What is depreciation, and why doesn't book profit match the cash in your account?

Depreciation is the key to understanding why your profit and loss statement and your bank balance don't line up. Here's how to calculate it, the methods allowed under accounting standards, and a clear worked example.

Many business owners have wondered why the profit and loss statement shows the company is profitable, yet checking the bank balance doesn't reveal the increase they expected. Part of the answer lies in a line item called "depreciation" (ค่าเสื่อมราคา) — an important accounting concept that is often misunderstood or overlooked.

What is depreciation?

Depreciation is an expense that's gradually written off against the value of an asset the business uses for more than one year and that typically carries a high value. The business must estimate the useful life of each asset in order to spread it out as an expense over each period. In simple terms, when a business buys a major asset — machinery, a vehicle, or office equipment — instead of recording the full cost as an expense in the month of purchase, the accounts spread out the asset's value into smaller expenses each year over its useful life instead.

The basic formula (straight-line method)

Depreciation = (Cost − Residual value) ÷ Useful life

Where residual value is the value the asset is expected to retain once its useful life ends or it is taken out of use, and must be estimated as reasonably as possible.

Example: A machine is purchased for 500,000 baht, expected to be used for 5 years, with a residual value of 50,000 baht when retired.

Annual depreciation = (500,000 − 50,000) ÷ 5 = 90,000 baht per year

Worth knowing: the straight-line method shown above is just one of several methods accounting standards allow. Thai Accounting Standard No. 16 (Property, Plant and Equipment) requires that the depreciation method used reflect the pattern in which the business expects to consume the asset's future economic benefits, and permits several methods, including:

• Straight-line method — writes off an equal amount of depreciation each year over the useful life; suits assets that deliver benefits evenly.
• Units-of-production method — calculated based on actual usage volume; suits machinery whose usage varies from year to year.
• Diminishing-balance method — writes off more depreciation early on, tapering off over time; suits assets that wear out quickly in their early years.

In addition, a business must review the useful life, residual value, and depreciation method it uses at least at the end of every accounting period. If new information shows the original estimate is no longer appropriate (for example, actual useful life turning out shorter or longer than originally assessed), this is treated as a change in accounting estimate, not a retrospective correction of an error.

Why doesn't book profit match the cash in hand?

This is the heart of the confusion business owners often run into. When the 500,000 baht machine is purchased, the cash in the bank account drops by the full amount immediately, on the day it's paid. But the accounts don't record the full amount as an expense in that year — it has to be spread out as 90,000 baht of depreciation per year over 5 years instead.

The result is:

• The year the asset is purchased — cash drops by 500,000 baht immediately, but the profit and loss statement records only 90,000 baht of expense, making book profit look much higher than the cash actually remaining.
• The following years — even though no more cash goes out, the profit and loss statement still carries 90,000 baht of depreciation expense each year, making book profit look lower than the reality that cash is no longer flowing out.

Put another way, depreciation is an "accounting expense", not "cash actually paid out" in that year, which is why book profit and actual cash flow move out of step with each other from one period to the next.

Tax depreciation rates

A business may use a rate lower than the statutory ceiling, based on actual useful life, but may not deduct more than the ceiling allows. Royal Decree (No. 145) B.E. 2527 (1984), issued under Section 65 bis (2) of the Revenue Code, sets maximum depreciation rate ceilings for each type of asset — for example, a permanent building may be depreciated at no more than 5% per accounting period, while assets other than land and inventory may be depreciated at no more than 20% per year.

Additional points to know

• Assets that are never depreciated — land and inventory, since these are not treated as depreciable assets under the law.
• Depreciation can't be deducted down to zero — the asset's value must always retain a residual balance of at least 1 baht.
• SME businesses with fixed assets excluding land not exceeding 200 million baht and no more than 200 employees are entitled to accelerated depreciation in certain cases, which lets them deduct the expense for tax purposes faster than usual.

Note: the tax depreciation rate under Royal Decree No. 145 is only a "maximum ceiling" used to calculate corporate income tax, and it may not match the rate used for financial reporting under accounting standards (which must reflect the business's own assessment of actual useful life). As a result, the book depreciation figure and the tax depreciation figure can differ, and the business must correctly adjust for this when calculating corporate income tax.

A worked example: profit vs. cash

ABC Company Limited had revenue of 2,000,000 baht this year, other cash expenses (salaries, rent, utilities) of 1,200,000 baht, and bought a new machine for 500,000 baht in cash during the same year (depreciated at 90,000 baht per year, as in the example above).

Book profit (710,000 baht) is 410,000 baht higher than the actual cash remaining (300,000 baht), because the cash already paid in full for the machine hasn't yet been fully recognized as an accounting expense this year.

Summary

Depreciation is an accounting method that spreads the cost of a high-value asset into expenses over its useful life, instead of recognizing it all at once in the year of purchase, so that the profit and loss statement more reasonably reflects how the business is actually running. Accounting standards allow a choice of several calculation methods depending on how the asset is actually used, but whichever method is used, depreciation is a key reason why "book profit" and "actual cash in hand" don't match up each year. Business owners should therefore look at both the profit and loss statement and the cash flow statement together to understand the business's true financial position, not just the profit figure alone. If you have questions about how to calculate depreciation for assets in your business, consult an accounting professional to choose the most appropriate method and rate.