Economic Depreciation

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What Is An Economic Depreciation?

Economic depreciation refers to the gradual decrease in the market value of a commodity over time due to economic factors. When it comes to selling an asset, economic depreciation may be more important than accounting depreciation.

Accountants typically employ book value as the main reporting approach, which pays little attention to corporate accounting. Several key financial studies can be used to examine its nature.

Accountants often prioritize book value in reporting, meaning economic depreciation is less emphasized in corporate accounting for large capital assets.

As a result, depreciation is often called 'fixed capital consumption.' Calculating 'net value' instead of 'total value' involves subtracting depreciation from the overall value of an asset.

Key Takeaways

Economic depreciation signifies the gradual decline in an asset's market value due to economic factors crucial in asset valuation and sales.
While accounting depreciation focuses on book value, economic depreciation is pivotal for asset owners as it directly influences market sale value and profitability.
Economic depreciation is analyzed across various sectors, with real estate being a common example, offering insights into future earnings and market dynamics.
Depreciation contributes to a decrease in capital value within the economy, reflected by subtracting it from the total value to calculate the net value.

How Economic Depreciation Works

Depreciation is the decrease in the value of an asset due to factors affecting its market worth in the economy. This is especially important when selling things in open markets.

Owners of assets tend to focus on economic depreciation rather than accounting depreciation when selling them.

The asset owner may pay attention to it because it has an impact on the asset's market sale value, which directly impacts the profitability of the asset owner when selling the asset.

Financial studies analyze depreciation under various conditions, which is crucial for understanding its implications. However, analysts may specifically utilize it in different scenarios. The real estate business is one of the most common examples in life.

Economic depreciation mostly has a role in forecasting future earnings from goods and services. Since accountants primarily use book value for reporting, economic depreciation is often not reflected in the financial statements of large capital assets.

Recording Economic Depreciation in National Accounts

Depreciation is primarily the decrease in the value of assets over time, contributing to a decline in capital value within the economy. When calculating the 'net' value instead of the 'total' value, depreciation is accounted for by subtracting it from the total value of the variable.

For example, depreciation is subtracted from the total gross domestic product (GDP) to determine net GDP.

Causes of Economic Depreciation

Various causes of economic depreciation are

Wear and tear: Wear and tear over time are mostly unavoidable. Frequent use with certainty causes damage to goods that have been utilized for a long period. For example, after a period of use, a company's machinery and equipment may begin to fail, become slower, and eventually be scrapped because of depreciation caused by machine wear and tear.
Obsolescence: Existing technologies often become obsolete due to rapid advancements, replaced by more efficient alternatives. As a result, the value of obsolete technology or assets depreciates. Mobile maps, for example, are becoming increasingly capable of navigating, rendering standalone GPS devices obsolete.
Perishability: It refers to raw materials and inventory having an expiration date, meaning they should be used within a specific timeframe to prevent depreciation of their value.
Expiration of rights: It refers to intangible assets, such as software licenses, patents, trademarks, and other intellectual property, which are only valid for a limited duration. Before the rights expire, intangible assets must be depreciated.

Note

Amortization is the term for the depreciation of intangible assets. Intangible assets are amortized over time, so when the rights expire, their value becomes zero.

Calculating Economic Depreciation

There are two methods of measuring depreciation.

1. The value of the items produced by the asset

The depreciation of machinery or equipment can be calculated using the value of the items the asset produces. For example, if a machine can produce 10 units of a good per day at $5 each, the total value of the goods produced is $50 at first.

When the machine depreciates, it can only produce 5 pieces of a good per day at $5 each. The total worth of the goods is $25 at this point. Here, depreciation is $25.

2. By resale value

The decrease in resale value, or the price at which you mostly sell an object to someone else, can also be used to determine depreciation. It is calculated by subtracting the asset's initial cost from its resale value.

Let's say you paid $100 for some gadget and plan to sell it for $60 now. The depreciation would be $40, calculated as the difference between the initial cost and the resale value.

Economic Depreciation vs. Accounting Depreciation vs. Tax Depreciation

Let's understand the difference in the table below:

Economic Depreciation vs. Accounting Depreciation vs. Tax Depreciation
Aspect	Economic Depreciation	Accounting Depreciation	Tax Depreciation
Definition	The decrease in the value of an asset over time due to wear and tear, obsolescence, or other factors that affect its usefulness and ability to generate income.	The allocation of the cost of an asset over its useful life for reporting purposes in financial statements.	The method used by tax authorities to allow businesses to deduct the cost of purchasing assets over time for tax purposes.
Purpose	Reflects the true economic loss in value of an asset.	Provides a systematic way to allocate the cost of an asset over its useful life to match revenue generation.	Allows businesses to recover the cost of acquiring assets for tax purposes, thereby reducing taxable income.
Calculation	Based on economic factors affecting the asset's value, such as wear and tear, technological advancements, market demand, etc.	Typically follows accounting standards (e.g., straight-line, declining balance) and is influenced by management's judgment and industry practices.	Governed by tax laws and regulations, which may offer various depreciation methods and recovery periods (e.g., MACRS in the U.S.).
Timing	Reflects the actual decline in asset value over time.	Spread evenly over the asset's useful life, providing a systematic approach for financial reporting purposes.	May differ from accounting depreciation due to specific tax regulations and incentives. Can accelerate or defer depreciation deductions based on tax rules.
Impact on Financial Statements	Not directly used in financial statements but may influence business decisions and valuation.	Recorded in financial statements to match expenses with revenue and determine the book value of assets.	Affects taxable income and cash flow, thus influencing tax liabilities and financial performance reported to tax authorities.
Flexibility	Flexible and can be adjusted based on economic conditions or asset usage changes.	Subject to accounting standards and policies but may offer some flexibility in choosing depreciation methods and useful life estimates.	Governed by tax laws and regulations, which may change over time and influence depreciation methods and rates.

Valuing Assets

Economic depreciation is a risk that all sorts of assets face. Companies and investors must study and track the repercussions in diverse ways to avoid losses as much as possible.

The impact on the market value of a company's tangible assets may not necessarily be a concern. On the other hand, companies and investors are primarily concerned about the market impacts on highly liquid assets such as stocks, bonds, and money market accounts.

Because depreciation has a higher impact on a company's overall performance, companies and investors pay special attention to it. Liquidity can also be a factor in determining economic depreciation for asset owners.

Depreciation and Profits

Depreciation costs may directly impact a company's profit and income statement. The larger a company's statutory profit, the greater the annual depreciation, which is quite significant.

Conversely, if a company's depreciation expenses are low in a given year, it represents a significant increase in profit. Depreciation is a non-cash expense that has little impact on a company's cash flow.

Economic Depreciation FAQs

What is depreciation in the economy?

In economics, depreciation is an asset's value loss due to variables that particularly affect its market value.

What are the economic factors that cause depreciation?

Some of the factors are:

Wear and tear is a significant factor in depreciation, as assets degrade over time with repeated use, decreasing their value.
That second one is, in particular, the idea of obsolescence. Rapid technical advancements have rendered outdated and replaced earlier technology with more effective ones. Depreciation occurs when technology assets become obsolete due to rapid advancements, decreasing their value.
Perishability is another factor contributing to depreciation. Products and raw materials have a limited shelf life, and their value decreases if not utilized within that timeframe.
The fourth depreciation category involves expiring rights, such as software licenses, patents, and trademarks.
Software licenses, patents, licenses, trademarks, and other forms of intellectual property are intangible assets with a limited shelf life. Intangible assets must be depreciated before their use-by date.
The depreciation of intangible assets is referred to as 'amortization.' As intangible assets are amortized over their useful life, their value gradually decreases until it reaches zero when the rights expire.

What is the purpose of depreciation?

The reasonable goal of depreciation is to match the cost of a productive asset with a longer useful life to the revenues generated by employing the asset.