KARACHI: Buried in every income statement, between the impressive revenue at the top and the profit at the bottom, sits a charge for something nobody bought this year: depreciation. It reduces reported profit, sometimes by billions of rupees, yet no money leaves the company when it is recorded. Beginners routinely make one of two mistakes with it — treating it as a fake cost that can simply be added back and ignored, or treating it as a real cash expense that double-counts the factory the company already paid for. Both mistakes distort every valuation ratio built on profit. This guide explains what depreciation and amortisation really are, why accountants insist on them, the main methods companies use, and how a PSX investor should handle the charge when reading accounts.
The core idea: spreading a cost over a useful life
When a company buys a machine, a building or a fleet of trucks, it does not — in proper accounting — charge the whole price against that year's profit. The asset will serve for years, so its cost is spread across the years it serves. That annual spread is depreciation for tangible assets: plant, machinery, vehicles, buildings, furniture. Amortisation is the identical idea for intangible assets: software, licences, patents, franchise rights and similar items with finite lives. One asset is the great exception: land is generally not depreciated, because its useful life is not consumed by use — though leasehold land and improvements on it are another matter.
The principle underneath is matching: each year's revenue should carry the costs that helped produce it, including a fair slice of the long-lived assets used up in producing it. A cement plant that charges nothing for its kiln for nineteen years and everything in the twentieth would report fantasy profits followed by a catastrophic loss, and investors comparing it with a rival would be comparing fiction with fact. Depreciation is accounting's attempt — imperfect, estimate-laden, but principled — to stop that. If you are still building fluency in the statement where the charge lands, start with our guide to reading an income statement alongside this one.
A worked example, with the cash kept visible
Take a clearly hypothetical company that buys a bottling line for Rs 100 million, expects it to run for ten years, and expects to sell it for scrap worth Rs 10 million at the end. Under the simplest method — straight-line — the depreciable amount is Rs 100m minus Rs 10m, that is Rs 90m, divided by ten years: a charge of Rs 9 million every year. In year one, the income statement shows Rs 9m of depreciation expense. The bank account shows something entirely different: the Rs 100m left when the machine was bought, in year zero. In years one to ten, no cash moves in respect of the machine at all.
Both views are true, and confusing them causes the classic errors. The profit is "real" in the sense that the machine genuinely is being used up — after ten years it will be scrap, and replacing it will need real money. But the charge is "non-cash" in the sense that this year's operations did not pay it. That dual nature is why the cash flow statement adds depreciation back to profit when calculating operating cash flow, a reconciliation our guide to reading a cash flow statement walks through line by line. The sophisticated conclusion is neither "ignore depreciation" nor "treat it as cash out", but: profit after depreciation is the better measure of economic earnings; cash flow is the better measure of liquidity; and a company whose profit persistently exceeds its cash flow, or the reverse, is telling you something worth investigating.
The main methods, and why the choice matters
Straight-line spreads the cost evenly, as in the example above. It is simple, predictable and the most common method for buildings and much plant. Reducing balance (also called diminishing balance) charges a fixed percentage of the asset's remaining book value each year, so the charge is heavy early and light later — arguably matching assets like vehicles and electronics that lose usefulness and resale value fastest when new. Units of production ties the charge to output: a mine, quarry or oil and gas field may depreciate (in that sector, deplete) in proportion to how much of the reserve was extracted, so quiet years carry small charges and boom years large ones.
The method and the assumed useful life are management estimates, disclosed in the accounting policy notes, and they move reported profit materially. Two identical factories, one depreciated over fifteen years and one over twenty-five, will report different profits every year for two decades despite identical cash. This is why comparisons between companies — and the ratios in our guide to earnings per share — must allow for policy differences, and why a sudden lengthening of useful lives, which flatters profit without changing anything in the real world, is a legitimate item for the sceptic's notebook. Auditors test these estimates, and accounting standards (in Pakistan, IFRS as adopted) require lives and residual values to be reviewed, but within a genuine range judgement rules.
Where you will find it — and where it hides
Depreciation rarely appears as one labelled line on the face of a Pakistani income statement. Most of it sits inside cost of sales — the factory's depreciation is part of producing the goods — with the office and showroom portions inside administrative and distribution expenses. The full figure is assembled in the notes: the property, plant and equipment note shows opening and closing balances, additions, disposals and the year's charge by asset class, and the cash flow statement states the total plainly as an add-back. Finding it there takes two minutes and repays the effort, because the total charge relative to revenue and to the asset base is one of the fastest diagnostics of what kind of business you are looking at.
Asset-heavy businesses — cement, steel, power, textiles, refineries — live and die by this line, and by its cash cousin, capital expenditure. Asset-light businesses — software, services, trading — barely show it. Banks and insurers are special cases whose assets are mostly financial. A useful cross-check is the balance sheet's net book value: cost minus accumulated depreciation. A very old, heavily depreciated asset base can flatter returns on assets for years — until the replacement bill arrives. Our guide to reading a balance sheet shows where accumulated depreciation sits and why net book value is a record of history, not a valuation.
EBITDA: the profit measure built by removing it
No discussion of depreciation is complete without EBITDA — earnings before interest, tax, depreciation and amortisation. Analysts popularised it because adding the charge back lets them compare companies with different asset ages, financing and tax situations, and because it approximates the cash a business generates before reinvestment. Used that way — a comparison tool, a rough cash proxy — it is serviceable. Used as "profit, but nicer", it misleads, because the assets being depreciated are real and will demand replacement cash; a business that must spend heavily every year just to stand still is not as profitable as its EBITDA boasts.
The honest test pairs EBITDA with capital expenditure: subtract maintenance capex and you approach the owner's true cash earnings — the logic formalised in our guide to free cash flow. When a management presentation leads with EBITDA, the experienced reader's hand moves automatically to the capex line. If the two have marched together for years, the depreciation charge was honest all along. If capex chronically exceeds depreciation, the asset base is being consumed faster than the accounts admit, or the company is growing — and the notes will tell you which.
One intangible deserves its own warning. Goodwill — the premium paid when one company buys another for more than its net assets — is not amortised under current standards; instead it is tested annually for impairment. A balance sheet carrying large goodwill from old acquisitions is therefore carrying a charge that has not happened yet and may arrive all at once, which is why experienced readers note the goodwill figure whenever they study an acquisitive group.
Tax depreciation is a different animal
Do not confuse the accounts with the tax return. Pakistan's Income Tax Ordinance sets its own depreciation rates and rules — prescribed percentages by asset class, applied on written-down value, with special allowances in defined cases — and the FBR computes taxable income using those, regardless of the lives management chose for the financial statements. The gap between accounting profit and taxable profit created by the two systems is a main source of deferred tax, the balance-sheet item that records timing differences expected to reverse later.
Why should an investor care? Because accelerated tax depreciation is a real, if modest, economic benefit: it defers tax, and deferred tax is an interest-free loan from the state. Governments know this, which is why budgets tinker with initial allowances and rates to encourage investment in favoured sectors — the structure is stable, the numbers are reset from time to time. When you read that a company's effective tax rate is oddly low in a heavy investment year, differing depreciation timetables are very often the explanation, and the deferred tax note will confirm it.
What "normal" looks like across PSX sectors
Because depreciation scales with physical assets, its weight in the accounts is a fingerprint of the business model, and learning the fingerprints sharpens every comparison you make. A cement or steel company carries enormous plant; depreciation is one of its largest costs, capacity additions arrive in multi-year waves, and profit in the first years of a new line is burdened by the full charge on an asset still ramping up. A textile composite sits in the middle: looms, spinning and processing plant depreciating steadily, with modernisation capex a recurring necessity rather than an event. An oil and gas producer depletes its fields by units produced, so the charge flexes with output and with reserve revisions — a downward reserve revision can raise the per-unit charge sharply even as production falls, a double squeeze worth recognising when it appears in results.
At the other end, a software or services company's depreciation is mostly laptops, fit-outs and capitalised software amortisation — small enough that its absence from your analysis costs little. Banks depreciate branches, systems and ATMs, but the dominant "using-up" cost in banking is not depreciation at all; it is credit losses on loans, a different line with a different logic. The practical rule follows: compare depreciation-heavy ratios — EBITDA margins especially — only within a sector, and use the charge's trend within one company over time, where a sudden drop in depreciation relative to the asset base asks the same question as a sudden drop in any other cost: what changed, and is it real?
Impairment: when depreciation admits it was too slow
Sometimes the story changes faster than the schedule. A plant becomes obsolete, a brand collapses, a field disappoints — and the asset's recoverable value falls below its book value. Accounting then demands an impairment: an immediate write-down, charged to profit, on top of ordinary depreciation. Impairments cluster in downturns and after bad acquisitions, and large ones deserve attention in both directions: they are non-cash (no money leaves that day), but they are confessions that past cash was spent on something now worth less. The reverse discipline also exists: revaluations of property can lift book values and equity, with the surplus routed through equity rather than profit under the applicable standards. Either way, the property, plant and equipment note is where the truth accumulates, five columns at a time.
This article is educational content, not financial advice. Treat depreciation neither as a fiction to add back and forget nor as a cash bill already paid: it is the measured consumption of real assets. Read it with capex beside it, compare policies before comparing profits, and let the notes — as usual — have the last word.
Key takeaway: Depreciation and amortisation spread the cost of long-lived assets over the years they serve: non-cash in any single year, but economically real — because every asset being depreciated will one day need replacing with real money.
