Depreciation is a way to calculate the reduction in value of an asset due to use, wear and tear, and obsolescence.
The value of most assets decreases over time after their purchase. Businesses need to take this decreasing value into consideration when analyzing their performance and doing costing.
Depreciation is an accounting method for estimating that decline over time. It helps businesses match their revenues with costs, including those of assets used to generate revenues.
More about depreciation
Several depreciation methods exist. Business owners are usually familiar with depreciation methods used for tax purposes. These require businesses to spread out the reporting of costs of longer-term assets over the useful life of the asset. Companies often have leeway to accelerate or defer some depreciation to optimize their tax liability.
But depreciation for tax purposes doesn’t necessarily represent a company’s actual costs for use of its fixed assets. It is common and acceptable for businesses to use a parallel depreciation method for financial reporting purposes that more accurately reflects the assets’ decrease in value.
The most common depreciation methods are straight-line and declining balance.
Straight-line: The asset is depreciated by the same amount for each year of its useful life. For example, for a machine with a $10,000 purchase price, scrap value of $0 and a 10-year lifespan, the depreciation expense is $1,000 each year.
Declining balance: The asset is depreciated by the same rate for each year of its useful life. This method is sometimes used to reflect the fact that assets lose more value early in their life. For example, for the machine above, using a 30% depreciation rate, the depreciation expense is $3,000 in the first year, $2,100 the second year, $1,470 the third year and so on.