What Is Depreciation?

What Is Depreciation?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

Depreciation is the reduction in the value of an asset over time due to wear and tear, age, or obsolescence. It’s a way businesses account for the cost of a long-term asset that they’ve purchased and used over time. It’s not an actual cash expense but an accounting expense allowing companies to lower their taxable income. It’s usually a percentage of the asset’s cost and it’s spread out over the asset’s useful life.

Related Questions

1. How is depreciation calculated?

Depreciation can be calculated using several methods, but the most common one is the straight-line method. In this method, the cost of the asset is divided by its estimated useful life. This gives the annual depreciation expense.

2. What’s the useful life of an asset?

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An asset’s useful life is the estimated timespan it can be used effectively for business operations. It can vary depending on the nature of the asset and it’s usually decided based on industry standards.

3. What is obsolescence in relation to depreciation?

Obsolescence refers to an asset becoming outdated due to technological advancements or changes in market demand. This type of depreciation is hard to predict but significantly impacts an asset’s useful life and value.

4. How does depreciation affect a company’s profit?

Depreciation reduces the value of assets and as an expense, it reduces taxable profits. Although it doesn’t involve outflow of cash, it impacts the profit figure on the income statement.

5. Can all assets be depreciated?

No, only tangible assets like machinery, equipment, and buildings can be depreciated. Intangible assets like brands or copyrights are not depreciated but may be amortized over their useful life.