Depreciation

What Is Depreciation?

Depreciation is the accounting method of spreading the cost of a tangible, long-lived asset across the years it is expected to be used. Instead of recording the full purchase price as an expense in the year a company buys a delivery truck, factory machine, or office building, the company records a portion of that cost each year. The aim is to match the expense of using an asset with the revenue the asset helps produce.

Depreciation is a non-cash expense. The money was spent when the asset was bought, not each year afterward. The yearly charge reduces reported profit without any new cash leaving the business in that year.

How Depreciation Works

The most common approach in financial reporting is straight-line depreciation, which spreads the cost evenly over the asset's life. The formula is:

Annual depreciation = (Cost − Salvage value) ÷ Useful life

Salvage value is the estimated amount the company expects to recover when it retires the asset. Useful life is the estimated number of years the asset will remain productive. Other methods, such as declining balance, record larger charges in early years and smaller charges later, which can better match assets that lose value quickly.

Each year's charge is added to accumulated depreciation, a contra-asset account on the balance sheet. Subtracting accumulated depreciation from the original cost gives the asset's book value. Land is generally not depreciated because it is not usually considered to wear out.

Example

Suppose a company buys a machine for $10,000. It expects the machine to last five years and to be worth $1,000 at the end. Using straight-line depreciation:

($10,000 − $1,000) ÷ 5 = $1,800 per year

After one year, accumulated depreciation is $1,800 and book value is $8,200. After three years, accumulated depreciation is $5,400 and book value is $4,600.

Why It Matters to Investors

Depreciation reduces reported net income, so two companies with similar operations can report different profits if they use different useful life estimates or methods. Because these estimates involve judgment, investors often read the notes to the financial statements to see which assumptions a company uses. Many investors also compare net income with EBITDA and capital expenditures to get a sense of how much a business spends to maintain and grow its asset base.