Depreciation

Definition

Depreciation refers to the systematic allocation of the cost of a tangible asset over its useful life. It is an accounting method used to recognise the gradual reduction in the value of an asset as it is used, consumed, or becomes obsolete over time.

What is depreciation?

In simpler terms, when a company purchases a long-term asset like machinery, buildings, vehicles, or equipment, the cost of that asset is spread out over its expected lifespan through depreciation. This reflects the fact that assets lose value over time due to wear and tear, technological advancements, and other factors.

There are different methods of calculating depreciation, with the most common being the straight-line method and the declining balance method. In the straight-line method, the cost of the asset is evenly distributed over its useful life. In the declining balance method, a higher portion of the asset’s cost is depreciated in the earlier years, reflecting a faster decline in value.

Depreciation is not a cash expense; it’s an accounting concept that reflects the reduction in the value of an asset on the company’s financial statements. This reduction in value is recorded as an expense on the income statement, which in turn reduces the company’s net income and, consequently, its tax liability.

Depreciation is an important concept because it helps companies accurately represent the true economic value of their assets over time. It also has implications for financial analysis, taxation, and decision-making, as it affects a company’s profitability, asset values, and tax obligations.

Try our handy depreciation calculator today to find out how much your asset is worth

Example of depreciation

Let’s say a company purchases a delivery van for $20,000 with an estimated useful life of 5 years. Using the straight-line method, the annual depreciation expense would be $20,000 / 5 years = $4,000.

Year 1:

• Van’s book value at the beginning: $20,000
• Depreciation expense for the year: $4,000
• Van’s book value at the end: $20,000 – $4,000 = $16,000

Year 2:

• Van’s book value at the beginning: $16,000
• Depreciation expense for the year: $4,000
• Van’s book value at the end: $16,000 – $4,000 = $12,000

This process continues until the end of the estimated useful life, at which point the asset’s book value becomes zero, and no further depreciation is recorded.