Definition: A business expense a company records to reflect the drop in the value of the company’s equipment that occurs as the equipment is used.
Example: Capital Corp. buys a copier for $6,000. This cost is also known as its cost basis. At the rate at which it make copies, it expects the copier to last five years. This is known as its useful life. At that point, it believes it’ll be able to sell the copier for $1,000 to a smaller company that will use it occasionally. This is its salvage value. To most-simply reflect the gradual loss in value of the copier as it bangs out copies, the company will use the following formula for straight-line depreciation:
Annual depreciation = (Cost basis – Salvage value) / Useful life. In our case, we have:
Annual depreciation = ($6,000 – $1,000) / 5 years, or $5,000 / 5, or $1,000.
Investeach explains: Notice that to compute the depreciation for a piece of equipment, we need: 1) the equipment’s original cost (ie, cost basis), 2) its salvage value, 3) its useful life, and 4) the chosen depreciation method.
Depreciation is very interesting for several reasons. First, it is a “non-cash” expense. When it is recorded, no money is paid out. In the above example, money was only paid when the copier was purchased, at which time the copier was recorded as an asset.
Second, governments can encourage businesses to invest in long-lasting equipment by allowing them to accelerate the depreciation of their equipment. See Accelerated depreciation.
Third, the whole idea of depreciation is to ensure that businesses adhere to the Accounting profession’s “matching” principle. The various equipment that companies purchase perform important roles in helping companies produce and sell products. By depreciating this equipment, companies match up the sales they achieve with the expenses incurred to achieve those sales.
Fourth, a rare few assets are not depreciable because they don’t wear out. An example is land. Consider the situation of a timber company (ie: one that owns and harvests trees). Its assets, the trees, actually appreciate in value over time!
Riddle me this:
1. What is depreciation intended to reflect?
2. Identify three examples of equipment that depreciates.
3. Why is depreciation unlike other business expenses such as rent and wages?
4. What accounting principle does depreciation allow companies to effectively follow?
5. Identify an asset that does not depreciate.
Opposite of: Appreciation.