What is ‘Depreciation’
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. Businesses depreciate long-term assets for both tax and accounting purposes. For tax purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however, businesses must depreciate these assets in accordance with IRS rules about how and when the deduction may be taken.
BREAKING DOWN ‘Depreciation’
Depreciation is often a difficult concept for accounting students as it does not represent real cash flow. Depreciation is an accounting convention that allows a company to write-off the value of an asset over time, but it is considered a non-cash transaction.
For accounting purposes, depreciation expense does not represent a cash transaction, but it indicates how much of an asset’s value has been used up over time. For example, if a company buys a piece of equipment for $50,000, it can either write the entire cost of the asset off in year one, or it can write the value of the asset off over the life of the asset, which is 10 years. This is why business owners like depreciation. Most business owners prefer to expense only a portion of the cost, which artificially boosts net income. In addition, the equipment can be scrapped for $10,000, which means it has a salvage value of $10,000. Using these variable the analyst calculates depreciation expense as the difference between the cost of the asset and the salvage value, divided by the useful life of the asset. The calculation in this example is: ($50,000 – $10,000) / 10, which is $4,000.
This means the company’s accountant does not have to write off the entire $50,000, even though it paid out that amount in cash. Instead, the company only has to expense $4,000 against net income. The company expenses another $4,000 next year, and another $4,000 the year after that, and so on, until the value of the equipment is completely written off in year 10.
In addition to an accounting convention, depreciation is also used to refer to the loss of market value. Currency and real estate are two examples of assets that can depreciate or lose value. During the infamous Russian ruble crisis in 1998, the ruble lost 25% of its value in one day. During the housing crisis of 2008, homeowners in the hardest-hit areas, such as Las Vegas, saw the value of their homes depreciate by as much as 50%.
There’s more to depreciation than just the definition.