Depreciation

In business finance, depreciation refers to the process of allocating the cost of a tangible asset over its useful life. This accounting method is used to account for the gradual reduction in the value of an asset as it is used over time. Depreciation helps businesses match the cost of an asset with the revenue it generates over its useful life, providing a more accurate picture of financial performance.

There are several methods to calculate depreciation, including:

Straight-Line Depreciation: The most common method, where the asset’s cost is spread evenly over its useful life. For example, if an asset costs $10,000 and is expected to last 10 years, the annual depreciation expense would be $1,000 ($10,000 / 10 years).

Declining Balance Depreciation: An accelerated method where the asset loses value faster in the earlier years of its useful life. The expense is calculated as a fixed percentage of the asset’s book value at the beginning of each year.

Sum-of-the-Years' Digits Depreciation: Another accelerated method where depreciation is calculated based on a fraction of the asset’s remaining useful life. This method provides a larger expense in the early years and gradually decreases.

Units of Production Depreciation: Based on the asset’s usage, activity, or output, rather than time. Depreciation expense varies with the number of units produced or hours used.

Depreciation affects financial statements by reducing the book value of the asset on the balance sheet and recording depreciation expense on the income statement, which lowers taxable income.