Depreciation (Depreciation) that investors and business owners need to know

When analyzing a company’s financial statements, investors often encounter the term depreciation — an expense that reduces income but does not involve cash outflow. Why is this important? Because depreciation is an accounting method that affects the company’s net profit and taxes. Let’s delve deeper to help you read financial statements more effectively.

Meaning of Depreciation (Depreciation)

Depreciation is the process where accountants allocate the cost of fixed assets (such as machinery, buildings, vehicles) over their useful life, rather than expensing the entire cost in the year of purchase.

There are two main perspectives to understand depreciation:

• Value perspective: Assets lose value over time due to usage and natural deterioration.
• Cost distribution perspective: The business can spread the initial cost of expensive assets over the years during which the asset is actually used.

For example, if a company buys a computer for 50,000 THB and the computer’s useful life is approximately 5 years, the company will allocate a depreciation of 10,000 THB per year (using the straight-line method).

Types of Assets with Depreciation

The Revenue Department sets guidelines on which assets can be depreciated. Assets must have the following characteristics:

• Owned by the business
• Used in operations or income generation
• Have a definable useful life
• Expected to be used for more than one year

Assets eligible for depreciation:

• Vehicles (trucks, cars, buses)
• Buildings and structures
• Machinery and equipment
• Furniture and office supplies
• Computers and electronic devices
• Patents, copyrights, software

Assets not eligible for depreciation:

• Land (land is non-depreciable)
• Collectibles (art, coins, souvenirs)
• Investments (stocks, bonds)
• Personal property
• Assets used for less than one year

Methods of Calculating Depreciation

There are four main methods to compute depreciation, each suitable for different situations:

1. Straight-line method (Straight-line Method)

The simplest and most commonly used method, which divides the asset’s value equally over its useful life.

Formula: (Original Cost – Salvage Value) ÷ Number of Years

Example: A company buys a car for 100,000 THB with a 5-year lifespan. Annual depreciation = 100,000 ÷ 5 = 20,000 THB

Advantages: Simple, easy to understand, suitable for small businesses

Disadvantages: Does not account for faster loss of value in the early years or increased maintenance costs over time

2. Double Declining Balance method (Double-declining Balance)

An accelerated depreciation method that results in higher depreciation expenses in the earlier years and lower in later years.

This approach is suitable for assets that lose value quickly initially, such as technology equipment.

Advantages: Provides cash flow benefits in early years, helps reduce taxable income

Disadvantages: More complex, may not be ideal for companies that are already highly taxed

3. Declining Balance method (Declining Balance)

An accelerated depreciation method where the asset’s book value is depreciated at twice the straight-line rate. It results in higher depreciation in the early years, decreasing over time.

Suitable for: Companies seeking maximum tax deductions early on

4. Units of Production method (Units of Production)

Depreciates based on actual usage rather than time.

Example: A machine has a total capacity of 100,000 hours. In this year, it is used for 10,000 hours. Depreciation expense = 10% of the asset’s value.

Advantages: Accurate for equipment with measurable output

Disadvantages: Complex to account for; requires careful tracking of usage

What is Amortization (Amortization)

Amortization is a key process similar to depreciation but applied to intangible assets and loan repayments.

When referring to loans, amortization involves paying principal and interest in installments. The principal portion increases over time, while interest decreases.

Example: You have a mortgage of 1,000,000 THB. Initially, you may pay more interest and less principal, but over time, the proportion shifts.

Types of amortization

Loan amortization: Helps the borrower pay off most of the principal in each installment. Over time, interest payments decrease.

Intangible asset amortization: Businesses can spread out the costs of patents, copyrights, trademarks over their useful lives.

Example: A company purchases a patent for 10,000 THB, with a 10-year lifespan. Annual amortization = 1,000 THB.

Difference Between Depreciation and Amortization

Although both processes involve reducing the value of assets, they differ significantly:

Why Are EBIT and EBITDA Important

EBIT (Earnings Before Interest and Taxes) = Operating profit before interest and taxes

EBIT = Net income + Interest expense + Taxes

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) = EBIT + Depreciation + Amortization

EBITDA adds back depreciation and amortization because they are non-cash expenses. EBITDA is better for comparing companies because it removes the effects of asset age (and interest).

When investors compare two companies—one with many fixed assets and another with fewer—EBITDA provides a clearer picture of their earning capacity.

Summary

Understanding depreciation as an accounting system is crucial—not just for accountants but also for investors and business owners.

• Depreciation: Spreads the cost of tangible assets over their useful life, reducing income but not cash.
• Amortization: Spreads the cost of intangible assets and/or loan payments over time.
• Choosing the depreciation method affects net income and taxes.
• EBITDA helps compare companies by excluding depreciation’s impact.

Next time you analyze financial statements, pay attention to depreciation. It tells the story of how much cash the company has spent on assets and how it is trending.