When a company purchases assets that will produce benefits (in some way make money for the company) over a long period they should be regarded as investments. This means that their cost can not fairly simply be charged immediately to the P & L.
Many assets a company buys as investments firstly are meant to produce a return over a period of time, but have a limited useful life. In order to follow the accrual principle, the cost shown on the P & L should be spread out over the years of an assets useful life.
The solution is to depreciate the cost over a number of years and take each year's depreciation as that year's cost. The most commonly used method is straight line depreciation which charges a fixed amount of depreciation every year. The depreciation for each year is:
(cost - residual value) ÷ expected life
If a company spends £100,000 on a machine that is expected to last 10 years and have negligible value after 10 years then, using straight line depreciation, each year the company would:
- reduce its value as shown on the balance sheet by £10,000
- show that £10,000 as a cost in the profit and loss account
This is by far the commonest method used in the accounts, but it is not the method used for tax purposes. This is one reason why taxable profits are often very different from accounting profits. The reducing balance method is often used for tax, but infrequently for reporting.
Intangible assets are amortised rather than depreciated, but the principle is much the same.
Certain assets such as land and investments are not depreciated.
In theory, depreciation should be separately calculated for each asset, and even for components of an asset. For example, if a building contains lifts that have a shorter expected life than the building, they should be depreciated separately. In addition, the the residual value and useful life should be reviewed (at least) annually, and the rate of depreciation changed in necessary.
In reality, the huge amount of work this implies means that the way in which depreciation is actually applied is likely to be somewhat simplified, and be closer to the old practice of assuming the same useful life and proportionate fall in value for each asset class.
It is important to understand that depreciation is not directly related to the replacement costs of assets, which investors may need to consider separately.
Depletion is a similar to depreciation but applied to assets that are used up in a directly measurable way.