Imagine you own an apple farm and you buy a \$50,000 tractor today.

It's a red tractor with stripes -- so you know it's cool.

Apples To Apples, Not Apples to Tractors

If you, the best apple farmer in all the lands, sold \$100,000 of apples (revenue) and you paid \$20,000 for fertiliser (cost), you would be left with \$80,000 in gross profit.

That's how you 'account' for costs that your business uses up everyday day, week or year.

But a tractor is not a Cost Of Doing Business (or "COGS" for short) because the tractor will be used for many years -- not in one day like the fertiliser was.

Let's imagine the tractor has a 'useful farm life' of 5 years.

After that, it will be put in the yard to rust.

Meaning, the tractor is an 'investment' in the farm over many years.

### How Is The Tractor Reported On The Balance Sheet?

If you want to geek out, your new tractor is recorded as a \$50,000 Asset under the "property, plant and equipment" (PPE) account on the farm's Balance Sheet.

## Introducing Depreciation

Because your cool, red, stripey, apple-making tractor will be used over 5 years we need to introduce a new yearly "cost" called depreciation.

Remember how we said your tractor cost you \$50,000 upfront?

Well if you're going to use it for 5 years, it's going to "cost" the business the equivalent of \$10,000 per year.

That is, \$50,000 (the upfront cost) / 5 years (useful life) = \$10,000 per year (depreciation).

The \$10,000 of depreciation is your new yearly cost for the business.

Each year, you'll incur a cost of \$10,000 for Depreciation (which can be shown on the Income Statement) and the value of the tractor on the Balance Sheet is reduced by \$10,000. That is, the depreciation reduces the value of the tractor from the year before.

By the sixth year (five years from today), your tractor has a "Carrying Value" of \$0 (this is sometimes called the "salvage value"). Look at this chart:

### Straight Line Vs. Accelerated Depreciation

The example we just used is called "straight line depreciation" because the yearly cost of depreciation is flat (like a line). Look again at the chart above.

We can also do something called "accelerated depreciation". Commonly, some businesses will depreciate the value of an asset (e.g. a tractor) quicker in the first few years.

For example, "double declining balance method" doubles the cost of depreciation in the first year.

In our example, the tractor's depreciation 'cost' was 20% of the purchase price. That is, \$10,000 / \$50,000 = 20% of the upfront value is depreciated each year.

Using the double-declining method, we can double the percentage of depreciation to 40% (\$20,000 of depreciation in the first year).

Then, we use 40% of the previous year's 'carrying value' until we get to the final year (year 5 in our example). At that point, we can use the straight-line method to take the 'carrying value' to zero (or the salvage value). Like this: