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Depreciation – How It Works And What It Means

Anyone analyzing a company's balance sheet is going to notice that long-term assets are reduced by an account called "Accumulated Depreciation" (or "Reserve for Depreciation").

This account is an accumulation of each year's depreciation expense. This is necessary because companies are not allowed to write off their investment in capital assets in a single year, but have to depreciate it over an asset's recovery period.

For example, a company spends $80,000 on trucks, furniture, and tools. These cannot be called a current-year expense, but have to be set up as assets. Each year, a portion of the investment is written off as depreciation, and the offset goes into the account reducing the asset's book value.

So annual depreciation is a non-cash expense, and this is important when you are also tracking cash flow. Annual income is increased by depreciation expenses to judge cash flow because it does not involve a cash payment. So if an asset has a five-year recovery period, it will be reduced as an asset over five years as one-fifth is moved over to expense.

Depreciation is calculated under several methods. The straight-line method is most easily understood; the same amount is written off every year until the asset value reaches zero. Another method is called accelerated depreciation. The company is allowed to write off more in the earlier years, with diminishing write-off levels later on. The IRS publishes instructions including specific tables for all of the types.

For analysis of balance sheets, be aware of both the gross value and net book value (net of accumulated depreciation). Also be aware that assets can only be reported at original basis, minus depreciation. As a consequence, an asset that has grown in value will be reported below market value. So if a company built its own headquarters building half a century ago, the building's net book value will be zero today, although its market value could be many times greater than its original cost. This is one of the oddities and shortcomings of financial reporting rules.

To better understand how the true market value of capital assets stands, and how tangible book value has to be adjusted from what you see on the balance sheet, it may be necessary to check the footnotes to the financial statement. As complex as these are to read, there is a chance that the company explains differences between net book value and current market value of its capital assets.

Depreciation is not a difficult concept, but the calculation has been made complex by the tax rules. For example, the first-year depreciation has to be calculated based on when the asset was placed in service. It can be calculated as though bought halfway through a specific month, quarter or year. Like actual rates allowed under each type, the instructions also mandate the first-year depreciation a company can claim.

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