How is depreciation calculated? Made easier to understand with real-life examples

When a company purchases machinery or vehicles for use, that asset will lose value over time. Accountants must record this loss in the books. This process is called depreciation(Depreciation), which is a key process in financial management.

What is Depreciation?

Depreciation (Depreciation) refers to the reduction in the value of a company’s asset over time. Accountants record this as an expense in the financial statements, which decreases the company’s profit but does not involve actual cash outflow.

This concept is divided into two main points:

First, the value of the asset naturally decreases: machinery becomes old, computers slow down, cars wear out.

Second, it spreads the cost of expensive assets over multiple years. For example, if a company buys machinery for 500,000 baht, instead of deducting the entire cost in the first year, it is spread over several years.

Fixed Cost vs. Variable Cost

When calculating depreciation using the straight-line method (equal amounts each year), the cost remains fixed each year. If other methods that change with usage are used, then the costs are variable.

Depreciation is included in the calculation of EBIT (Earnings Before Interest and Taxes), affecting how companies with many or few fixed assets appear in terms of profit.

EBIT vs. EBITDA: Key Differences

EBIT (Earnings Before Interest and Taxes) = profit after deducting all costs but before interest and taxes. Companies with high debt will have high interest expenses. EBIT helps eliminate this issue.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) = profit excluding depreciation and amortization, which are added back.

This difference is important when comparing two companies: if one has many fixed assets and the other has none, EBIT provides a more accurate picture than EBITDA.

Which Assets Are Subject to Depreciation?

Assets that can be depreciated must meet these conditions:

• Owned by the company, not leased
• Used in business operations or revenue generation
• Have a definite useful life, e.g., computers around 5 years
• Expected to be used for more than 1 year

Examples of depreciable assets:

• Vehicles and locomotives
• Buildings and structures
• Furniture and office equipment
• Machinery and factory equipment
• Software, patents, copyrights (Intangible Assets)

Non-depreciable assets include: land, collectibles (art, coins), investments (stocks, bonds), personal property

Four Methods of Calculating Depreciation

1. Straight-line method (Straight-line)

The simplest and most popular method, dividing the asset’s value equally over each year.

Example: Buying a car for 100,000 baht with a 5-year lifespan → depreciation of 20,000 baht/year.

Advantages: Simple, few errors, suitable for small businesses.

Disadvantages: Does not account for the fact that older assets may lose value faster in the first year; maintenance costs increase as assets age.

2. Double-declining balance (Double the rate)

Calculates higher depreciation in the first year, then gradually decreases. Suitable for businesses wanting to recover costs quickly.

Advantages: High tax deductions in the first year, offsets increased maintenance costs.

Disadvantages: Less beneficial if the company is operating at a loss.

3. Declining balance (Declining multiple)

An accelerated method, with depreciation calculated as twice the straight-line rate.

Results in high expenses in the first year, then decreasing in subsequent years. Useful for comparison with straight-line.

4. Units of production (Based on usage)

Depreciates according to the asset’s actual usage, such as hours operated, cycles, or units produced.

Example: Machinery expected to operate 100,000 hours, costing 100,000 baht → 1 hour = 1 baht.

Advantages: Accurate based on actual usage.

Disadvantages: Difficult to implement, as it requires tracking actual usage.

What is Amortization?

Amortization is the process of reducing the value of intangible assets (such as patents, copyrights) or loan repayments made periodically.

When a company borrows money, monthly payments are split into two parts: interest and principal. In the first month, the principal is small, and interest is high. Over time, this ratio changes.

( Example of amortization:

Example 1 - Intangible Asset: Patent for machinery, costing 10,000 baht, lifespan 10 years → amortization of 1,000 baht/year.

Example 2 - Loan: Borrowed 10,000 baht, repaying 2,000 baht principal/year → amortization of 2,000 baht.

Loan Amortization

When repaying a loan, the interest portion is higher initially and decreases over time, while the principal repayment increases. The goal is to fully repay the loan by the due date. The total monthly payment remains the same, but the composition )interest vs. principal### changes over time.

Amortization of Intangible Assets

Companies spread the expense of intangible assets over their useful life. This method links costs with the revenue generated from using the asset.

Examples of intangible assets: trademarks, patents, copyrights, software.

Difference Between Depreciation and Amortization: What Are They?

Summary

Depreciation and Amortization are fundamental concepts in financial management. Understanding how they are calculated helps accurately analyze a company’s financial position, whether for investment or future income planning. For managers or investors, learning how depreciation is calculated improves financial decision-making.