Depreciation
Depreciation is the accounting allocation of the cost of a tangible asset — equipment, vehicles, buildings, hardware — over its useful life, so that each year's profit bears a share of the investment that produced it rather than the whole cost in the year of purchase; amortisation is the same for intangible assets — software, licences, and the intangibles a buyer records after an acquisition. It is a non-cash expense, which is why EBITDA adds it back.
- Also known as
- Amortisation, Depreciation and amortisation, D&A, Capital allowances
- Used at
- every set of accounts with fixed or intangible assets; in fintech, the amortisation of capitalised software development is often the largest item, and after an acquisition the amortisation of acquired intangibles (customer relationships, technology, brand) can turn an acquired business's accounting profit negative for years
- Binding
- IFRS (IAS 16 for tangible assets, IAS 38 for intangibles, IFRS 3 for acquired intangibles) and US GAAP (ASC 350, 360, 805); tax law sets separate rules — capital allowances in the UK, MACRS in the US — so tax depreciation and book depreciation differ, and the difference creates deferred tax
- Typical methods
- straight-line (equal amounts each year; the default), reducing balance (more early), units of production; useful lives from three years for computer hardware and software to decades for buildings; goodwill is not amortised under IFRS or US GAAP but tested for impairment
- Typical deal effects
- EBITDA excludes it, so a company that capitalises development shows higher EBITDA than one that expenses it (and the buyer's quality-of-earnings review normalises); purchase-price allocation creates new amortisation in the buyer's accounts; tax-deductible amortisation of acquired intangibles (in an asset deal, or in some jurisdictions in a share deal) has a value the buyer prices
- Parties
- the finance team that sets policies, the auditors who test useful lives and impairment, the buyer's accountants who read the capitalisation policy, and the tax advisers who structure for the deductions
How depreciation works in practice
A payments company buys €3 million of servers with a four-year life. Straight-line depreciation charges €750,000 a year to the income statement; the cash left in year one. EBITDA ignores the charge; operating profit includes it; free cash flow includes the €3 million in year one and nothing after. The same company spends €4 million a year on engineers building its platform and capitalises €2.5 million of it as development cost under IAS 38, amortised over five years: the income statement bears €500,000 of amortisation per year's cohort instead of €2.5 million of salary, and EBITDA is €2.5 million higher than it would be with everything expensed. Both treatments are permitted; the buyer's job is to see through them.
In a deal, depreciation and amortisation move in three places. The seller's EBITDA is normalised for capitalisation policy: a buyer that would expense the development sees a lower EBITDA and prices on it. Purchase-price allocation then records the acquired customer relationships, technology and brand as intangibles at fair value, amortised over their lives — often €10–30 million a year on a €100 million deal — which reduces the buyer's reported profit without touching cash, and is why acquisitive companies report "adjusted" earnings excluding it. And tax: where the amortisation of acquired intangibles is deductible, it shelters the buyer's profits, and the value of that shelter (often 5–15% of the price) is part of the buyer's model and sometimes of the negotiation over structure.
For a fintech, depreciation policy is a lever on reported EBITDA that a buyer will reverse, and the amortisation a buyer creates is the reason acquired businesses look unprofitable on paper for years.
Example
A buyer acquires a software fintech for €120 million. Purchase-price allocation: net tangible assets €8 million; customer relationships €35 million (amortised over eight years); technology €22 million (five years); brand €5 million (ten years); goodwill €50 million (not amortised; tested annually). The buyer's income statement now carries €9.3 million a year of acquisition amortisation; the acquired business, which earned €11 million of EBITDA, shows an operating profit of €1 million after it and its own depreciation. Cash flow is unchanged. In the buyer's jurisdiction the technology and customer intangibles are tax-deductible over their lives in a share deal, worth about €12 million in present-value tax savings, which the buyer's model had included and which explains a third of the premium it paid over a rival bidder from a jurisdiction where they were not.
Common mistakes
- Reading EBITDA differences between companies without reading their capitalisation policies. - Treating acquisition amortisation as an operating loss; it is a non-cash allocation of the price. - Ignoring the tax value of deductible amortisation when comparing deal structures. - Useful lives set long to flatter profit, then impaired in one year. - Confusing depreciation with a cash reserve for replacement; nothing is set aside.