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What is Depreciation?

Definition: Depreciation expense is the cost allocated to a fixed asset during a period. Many people think this is a way to "expense" assets over time, but thatís not really true. It is recorded as an expense on the income statement, but it isnít an expense of the asset. Instead, it is allocating the cost of the asset over its useful life.

What Does Depreciation Mean?

What is the definition of depreciation? Remember, fixed assets are capitalized when they are purchased. No expenses hit the income statement during the purchase. An asset account is debited and the cash or payables accounts are credited. This capitalization concept is based on the matching principle, which states that we need to match expenses with the revenues they help generate.

If we expensed capital assets, we would be recording all of the expenses for an asset that will last five plus years in the year of the purchase. This doesnít match the revenues or expenses.

Depreciation is a way to fix this problem. It takes the depreciable cost of an asset and allocates it over the useful life. This way the expense actually reflects the income produced from the asset in that period.

There are several different depreciation methods that accountants can use to allocate costs. Traditionally, financial accounting textbooks tend to focus on the straight-line method because it is easy to calculate. Simply divide the depreciable cost by the useful life. This allocates an even amount of costs for each year.

Letís look at an example.

Example

Jimís Machine Shop purchases one Lathe for $10,000. This piece of equipment has a useful life of 10 years and a salvage value of zero. When Jim purchases this asset, he will first record it on the balance sheet for the amount he paid for it by debiting the equipment account and crediting the cash account.

Each year after the purchase, Jim will allocate that yearís cost of the machine using the straight-line method. He calculates the expense by subtracting the salvage value of the equipment from the purchase price and dividing the difference by the useful life.

Thus, Jim records a $1,000 expense for each year of the machineís useful life until all of the costs are allocated.

There are several problems with this method, however. Most assets tend to be more useful when they are newer. Take a computer for example. A new computer is much more useful than a five year old one. Thus, on assets like this we use accelerated depreciation methods like the double declining method.

Summary Definition

Define Depreciation: Depreciation is an accounting expense that recognized the cost of an asset over its useful life.

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