Depreciation: How Asset Costs Flow Through the Financial Statements
A manufacturing company buys a $1,000,000 machine that will last five years. One depreciation method charges $400,000 to the income statement in Year 1. Another charges $200,000. Depreciation spreads an asset's cost over its useful life, and the method determines how much expense hits each year.
Key takeaway: Depreciation allocates an asset's cost over its useful life. The total expense is the same regardless of method. What changes is the timing, and that timing difference affects taxes and cash flow.
The Asset
Here is the equipment the company purchased:
| Amount | |
|---|---|
| Equipment Cost | $1,000,000 |
| Useful Life | 5 years |
| Salvage Value | $0 |
The company pays $1,000,000 in cash on Day 1. That cash outflow is a capital expenditure. Depreciation determines how the cost flows through the income statement over the next five years.
Straight-Line Depreciation
Straight-line distributes the cost evenly across each year:
Annual Depreciation = (Cost - Salvage Value) / Useful Life
Annual Depreciation = ($1,000,000 - $0) / 5 = $200,000
| Year | Depreciation | Book Value |
|---|---|---|
| 0 | $1,000,000 | |
| 1 | $200,000 | $800,000 |
| 2 | $200,000 | $600,000 |
| 3 | $200,000 | $400,000 |
| 4 | $200,000 | $200,000 |
| 5 | $200,000 | $0 |
The income statement records $200,000 in depreciation expense each year. The balance sheet shows the asset's book value declining by the same amount. After five years, the asset is fully depreciated.
Straight-line is the most common method in financial reporting because the even expense stream makes earnings predictable across periods.
Double-Declining Balance
Double-declining balance (DDB) front-loads the expense. The depreciation rate is double the straight-line rate, applied to the remaining book value each year:
DDB Rate = (1 / Useful Life) x 2 = (1/5) x 2 = 40%
| Year | Book Value (Start) | Rate | Depreciation | Book Value (End) |
|---|---|---|---|---|
| 1 | $1,000,000 | 40% | $400,000 | $600,000 |
| 2 | $600,000 | 40% | $240,000 | $360,000 |
| 3 | $360,000 | 40% | $144,000 | $216,000 |
| 4 | $216,000 | SL | $108,000 | $108,000 |
| 5 | $108,000 | SL | $108,000 | $0 |
Year 1 charges $400,000, twice the straight-line amount. Each subsequent year charges less because the rate applies to a shrinking book value.
Starting in Year 4, straight-line over the remaining life ($216,000 / 2 = $108,000 per year) exceeds what DDB would produce ($216,000 x 40% = $86,400), so the company switches. This is standard practice: companies using DDB switch to straight-line once it gives the larger annual deduction.
Total depreciation over five years is $1,000,000, the same as straight-line. Only the timing differs. DDB charges 64% of the total ($640,000) in the first two years versus 40% ($400,000) under straight-line.
Side by Side
| Year | Straight-Line | DDB |
|---|---|---|
| 1 | $200,000 | $400,000 |
| 2 | $200,000 | $240,000 |
| 3 | $200,000 | $144,000 |
| 4 | $200,000 | $108,000 |
| 5 | $200,000 | $108,000 |
| Total | $1,000,000 | $1,000,000 |
In the early years, DDB charges significantly more. By Years 4 and 5, the pattern reverses. A company choosing between the two is deciding when to recognize the expense, not how much.
How Depreciation Hits the Income Statement
Depreciation reduces EBIT and net income. Here is Year 1 under both methods, holding all other line items constant.
The company earns $2,000,000 in revenue with $1,200,000 in other operating expenses (excluding depreciation). The tax rate is 25%.
Straight-Line (Year 1):
Revenue: $2,000,000
Other Operating Exp: $1,200,000
Depreciation: $200,000
EBIT: $600,000
Tax (25%): $150,000
Net Income: $450,000
DDB (Year 1):
Revenue: $2,000,000
Other Operating Exp: $1,200,000
Depreciation: $400,000
EBIT: $400,000
Tax (25%): $100,000
Net Income: $300,000
| Straight-Line | DDB | Difference | |
|---|---|---|---|
| Depreciation | $200,000 | $400,000 | +$200,000 |
| EBIT | $600,000 | $400,000 | -$200,000 |
| Tax | $150,000 | $100,000 | -$50,000 |
| Net Income | $450,000 | $300,000 | -$150,000 |
DDB reports $150,000 less in net income. On paper, the company looks less profitable. But the cash tells a different story.
The Tax Shield
The company pays $50,000 less in taxes under DDB in Year 1:
Tax Savings = Additional Depreciation x Tax Rate
Tax Savings = $200,000 x 25% = $50,000
That $50,000 is real cash saved. Depreciation is a non-cash expense, so the lower net income figure doesn't mean less cash. Adding depreciation back to net income shows the actual cash generated from operations:
SL: $450,000 + $200,000 = $650,000
DDB: $300,000 + $400,000 = $700,000
DDB produces $50,000 more in operating cash flow. The extra depreciation expense reduces the tax bill, and taxes are paid in cash.
Over five years, total depreciation is the same under both methods, so total taxes are the same too. The benefit of DDB is timing. Getting $50,000 in tax savings in Year 1 instead of spreading it across five years is worth more because of the time value of money. At a 10% discount rate, the present value advantage of DDB's tax savings over straight-line is roughly $13,000 on a $1,000,000 asset. On a $100M manufacturing facility, that same effect scales to over a million dollars.
EBITDA and Depreciation
EBITDA strips depreciation out entirely by adding it back to EBIT:
EBITDA = EBIT + Depreciation
SL: $600,000 + $200,000 = $800,000
DDB: $400,000 + $400,000 = $800,000
Both methods produce the same $800,000 in EBITDA. This is one reason analysts prefer EBITDA for comparisons: it removes the effect of depreciation method choices, asset age, and accounting policies. Two companies with identical operations will report different EBIT figures if one uses straight-line and the other uses DDB, but their EBITDA will match.
Why Depreciation Matters
Depreciation applies across several areas of corporate finance:
- Free cash flow: The FCF formula adds back depreciation because it's non-cash, then subtracts actual capital expenditures. The gap between D&A and CapEx reveals whether a company invests more or less than its existing assets wear down.
- Valuation models: DCF projections need a depreciation forecast. Analysts typically project D&A as a percentage of revenue or as a ratio to CapEx, anchored to the company's asset base and historical accounting policies.
- Tax planning: Accelerated methods front-load tax deductions, improving near-term cash flow. Governments sometimes offer bonus depreciation rules to encourage capital investment.
- Earnings quality: A company with D&A well below CapEx is replacing and expanding its asset base. A company where D&A exceeds CapEx for several years may be underinvesting, running on aging equipment that will eventually need replacement.
Conclusion
Depreciation spreads an asset's cost across its useful life. Straight-line distributes the expense evenly, while double-declining balance front-loads it for higher early tax savings at the cost of lower reported earnings. The total is the same either way; only the timing changes.
For how depreciation feeds into the cash flow metric that drives valuation, see our guide on free cash flow. For the valuation framework built on those cash flows, see our guide on DCF valuation. For how D&A flows through an acquisition model, see our guide on LBO analysis.
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