What is depreciation?
Depreciation is the accounting method used to allocate the cost of a tangible asset. The depreciation definition may refer to two aspects of the same concept: the decrease in the value of assets and the method used to reallocate, or “write down” the cost of a tangible asset over its useful life span.
Depreciation describes an actual decrease in an asset's value that occurs over time due to usage, general wear and tear or obsolescence. It is the opposite of appreciation, when an asset’s value increases over time. Some common examples of assets that depreciate include buildings, vehicles, furniture, office equipment and machinery.
However, depreciation can also refer to the method used for accounting and tax purposes and employed by a business to allocate the cost of its tangible assets over their useful life in financial statements. Depreciation is an important part of accounting records as it helps companies maintain their balance sheet and income statement properly. If not considered, it can greatly affect profits.
- Depreciation is the accounting practice of allocating the cost of a tangible asset over its useful life.
- Depreciation reduces the value of an asset on the balance sheet over time, reflecting its decreasing worth due to wear and tear, obsolescence, or other factors.
- There are several methods for calculating depreciation, including straight-line, accelerated, and sum-of-years digits.
- Depreciation is important for both tax and financial reporting purposes, as it can have a significant impact on a company's net income and tax liability.
Where have you heard about depreciation?
Because companies are required to account for any value fluctuations of their assets, annual reports often contain references to any assets that have appreciated and depreciated over a given period of time. This information can make a business more or less attractive as a potential investment or target for a takeover. For that reason, you may have heard about depreciation from the financial media covering financial reports of the large companies.
What you need to know about depreciation
Let us take a look at a simple depreciation example. A company purchases an expensive physical asset with a useful life of longer than a year, such as manufacturing equipment or costly software, that will decrease in value over time. Instead of recording one large expense in the first year, the accountants will depreciate the asset and spread its cost over several years. The main purpose of depreciation is to match the revenues generated by using the asset to its cost in the company’s balance sheet.
There are several types of depreciation methods. Depending on their preferences, companies are free to choose how to calculate the depreciation expense.
One of the most basic methods is the straight-line method. Under it, the depreciation of an asset is evenly divided throughout its useful lifetime. The straight-line depreciation formula is as follows:
Straight-Line Depreciation = (Cost of the asset - the asset's salvage value) / years of estimated useful life
Let us assume a company purchased a machine to manufacture car tires. It costs $10,000 and is expected to work for 10 years. The machine’s salvage value, or the amount it is worth after 10 years of use, is $1,000. According to the straight-line method, the machine would depreciate by ($10,000 - $1,000)/10 = $900 per year. At the end of each year, the company’s accountants would write down a non-cash expense of $900 until the asset’s useful life is over.
Having an efficient asset tracking system is crucial for the companies. By conducting frequent fixed asset audits, businesses can make rational decisions based on the latest and most accurate data. In addition, depreciation lowers the company’s expenses in a given year, making its earnings look more stable and profitable to investors.