Depreciation explained
Depreciation 101: understanding why it's important and how it's used in business accounting
👋🏼 everyone,
What’s something you might buy and within minutes of buying it loses value by approx 11%?
A shiny new 🚗 that’s what.
According to Trusted Choice, a car's value depreciates by about 11% the minute you start driving it. A year later, the value drops further - down to 25%, and five years later, your car will be worth roughly 37% of what you paid for it 🤯
For me, it raises the question of what else do I buy or plan to buy in the near future that could depreciate rapidly, or conversely, what doesn't depreciate and how does that affect my financial life, net worth over time and general financial decisions in life.
It probably goes without saying, but depreciation as a concept isn't something we think about when we're picking up our groceries in the shop, but it's something that can deeply affect our overall finances, so it's wise to keep it in mind for our big life purchases.
With that in mind, let's take a closer look at depreciation.
(Quickly) explained
First of all let’s explain what depreciation means in the context of a person vs a company.
💁🏾♀️ A regular person:
For a regular person, depreciation refers to the decline in the value of their personal assets over time.
For example, a car, iPhone or laptop may lose value as they are used, become outdated or are subject to wear and tear.
This reduction in value is known as depreciation, and it can be a factor to consider when determining the resale value of these assets.
🏢 A business:
For a business, depreciation is a way of accounting for the decrease in value of its assets (e.g. equipment, machinery, buildings etc) over time.
As these assets are used or become outdated, their value declines. Depreciation is a way to account for this decline in value over the useful life of the asset, typically by allocating the cost of the asset over its expected useful life. This allows businesses to match the cost of the asset with the revenue it generates over time, and to accurately reflect the true value of their assets on their financial statements.
Depreciation is an important concept for businesses because it affects their financial statements, taxes, and overall profitability.
💻 Working example (business context):
Let's say a business purchases a new laptop 💻for $1,000 (obviously this would not be a MacBook for that price 😬). The business expects the laptop to have a useful life of three years, after which it will no longer be useful or have any significant resale value. The business would need to account for the decrease in value of the laptop over its useful life, which is where depreciation comes in.
In this case, the business would depreciate the laptop over three years, meaning that it would divide the cost of the laptop ($1,000) by the expected useful life (three years) to get an annual depreciation expense of $333.33.
This annual depreciation expense would then be recorded on the business's income statement as an expense, reducing the business's taxable income.
Each year, the laptop's value on the business's balance sheet would decrease by the annual depreciation expense, reflecting the decrease in value of the laptop over time. After three years, the laptop would have a book value of $0 on the business's balance sheet, meaning that its total cost has been fully depreciated.
⏳ Depreciation slow vs rapid…
Assets can broadly be divided into two types: those that lose their value quickly, such as electronic devices and cars, and those that hold their value well, such as luxury watches and vintage cars. Knowing a product's depreciation rate can help you to make better purchasing decisions.
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.
Depreciation explained
Love your content, Jason. Thank you.
Brilliant article as always! 🙏
Learn something new everytime I read one of yours posts 😃