Depreciation is an accounting term for managing the loss of value over time of a tangible asset.
A straightforward real-world example of depreciation is in the value of a car, which loses its value quickly. You might buy a car for £10,000 and then in 5 years time think the car will be worth £0. In this case, the asset will depreciate in value by 20% per year (or £2,000). This means that on a company’s financial statements, the first year will show £8,000 on the balance sheet as fixed assets and £2,000 on the profit and loss (PnL) as a depreciation expense, and so on.
The objective is that the balance sheet reflects the value of that asset at any given time if it was exchanged for cash.
For example, the assumption is that selling the above car at the end of year 2 would get £6,000 for the car, but at the end of year 4, you would only get £2,000 for it. This loss of value will reflect in the PnL, so the depreciation over the intervening 2-year period would show £4,000.
You can account for depreciation in a few different ways, chosen by the company in respect of the ‘useful life’ of the asset. Ultimately, businesses tend to depreciate on a ‘straight-line basis’ (IE 20% per year for 5 years). However, they can decline the assets at their discretion, so long as they are making their best efforts to reflect the value of the asset at that point in time.
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