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Allocates tangible asset costs across reporting periods on the income statement, exposing the non-cash charge that reflects ongoing physical asset consumption.
Income statement depreciation is the periodic expense for tangible assets. It spreads the cost of property, equipment, and other physical assets over their useful life.
Depreciation as reported on the income statement represents the periodic allocation of tangible asset costs over their useful lives. This non-cash expense recognises that physical assets like buildings, equipment, and vehicles lose value over time through wear, obsolescence, or age. Depreciation reduces reported income but doesn't consume cash in the current period.
Common depreciation methods:
- Straight-line: Equal expense each year; (Cost - Salvage) / Useful Life
- Declining balance: Accelerated; higher expense in early years
- Double declining balance: 2× straight-line rate applied to remaining balance
- Units of production: Based on actual usage or output
Example (straight-line):
Equipment cost: $500,000 Salvage value: $50,000 Useful life: 10 years Annual depreciation: ($500,000 - $50,000) / 10 = $45,000
Why depreciation matters:
- Matching principle: Aligns asset cost with periods benefiting from the asset
- Tax benefit: Reduces taxable income (accelerated depreciation for tax purposes)
- Profitability impact: Directly reduces operating income
- Capital intensity indicator: High depreciation suggests asset-heavy business
Depreciation on different statements:
- Income statement: Expense reducing operating income
- Cash flow statement: Added back to net income (non-cash)
- Balance sheet: Accumulated depreciation reduces asset values
Analytical applications:
- EBITDA: Operating income + Depreciation + Amortisation
- CapEx comparison: Depreciation vs. capital expenditures shows investment rate
- Asset age: Accumulated depreciation / Annual depreciation ≈ average asset age
Important considerations:
- Accounting estimates: Useful life and salvage value are management judgments
- Book vs. tax: Different methods may be used for financial and tax reporting
- Impairment: Assets may require additional write-downs beyond regular depreciation
- Not optional: While non-cash, depreciation represents real economic cost of asset usage
Depreciation is a real expense representing asset consumption, even though it's non-cash. Ignoring depreciation overstates cash-generating ability because assets must eventually be replaced.