Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity

CHAPTER 3

Depreciation Schedule

Depreciation is accounting for the aging of assets.

Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.

 Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable.

—from IRS.gov

So, in other words, as a company owns and utilizes an asset, its value will most likely decrease. We haven’t discussed the balance sheet yet, but if an asset value reduces, there must be another change to one of the other line items in the balance sheet to offset the asset reduction. Accounting rules state that the reduction in asset value can be expensed, with the idea being that the asset’s aging or “wear and tear” was partly to do with utilization of the asset to produce or generate revenue. If the item is expensed, net income is reduced, which in turn will reduce the retained earnings in the shareholders’ equity section of the balance sheet. We will learn about how net income affects retained earnings in Chapter 5.

Let’s take an example of an asset that has a depreciation expense of $5, 000. Depreciation expense reduces net income after taxes, as per the following example. Net income drives the cash flow statement, but since depreciation ...