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Depreciation

Kevin: In the main, large assets are bought to run and operate the company for many tax years. In accounting terms, we wish to smooth out the impact of those asset purchases across the lifetime of the asset, in other words, we lower the profit in any single year by part of the cost of the asset. This then gives a much better estimate of profitability. It also gives a better company valuation as assets would have a residual value if sold after a number of years.

Depreciation is the accounting mechanism by which the cost of an asset is deducted from profits over many years. If an asset was depreciated evenly over 20 years then each year 5% of the cost of the asset would be declared as a cost.

Aunty May: A company buys something like a machine to help it produce the goods it sells. We pretend to pay the cost of that machine over many years. Depreciation is the rate at which we pretend to be paying for the machine.