Depreciation Expense

Depreciation Expense is an accounting method used to allocate the cost of a tangible asset over its expected lifespan. Think of it as the gradual “expensing” of a large purchase. When a company buys a new factory or a delivery truck, it doesn't count the entire cost as an expense in the year of purchase. Instead, it spreads that cost out over the years it expects to use the asset. This annual allocation is the depreciation expense, and it appears on the company's Income Statement as a cost, reducing its reported profit. Crucially, depreciation is a Non-Cash Charge. No actual money leaves the company's bank account when depreciation is recorded. The cash already went out the door when the asset was originally purchased. However, this accounting entry is vital because it attempts to match the cost of an asset with the revenues it helps generate over time, giving a more accurate picture of a company's true profitability. Ignoring it would make a company look incredibly profitable in the years it isn't buying new equipment and terribly unprofitable in the years it does, which isn't a realistic view of the business's ongoing performance.

For a value investor, understanding depreciation is non-negotiable. It's the key to unlocking a company's real economic earnings. The legendary investor Warren Buffett has long argued that depreciation is one of the most misunderstood figures in finance. While accountants treat it as a non-cash item, Buffett emphasizes that depreciation is a very real cost. Why? Because the machines, buildings, and equipment that wear out will eventually need to be replaced. The depreciation charge is the accounting world's (often imperfect) estimate of that future replacement cost. A company's reported profit, or Earnings Per Share (EPS), can be easily manipulated by management's assumptions about depreciation. By choosing a longer Useful Life for an asset, a company can report a lower annual depreciation expense, which in turn inflates its reported profits. As an investor, your job is to be a detective. You must look beyond the reported numbers and assess whether the depreciation charge is a reasonable proxy for the true economic cost of maintaining the company's productive assets. This is the cornerstone of calculating what Buffett calls Owner Earnings.

Imagine two identical widget-making companies.

• Company A uses aggressive accounting, claiming its machines will last 20 years. It reports a low depreciation expense and, consequently, high profits.
• Company B is more conservative, estimating a realistic 10-year life for its machines. It reports higher depreciation and lower profits.

On the surface, Company A looks like the better investment. But the value investor knows Company B's earnings are of higher quality and more representative of reality. Company A is simply delaying the inevitable and will face a “sticker shock” when its machines need replacing far sooner than its accounting suggested.

While several methods exist, the vast majority of companies use the simplest and most common one.

This method spreads the cost of an asset evenly across each year of its useful life. The formula is straightforward: (Asset's Purchase Cost - Estimated Salvage Value) / Estimated Useful Life (in years)

• Purchase Cost: What the company paid for the asset.
• Salvage Value: The estimated resale value of the asset at the end of its useful life.
• Useful Life: How long the company expects the asset to be productive.

Let's say “Capipedia Couriers” buys a new delivery van for €35,000. They expect to use it for 5 years and then sell it for scrap for €5,000.

1. Depreciable Amount: €35,000 (Cost) - €5,000 (Salvage Value) = €30,000
2. Annual Depreciation Expense: €30,000 / 5 years = €6,000 per year

For the next five years, the company will record a €6,000 depreciation expense on its income statement, reducing its taxable income and reported profit by that amount.

While less common for financial reporting, you might encounter other methods, especially in footnotes or discussions about taxes:

• Accelerated Depreciation: Methods like the “Double-Declining Balance” front-load the expense, meaning more depreciation is recorded in the early years of an asset's life and less in the later years. This is often used for tax purposes to get larger deductions sooner.
• Units of Production: This method links depreciation directly to usage. A machine might be depreciated based on the number of widgets it produces or the hours it runs, which is perfect for assets whose wear is not simply a function of time.

These three terms are siblings, all serving the same purpose of spreading an asset's cost over time. The only difference is the type of asset they apply to.

• Depreciation: Used for tangible assets you can physically touch (e.g., buildings, vehicles, machinery).
• Amortization: Used for Intangible Assets that you can't touch (e.g., patents, copyrights, trademarks).
• Depletion: Used for the extraction of natural resources (e.g., oil, timber, coal).

Never take depreciation at face value. It's a management estimate, not a hard fact. For the savvy value investor, depreciation is a critical piece of the puzzle for understanding a business.

• It's a Real Cost: Treat depreciation as a real cash expense that just hasn't happened yet. A business that generates lots of cash but has massive depreciation charges may not be as profitable as it seems, because that cash will be needed to replace aging assets.
• Compare with CapEx: The most powerful analysis is to compare a company's total depreciation expense over several years with its actual spending on Capital Expenditures (CapEx). You can find these figures on the Cash Flow Statement. If a company consistently spends far more on CapEx than it records in depreciation, it's a red flag that its reported earnings are likely overstated. This signals that the “cost” of maintaining the business is much higher than what the income statement suggests.
• Look for Consistency: Be wary of companies that suddenly change their depreciation assumptions or have unusually low depreciation charges compared to competitors in the same industry. This can be a sign of management trying to artificially boost short-term profits.