Definition of Depreciation
Depreciation is defined as the expensing of an asset involved in producing revenues throughout its useful life. Depreciation for accounting purposes refers the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching of revenues to expenses principle). Depreciation expense affects the values of businesses and entities because the accumulated depreciation disclosed for each asset will reduce its book value on the balance sheet. Depreciation expense also affects net income. Generally the cost is allocated as depreciation expense among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes.
Depreciation reflects the wear and tear experienced by an asset in use.
Cars depreciate in value throughout their useful life.
Depreciation and the Matching Principle
Depreciation expense reduces an accounting period's income even though the expense does not require a cash or credit payment. The reason for the expense is to comply with the matching principle required by accrual accounting. According to the principle, expenses are recognized regardless of cash payment when obligations are:
- incurred (usually when goods are transferred (sold) or services rendered),
- generated by expenses involved in the earning of the accounting period's revenues.
Depreciation Expense Calculation
Depreciation expense can be calculated using a variety of methods. The depreciation method chosen should be appropriate to the asset type, its expected business use, its estimated useful life, and the asset's residual value. The expense is recognized and reported when the asset is placed into use and is calculated for each accounting period and reported under Accumulated Depreciation on the balance sheet and Depreciation Expense on the income statement. The amount reduces both the asset's value and the accounting period's income. A depreciation method commonly used to calculate depreciation expense is the straight line method.