Depreciation

How depreciation works

When a company buys an asset that will be used over multiple years — a building, machinery, vehicles, computers — accounting principles require spreading the cost across the asset's useful life rather than expensing it all at once. The annual portion charged against income is depreciation.

Three pieces define each schedule:

• Cost basis — what was paid for the asset, plus any costs to put it in service.
• Useful life — the period over which the asset is expected to remain productive. Typically 5 years for vehicles, 7 for office furniture, 27.5 or 39 years for buildings under US tax rules.
• Salvage value — estimated worth at the end of useful life. Often $0 in straightforward cases.

A $50,000 truck with a 5-year useful life and $0 salvage value depreciates at $10,000/year using straight-line depreciation.

Depreciation methods

Several approaches:

• Straight-line — equal expense each year over the useful life. The simplest and most common.
• Declining balance / accelerated — larger expense in early years, smaller later. Better matches the economic reality of many assets that lose value fastest when new.
• Units of production — depreciation based on use rather than time. A machine depreciated per unit it produces.
• MACRS (US tax) — Modified Accelerated Cost Recovery System, the standard method for US tax depreciation. Uses defined recovery periods and conventions to specify how each asset class is depreciated.

The book and tax treatments often differ. Companies usually use straight-line for financial reporting (smoother earnings) and MACRS for tax (faster deductions, lower current-year tax).

Why depreciation matters

Three structural effects:

• Reduces reported earnings without affecting cash flow. Depreciation is a non-cash expense — the cash already left the business when the asset was purchased. This is why operating cash flow is often higher than net income.
• Reduces taxable income. Depreciation deductions lower current-year tax, even though they don't affect current-year cash position. Faster depreciation methods front-load these tax savings.
• Tracks asset values over time. The undepreciated portion of an asset (cost minus accumulated depreciation) is its "book value" on the balance sheet. Often diverges sharply from market value.

EBITDA and the controversy

EBITDA explicitly removes depreciation:

EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization

Proponents argue EBITDA shows the cash-generating capacity of the business before financing decisions and accounting allocations. Critics — most famously Warren Buffett — argue depreciation is a real economic cost, just one paid in advance. Equipment wears out and needs replacing; ignoring depreciation overlooks that future capital expenditure.

Both views have merit. EBITDA is useful for comparing companies with different capital structures and depreciation policies. Free cash flow (operating cash flow minus capital expenditures) is more honest about ongoing investment requirements.

In the real world

A few practical dynamics:

• Real estate. Depreciation deductions are a major reason real estate is tax-advantaged. Even appreciating buildings depreciate for tax purposes, generating ongoing deductions.
• Bonus depreciation. US tax law has periodically allowed accelerated depreciation (sometimes 100% in year one) to encourage capital investment. Phasing down through 2027 under current law.
• Asset sales. Selling an asset for more than its remaining book value generates a gain ("depreciation recapture"), often taxed at higher rates than capital gains.
• Section 179. Lets small businesses immediately expense up to a limit (varies by year) rather than depreciating over multiple years.

What individuals should care about

For most individuals, depreciation directly matters in two contexts:

• Real estate investment — landlords can depreciate residential rental properties over 27.5 years. The deduction often makes rental income tax-efficient even when it's positive.
• Business equipment — self-employed and small-business owners depreciate equipment, vehicles, and other capital assets bought for the business.

Beyond these specific cases, depreciation appears mainly as a line item on financial statements that's worth understanding when reading them, but rarely a direct planning factor.