statement as depreciation expense while the asset’s carrying value on the balance sheet is reduced by the same amount.

The economic logic is matching: if a delivery van generates revenue for five years, its cost should be spread across those five years rather than distorting the profit of year one. Three methods are common. Straight-line divides cost minus residual value equally across the useful life — a €30,000 van with a five-year life and €5,000 residual value depreciates at €5,000 a year. Declining balance applies a fixed percentage to the remaining book value, producing larger expenses early and smaller ones later. Units of production ties depreciation to actual usage — miles driven, hours run, units produced.

Depreciation is a non-cash expense, which means it reduces reported profit without any money leaving the bank — that is why a profitable business can show positive net income while its cash flow statement looks healthier still. It also reduces taxable income, so the choice of method and useful-life estimate has a real cash consequence through deferred tax. Land is the one tangible asset that is never depreciated, because it does not wear out or lose value through use in the way buildings and equipment do.

Example

A catering company buys a refrigerated van for €40,000, expects to use it for eight years, and estimates a €4,000 resale value at the end. Under straight-line depreciation the annual expense is (€40,000 − €4,000) ÷ 8 = €4,500, charged every year for eight years.

Questions

What are the three main depreciation methods?

Straight-line spreads the cost equally across the useful life — simplest and most common. Declining balance applies a fixed percentage to the remaining book value, front-loading the expense into the early years. Units of production ties the expense to actual usage — miles driven, machine hours, units made — so it fluctuates with activity rather than time.

Is depreciation a cash expense?

No. Depreciation is a non-cash expense — it reduces reported profit without any money leaving the bank account, because the cash was already spent when the asset was bought. This is why the cash flow statement adds depreciation back to net income under the indirect method: it never actually consumed cash in the current period.

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