What is... | July 31, 2018

What is depreciation?

Whether shopping for a car or a computer, it’s hard to tell whether the purchase is worth its price longer term.


Few items are valued more highly at the end of their lives than when they’re new. Exceptions are goods that can appreciate in value, such as rare items like certain antiques or works of art. In general, however, the products we buy are worth less every year.

Most things show signs of age and degradation over time, and their financial value shrinks as well. Others are quickly outmoded as new technologies are developed, becoming commercially obsolete or simply unable to keep up with the performance of newer items – like last year’s mobile phone or computer with its fading battery life. If you wanted to resell these items, you would normally expect to get a lot less than what you originally paid.

So far, so obvious
It’s easy to ignore depreciation, as it’s effectively invisible when you’re in the process of purchasing an item. But if you want to grow or at least maintain your wealth, this loss of value – what accountants call depreciation – is worth understanding.

Working out how the value over time of an item such as a car, a computer or even a home will decline can help you make the best use of what you have. Calculating depreciation can suggest how long to keep an item before upgrading, while smoothing out the record on costs and expenses. Sometimes, documenting depreciation can give a tax advantage, subsidy or other benefit.

In accounting language, depreciation can be defined as the transfer of part of an asset’s cost from the balance sheet to the income statement, a process which is typically divided by each year of the asset’s useful life.

If running a business, buildings, machinery, equipment, furniture, and other reasonably “big-ticket” items can all be assessed for depreciation, with a portion of the asset’s original cost listed as an expense in each reporting period.

A healthy fear of depreciation can help you delay purchases – especially when it comes to evolving technologies. Keeping up with the Joneses can be both expensive and pointless.

Working it all out
There are different ways to calculate depreciation. One of the simplest is “straight-line depreciation”. Say a company buys a car for €10,500; the car is estimated as having a useful life of about 10 years, after which it could be sold for a few hundred euros for scrap. Subtracting €500 from the original purchase price leaves €10,000, which must be accounted for over the 10 year life of the vehicle – meaning it will depreciate at around €1,000 per annum.

Every year for 10 years, the owner might list a depreciation expense of €1,000 for the purchase of the car when doing the accounts. This spreads the effect of buying the car over annual net income, writing the expense off during those 10 years.

Other methods for calculating depreciation include accumulated depreciation, salvage value, double-declining balance depreciation or accelerated depreciation.

Currencies and real estate can also be said to depreciate. Sometimes the term refers in a straightforward way to a loss of market value – for instance, when the price of buying a currency (or a property) falls.

Stop and think
The high price of an item can anchor our view of its value – convincing us to think it is worth “investing” in. But if it depreciates rapidly, the value over time may be far less.

Consider instead how long it originally took to save the amount of money to purchase the item. Our time continues to “cost” us the same. That high-priced “valuable” item, conversely, may not provide such a good return as we assume. It may not, in reality, be a good use of our time.

And what about maintenance spending, such as on a home or car? How far you intend to drive a car has an effect on value, and therefore, depreciation. These factors all go hand-in-hand; what is the cost of any repairs necessary to maintain the value?

Slower spending
In other words, you’re often better off with a secondhand vehicle that will depreciate less – even if it has a few scratches and dents. Think about gadgets like smartphones. Often worth hundreds of euros when new, in several months’ time they’re obsolete with a resale value a fraction of that. They’re worth even less 18 months later when the battery starts to fail.

Owning the phone on a contract can obscure this fact, by breaking the cost down into monthly instalments over time.

A healthy fear of depreciation can help you delay purchases – especially when it comes to evolving technologies. Keeping up with the Joneses can be both expensive and pointless. Next time you’re smitten by a “valuable” item, take a step back and think about depreciation.

Will it be worth it – to you – in a few years’ time?

SpendingShoppingBiasTax

eZonomics team
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