Depreciation
Depreciation is the accounting expression of entropy --- the systematic recognition that most assets lose value over time through use, age, or obsolescence.
What is it?
Almost everything you buy starts losing value the moment you acquire it. A car driven off the lot. A laptop used for a year. A machine on a factory floor. The value decline is not sudden or random --- it is gradual, predictable, and structural. Depreciation is the formal accounting process of recognising this decline over time.1
When a business buys a CHF 60,000 machine expected to last five years, it does not record a CHF 60,000 expense on day one. That would distort the picture --- the machine will generate revenue for five years, not one. Instead, the cost is spread over the machine’s useful life: CHF 12,000 per year as a depreciation expense. Each year, the machine’s recorded value (book value) on the balance sheet decreases by CHF 12,000, and CHF 12,000 appears as an expense on the income statement.1
This matters because depreciation creates a gap between profit and cash flow (see profit-vs-cash-flow). The CHF 60,000 left the bank account on day one. But the expense appears at CHF 12,000/year for five years. In year one, cash flow is CHF 60,000 worse than profit suggests. In years two through five, cash flow is CHF 12,000 better than profit suggests (the expense is recorded but no cash leaves).
Amortisation is the same concept applied to intangible assets --- patents, software licenses, intellectual property. Depreciation is for tangible assets; amortisation is for intangible ones. The mechanics are identical.
In plain terms
Depreciation is the financial system’s way of saying: things wear out, and we should account for that honestly. A machine bought five years ago is not worth what you paid. Pretending otherwise makes your balance sheet a fiction.
At a glance
How depreciation flows through the statements (click to expand)
graph TD P[Purchase<br/>CHF 60K machine] --> BS[Balance sheet<br/>asset recorded at CHF 60K] BS --> Y1[Year 1<br/>book value CHF 48K<br/>depreciation expense CHF 12K] Y1 --> Y2[Year 2<br/>book value CHF 36K] Y2 --> Y3[Year 3<br/>book value CHF 24K] Y3 --> Y4[Year 4<br/>book value CHF 12K] Y4 --> Y5[Year 5<br/>book value CHF 0<br/>fully depreciated] style P fill:#4a9ede,color:#fff style Y5 fill:#95a5a6,color:#fffKey: The cash left on day one (CHF 60K). The expense spreads over five years (CHF 12K/year). The asset’s book value declines until it reaches zero or salvage value.
How does it work?
1. Methods of depreciation
Three common methods produce different expense patterns:
Straight-line --- equal expense each year. CHF 60,000 over 5 years = CHF 12,000/year. Simple, predictable, most commonly used.
Declining balance --- higher expense in early years, declining over time. Reflects that many assets lose value fastest when new (a car loses 20% in year one, then 15%, then 10%). More aggressive but often more realistic.
Units of production --- expense tied to usage, not time. A machine that can produce 100,000 units depreciates CHF 0.60 per unit produced. Low usage = low depreciation. High usage = high depreciation. Most accurate when wear is driven by activity, not age.
| Method | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Straight-line | 12,000 | 12,000 | 12,000 | 12,000 | 12,000 |
| Declining balance (40%) | 24,000 | 14,400 | 8,640 | 5,184 | 7,776* |
| Units (20K/yr) | 12,000 | 12,000 | 12,000 | 12,000 | 12,000 |
*Adjusted in final year to reach zero book value.
2. Depreciation in personal finance
Accounting depreciation is a business concept, but the underlying reality applies to personal finance. Every consumer purchase depreciates:
| Asset | Approximate annual depreciation |
|---|---|
| New car | 15-20% in year 1, then ~10%/year |
| Electronics (laptop, phone) | 30-40%/year |
| Furniture | 5-10%/year |
| Clothing | 25-50% immediately, then gradual |
| Property (building only, not land) | 1-2%/year (but market value may rise) |
Understanding depreciation changes how you think about purchases. A CHF 1,200 phone that depreciates 35% per year costs you roughly CHF 420 in value loss in year one --- that is CHF 35/month in depreciation alone, before usage costs. A CHF 30,000 car depreciates ~CHF 5,000 in year one. These are invisible costs that never appear on your bank statement but steadily erode your net worth.
The asset concept card asked: “does this generate future economic benefit?” Depreciation is the follow-up question: “and at what rate does that benefit erode?”
Think of it like...
Every purchase has a visible price tag and an invisible countdown timer. The price tag is what you pay. The timer is how fast the value disappears. A good financial decision accounts for both.
3. What does not depreciate
Land does not depreciate (it has no useful life that expires). Certain financial assets (stocks, bonds) are not depreciated --- they are marked to market (revalued periodically to reflect current prices). Some collectibles and art appreciate rather than depreciate, though this is unpredictable.
The distinction matters for wealth building. Assets that depreciate (cars, electronics, most consumer goods) erode your net worth. Assets that appreciate or hold value (land, well-chosen investments, intellectual property with ongoing revenue) build it. The composition of your assets --- how much is depreciating vs appreciating --- determines the long-term trajectory of your equity.
Why do we use it?
Key reasons
1. Honest accounting. Without depreciation, a business could buy a CHF 1 million machine and show no expense for five years --- then record a CHF 1 million expense when it is scrapped. Depreciation spreads the cost to match the periods that benefit from the asset. 2. Tax efficiency. Depreciation expense reduces taxable profit. Governments allow businesses to depreciate assets precisely because it reflects real economic decay. 3. Replacement planning. Depreciation is a reminder that assets must eventually be replaced. A fully depreciated machine is a machine that needs its successor.
When do we use it?
- Business accounting: recording the annual cost of long-term assets
- Tax filing: deducting depreciation expense from taxable income
- Investment analysis: adding depreciation back to profit to estimate operating cash flow (since depreciation is a non-cash expense)
- Personal finance: understanding the true cost of ownership of depreciating assets (cars, electronics)
Rule of thumb
When buying anything expensive, estimate the annual depreciation as a percentage of the purchase price. If the depreciation cost per month exceeds your comfort threshold, the item is more expensive than its price tag suggests.
How can I think about it?
Analogy: the melting ice sculpture
An asset is an ice sculpture. Beautiful, valuable, and slowly melting. Depreciation is the drip rate. Some sculptures melt fast (a car on the lot). Some melt slowly (a well-maintained building). A few, placed in the right conditions, do not melt at all (land, well-chosen investments). Knowing the drip rate before you buy changes what you are willing to pay.
Concepts to explore next
| Concept | Status | What it adds |
|---|---|---|
| asset | complete | The broader category --- depreciation is a property of assets |
| time-value-of-money | complete | Why value decays across time, and the discount rate that governs it |
| financial-statements | complete | Where depreciation appears (income statement as expense, balance sheet as reduced book value) |
| cost-structure | stub | How depreciation fits into a business’s expense architecture |
Check your understanding
Five questions (click to expand)
- Explain why depreciation creates a gap between profit and cash flow. In which direction does the gap go in year one of a major purchase vs later years?
- Compare straight-line and declining balance depreciation. When is each method more realistic?
- Calculate the approximate monthly depreciation cost of a CHF 2,000 laptop that depreciates 35% per year. Does this change how you think about the purchase?
- Distinguish between assets that depreciate and assets that do not. Why does this distinction matter for wealth building?
- Connect depreciation to the concept of equity. How does buying depreciating assets affect your net worth trajectory compared to buying appreciating assets?
Where this concept fits
Where this concept fits
graph TD A[Asset] --> DEP[Depreciation] TVM[Time Value of Money] --> DEP DEP --> FS[Financial Statements] DEP --> CS[Cost Structure] DEP -.-> PvC[Profit vs Cash Flow] style DEP fill:#4a9ede,color:#fff
- Prerequisites: asset (what depreciates), time-value-of-money (why value decays across time)
- Leads to: financial-statements, cost-structure; reinforces profit-vs-cash-flow