What is Depreciation

Depreciation (depn) is used to measure the reduction in the useful life of an asset in dollar term. The measurement is an estimate because an asset may last longer than the estimate useful life or vice versa. It's purpose is to help a business better reflect the cost of using the asset (excluding maintenance cost) during the asset useful life. Without this measure, a business's profit is lowered or even suffers a loss for the period when an asset is acquired and reflects a higher profitability in subsequent periods while the asset is still being used for the business.

Accumulated depreciation is the total reduction in the value of the asset since the asset is purchased. Assuming that you have an asset that you have purchased for $9,000 and it is estimated to have a useful life of 3 years. Two years have passed. The accumulated depn is therefore two-thirds of the purchase value or $6,000. Using this, you will be able to calculate the book value or remaining value of the asset. Continue from our example, the book value would have been $3,000 because the asset is left with an estimated useful of one year.

After 3 years, you may continue to use the asset at "zero cost". You can continue to use the asset and your net profit (which is the amount after deducting cost of goods and operating cost) would have increase by the amount of depn. Although this is not ideal, we are better off than recognizing the full cost of purchase in one year.

The most common method of depn is straight-line. An estimate is first done on the useful life of asset. The price of the asset is then divided equally (usually by month) across the useful life of the project and that would be the depn value. For most assets, there are already statutory standards or recommendation on their useful life. Most businesses just adopt these statutory standards. For example, it is a general rule of thumb to depreciate computers and computers peripherals over a period of 3 years. Other methods of depn include sum-of-the-year's-digits and double declining balance. The depn method to adopt for a particular asset is usually determined by how its value changes over time.

Depreciation can be a major contribution to the profit and loss of a company, especially for businesses which require hefty capital investments. For example, in a telecommunication company (telco), a huge investment on its telecommunication network is required before a telco could offer its service to customer. This network once invested could be used by the telco to its services for a number of years. It is therefore important for the telco to depreciate this cost over its useful life so that the company could reflect the real cost of providing the service to its customers. In this case, it is important for a telco business analyst when setting up a business model, to make sure that the depn is computed accurately or it may completely distort the profitability of the business.

Calculating depn is relatively easy in an Excel based business model if you have a good understanding of Excel worksheet functions. You will only need to use some formula and one row to calculate depn instead of using a 36 columns by 36 rows table to compute the depn for an asset with an useful life of 3 years. Click on this depreciation link to find out how!

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