Depreciation is an accounting concept that describes the systematic allocation of an asset’s value over the period in which the asset is expected to be used in the business. The purpose is to show how the value of a fixed asset - for example machinery, buildings, cars, or IT equipment - is gradually consumed as the asset is used and wears out.
Why do you use depreciation?
Depreciation ensures the accounts present a true and fair view of the company’s finances. Instead of expensing the full purchase price of an asset at once, the cost is spread over its expected useful life. This matches the cost with the income the asset helps generate.
Methods of depreciation
- Straight-line depreciation - the asset’s value is depreciated by a fixed amount each year.
- Declining balance method – a fixed percentage is depreciated from the remaining value, resulting in higher depreciation at the start and lower later on.
- Units of production method - depreciation is calculated based on the asset’s actual use, e.g. number of units produced or operating hours.
Example
If a company buys a machine for DKK 100,000 with an expected useful life of 10 years, straight-line depreciation could be DKK 10,000 per year. This way, the machine’s book value is reduced over time until it reaches 0 or any residual value.
Impact on accounts and tax
Depreciation affects the profit and loss statement as an expense and therefore reduces the year’s profit. At the same time, tax rules determine how much and how different types of assets may be depreciated. These rules can differ from accounting methods and therefore create differences between accounts and tax.
Brief summary
Depreciation is a way of spreading the cost of an asset over several years so the accounts reflect both the asset’s use and the company’s true financial position. It is a core element of the annual report and in assessing a company’s profitability and solvency.