What is Depreciation?

The term depreciation refers to an accounting method used to allocate the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset’s value has been used. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. Not accounting for depreciation can greatly affect a company’s profits. Companies can also depreciate long-term assets for both tax and accounting purposes.

Assets such as machinery and equipment are expensive. Instead of realizing an asset’s entire cost in year one, companies can use depreciation to spread out the cost and generate revenue from it. This is done through depreciation, which allows a company to write off an asset’s value over a period of time, notably its useful life. It may be used to account for declines over time in the carrying value, which represents the difference between the original cost and the accumulated depreciation of the years.

Depreciation is taken regularly so a company can move the asset’s cost from the balance sheet to the income statement. When a company buys an asset, it records the transaction as a debit to increase an asset account on the balance sheet and a credit to reduce cash (or increase accounts payable), which is also on the balance sheet. Neither journal entry affects the income statement, where revenues and expenses are reported.

Businesses can take advantage of depreciation for both tax and accounting purposes. This means they can take a tax deduction for the cost of the asset, reducing taxable income. But the Internal Revenue Service (IRS) states that when depreciating assets, companies must spread the cost out over time. The IRS also has rules for when companies can take a deduction. Depreciation is considered a non-cash charge since it doesn’t represent an actual cash outflow. The entire cash outlay might be paid initially when an asset is purchased, but the expense is recorded incrementally for financial reporting purposes.

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