Economic Depreciation: Definition, Vs. Accounting Depreciation

What Is Economic Depreciation?

Economic depreciation is a measure of the decrease in the market value of an asset over time from influential economic factors. This form of depreciation usually pertains to real estate, which can lose value for several reasons such as the addition of unfavorable construction in close proximity to a property, road closures, a decline in the quality of a neighborhood, or other negative influences. 

Economic depreciation is different than accounting depreciation. In accounting depreciation, an asset is expensed over a specific amount of time, based on a set schedule.

How Economic Depreciation Works

Depreciation in economics is a measure of the amount of value an asset loses from influential factors affecting its market value. Asset owners may more closely consider economic depreciation over accounting depreciation if they seek to sell an asset at its market value.

Economic depreciation affects the selling value of an asset in the market. It may be followed and tracked by asset owners. In business accounting, economic depreciation is not typically notated on financial statement reporting for large capital assets since accountants usually use book value as the primary reporting method.

There can be several scenarios where economic depreciation is considered in financial analysis. Real estate is one of the most common examples but analysts may also consider it in other situations as well. Economic depreciation can also be a factor in forecasts of future revenues for goods and services.

Economic Depreciation vs. Accounting Depreciation

Calculating economic depreciation is not always as simple as in accounting depreciation. In accounting depreciation, a tangible asset’s value decreases over time based on a set depreciation schedule. With economic depreciation an asset’s decreases in value are not necessarily uniform or scheduled but rather based on influential economic factors.

Economic depreciation can often occur with real estate. In periods of economic downturn or a general housing market decline, economic depreciation may lead to a decrease in market value. The housing market environment can play a part in real estate valuations but individual valuations may also be affected by unfavorable neighborhood construction, road closures, a decline in the quality of a neighborhood, or other negative influences. Any type of negative economic factors can lead to economic depreciation and therefore a lower appraisal value. The difference in value from one appraisal to the next can show a property’s economic depreciation.

Appraisals can be key to understanding economic depreciation. Appraisals can occur on all types of assets and are often the biggest determinant of economic depreciation.

Financial analysts may also consider economic depreciation when forecasting future projections and cash flows. Economic depreciation in these scenarios would be based on the decreases in the value of revenues expected from goods or services due to negative economic influences.

Accounting Depreciation

When people talk about depreciation, it is often in reference to accounting depreciation. Accounting depreciation is the process of allocating the cost of an asset over the course of its useful life so as to align its expenses with revenue generation. Businesses also create accounting depreciation schedules with tax benefits in mind since depreciation on assets is deductible as a business expense in accordance with the Internal Revenue Service's (IRS) rules.

Most businesses depreciate an asset to $0 in book value because they believe the asset’s value and expenses have been fully matched with the revenue it generates over its expected useful life. Companies may choose to hold some book value of a depreciated asset after it has been fully depreciated.

The book value of an asset and the market value of an asset are usually very different. The economic value or market value of an asset may not be reported on financial statements but it is the value a company could potentially get if they chose to make an asset sale.

Depreciation vs. Appreciation

In general, both economic depreciation and economic appreciation can affect the market value of an asset. In some instances, one appraisal to another may show an increase in value. This would be the result of negative depreciation or positive appreciation.

During the credit crisis and housing market collapse of 2008, the combination of subprime loans requiring low or no down payments with the dramatic drop in housing values resulted in a significant amount of U.S. homeowners owing more money on their home than it was actually worth due to economic depreciation.

Hypothetically, economic influences can also lead to increases in value or economic appreciation. Following the height of the 2008 financial crisis, regulators and the central bank took steps to improve economic conditions for the housing market that resulted in a housing market rebound and significant economic appreciation in real estate values from one appraisal to the next.

Valuing Assets

All types of assets are subject to the risks of economic depreciation and economic appreciation. Companies and investors may need to analyze and follow these effects differently. A company may not always be concerned with how economic depreciation is affecting the market value of its tangible assets. However, companies and investors will be concerned with how market influences are affecting highly liquid assets like stocks, bonds, and money market accounts.

Companies will follow more closely the depreciation and appreciation of assets that it marks to market on its books regularly since that has a greater impact on its overall performance. Investors certainly follow the economic depreciation and appreciation of assets in their portfolio regularly since it can have a big effect on their net worth from one day to the next.

For asset owners, liquidity can also be a factor in analyzing economic depreciation and appreciation. Real estate assets may see a larger increase or decrease in value from year to year due to economic effects. Investors may view the economic depreciation or appreciation of their more liquid assets differently since economic factors can influence values from one day to the next.