The easiest way to think of depreciation is as accountants spreading the cost of an asset over its life. For example, if we bought an asset for 50 and we thought it would last for 10 years, on a straight line basis the depreciation expense would be 5 per year.
Depreciation is a non cash cost
The depreciation expense would appear on the profit and loss statement, but it’s not a cash cost. The cash flow statement would show a 50 drain under “capital expenditure”.
The balance sheet would show a reduction in cash of 50 (cash assets would reduce by 50) matched by an increase in fixed assets of 50 (one asset would have been converted into another). Retained earnings would drop by the depreciation expense, as would the value of fixed assets. A drop in net assets/ shareholders’ funds would be matched by a drop in the value of assets. The balance sheet would say balanced.
Depreciation vs. amortisation
The easiest way to think of amortisation is as depreciation for intangible assets. An example of an intangible asset is goodwill. If an acquiring business purchased a target company, and paid an excess over the target’s net assets, the excess would be shown as goodwill on the acquirer’s balance sheet. Instead of purchasing fixed assets, the acquirer has purchased goodwill. Amortisation is like depreciation on intangible assets – it spreads their cost over time.