Depreciaton of an Investment
What is an Investment?
Before we can talk about depreciation, it is important to understand what an investment is. An investment refers to the purchase of an asset or object that is expected to provide long-term benefits. For example, this could be a machine, a vehicle or a building. Companies and individuals make investments to create value, make a profit or support their operations.
In the Netherlands, a threshold amount of €450 (excl. VAT) is generally used to determine whether a purchase of an asset is considered an investment. This threshold amount refers to the net book value of the asset, which is the amount after deduction of any subsidies, rebates, and excluding VAT.
If the net book value of an asset equals or exceeds €450 (excl. VAT), it is considered an investment and may be eligible for depreciation.
What is the Depreciation of an Investment?
Depreciation is the process of gradually reducing the value of an investment over the life of the asset. This is done to account for wear and tear, obsolescence and technological changes that occur during the use of the asset. In other words, depreciation recognises that the value of an investment decreases over time. After an investment is depreciated, it may still have a residual value.
The residual value of an investment is the estimated value at the end of the life expectancy of the investment, so after it has been fully depreciated. The residual value shows what a company can be expected to receive when selling or disposing of the investment. The residual value can be important when calculating the depreciation cost per year, because in principle the residual value does have to be taken into account.
Why is an Investment Depreciated?
There are several reasons why companies choose to depreciate investments:
Accurate representation of value: Writing off the investment allows a company to record the true value of the assets on its books. It shows the real-time value of the assets as time passes.
Spreading costs: Investments often require a large initial outlay. By spreading costs over time, companies can better manage the financial impact.
Tax benefits: Depreciation can provide fiscal benefits for companies. By factoring in the depreciation of an investment, companies can reduce their taxable profits, potentially reducing their tax liability.
How does Depreciation work?
There are several methods of calculating depreciation. The most common method is the straight-line depreciation method. This method distributes the cost of the investment evenly over the expected life of the asset.
For example, a company who buys a machine for €20,000 with a life expectancy of 5 years. Using the straight-line depreciation method, the depreciation per year is calculated as follows:
In the table above, you can see how the initial value is reduced to the end value by means of a depreciation. The initial value is the value of your investment at the beginning of the (financial) year. The depreciation costs are calculated based on the initial value, resulting in a final value of €0 after a depreciation period of 5 years. The end value is the value of the investment at the end of the (financial) year, but also the value at the beginning of the following year.
You can see that the depreciation costs are €4.000 each year, which is 20% of the original initial value. After 5 years, the value of the machine investment has decreased by depreciating 20% of the initial value each year. After 5 years, the investment has been fully depreciated, reaching €0, which means the investment has been completely written off.
Can you Depreciate an Investment over the Whole Year?
Officially, you may only depreciate an investment for the part of the year the investment is in use. For example, if you bought your investment of €20,000 on 1 July, you are only allowed to depreciate this investment for €4,000 x (6 / 12) = €2,000 in that year.
This way, the value of an investment can also be gradually reduced until the residual value of the investment is reached and the end value remains the same as the residual value at the end of the depreciation period.
It is important to note that other depreciation methods also exist, such as accelerated depreciation (where higher depreciation costs are allowed in the first few years) and random depreciation. However, these methods are not covered in this wiki article.