EFA (6): Depreciation

Personally, we all like appreciation. But another form of appreciation plays a key role in the world of economics. So does depreciation, the subject of the sixth item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

Depreciation has two main meanings in economics:

In this case, depreciation refers to a fall in the value of a currency. In particular, the word is used to talk about falls in floating exchange rates — those that vary each day according to the balance of supply and demand on the foreign exchange market. When a country's currency depreciates, its exports become cheaper (and it imports more expensive) in terms of other currencies. An upward movement of a floating exchange rate is an appreciation, which makes exports more expensive and imports cheaper.

Such currency depreciation is also sometimes referred to as currency devaluation, although strictly speaking this refers to a one-off reduction in a fixed exchange rate. For example, in 1967, the British pound was devalued from a fixed rate of $2.80 to a new fixed rate $2.40. The opposite of a currency devaluation is a revaluation.

2. Fixed asset depreciation

For companies, depreciation is the fall in the value of fixed assets (buildings, machines, etc.) over time, for example through wear and tear or obsolescence. Companies include a provision for this depreciation in their costs, which reduces their profits and the taxes they have to pay.

Normally, companies write off their fixed assets over a number of years. For example, if an asset costs $100,000, and is fully written off over five years using the "straight-line method", the depreciation would be $20,000 a year.

Governments sometimes try to encourage capital investment by allowing companies to write off larger proportions (or all) of their capital investments in the first year or two. This is called accelerated depreciation.

One special form of depreciation is amortization. This is the writing off of goodwill. Goodwill arises when one company buys another and pays more than the value of its tangible assets. This extra amount is goodwill — representing, for example, the value of the second company's customers — and it is normally written off over a number of years.