Depreciation
Key Takeaways
- Depreciation allocates the cost of tangible assets over their useful life
- Common methods: straight-line, declining balance, and units of production
- Non-cash expense that reduces taxable income but does not affect cash flow
- Added back in EBITDA and cash flow calculations
Definition
Depreciation is an accounting method that allocates the cost of a tangible asset over its expected useful life. Physical assets like buildings, machinery, vehicles, and equipment lose value over time due to wear and tear, obsolescence, or age. Depreciation recognizes this decline systematically rather than expensing the full cost when the asset is purchased.
Depreciation is a non-cash expense — it reduces reported earnings on the income statement and the asset's carrying value on the balance sheet, but no cash actually leaves the company. Because it reduces taxable income without reducing cash, depreciation provides a tax shield that effectively subsidizes capital investment.
Depreciation is the tangible-asset counterpart to amortization, which applies to intangible assets. Both are added back when calculating EBITDA and operating cash flow.
How It Works
The three main depreciation methods are: Straight-line: (Cost - Salvage Value) / Useful Life. Declining balance: applies a fixed percentage to the declining book value each year (front-loads depreciation). Units of production: allocates cost based on actual usage or output.
Example (straight-line): A company buys equipment for $100,000 with a 10-year useful life and $10,000 salvage value. Annual depreciation = ($100,000 - $10,000) / 10 = $9,000 per year. After 5 years, the book value is $100,000 - $45,000 = $55,000.
For tax purposes, companies often use accelerated depreciation methods (like MACRS in the U.S.) that allow larger deductions in the early years, deferring taxes. This creates a difference between book depreciation (for financial statements) and tax depreciation (for IRS purposes), resulting in deferred tax liabilities on the balance sheet.
Example
An airline like Delta Air Lines (DAL) purchases a new Boeing 737 for $100 million and depreciates it over 20 years with a $15 million residual value. Annual straight-line depreciation is ($100M - $15M) / 20 = $4.25 million per year. Delta reports this as a depreciation expense that reduces reported earnings but does not use cash. With a fleet of 700+ aircraft, Delta's total annual depreciation exceeds $3 billion — a massive non-cash charge that makes cash flow and EBITDA much higher than reported net income.
Why It Matters
Depreciation significantly affects how capital-intensive businesses report earnings. Companies with large property, plant, and equipment (PP&E) — airlines, utilities, manufacturers, telecom — report substantially lower net income than their cash flow due to depreciation. This is why EBITDA and free cash flow are often preferred metrics for these industries.
Understanding depreciation also matters for tax planning and cash flow analysis. The tax shield from depreciation (Depreciation × Tax Rate) represents real cash savings. Governments sometimes offer bonus depreciation or accelerated depreciation to encourage business investment in equipment and infrastructure.
Advantages
- Matches asset cost to the periods that benefit from the asset
- Tax shield reduces taxable income without reducing cash
- Non-cash nature means it does not affect actual liquidity
- Standard accounting treatment ensures comparability across companies
Limitations
- Book depreciation may not reflect actual decline in asset value
- Different methods produce different earnings figures for the same company
- Does not capture changes in market value of assets
- Capital-intensive companies may appear less profitable than they are
Frequently Asked Questions
Related Terms
Browse more definitions in the financial terms glossary.