Depreciation shows how much of an asset’s value is used each year. Companies use it for assets that last many years, such as machines, vehicles, equipment, and buildings. Instead of recording the entire cost in the year the asset is purchased, the cost is allocated across the years the asset is expected to be useful.
Depreciation helps companies match expenses with the revenue generated by those assets. For example, if a piece of equipment will help the company for 10 years, its cost is spread across those 10 years. This results in a more accurate view of operating performance, as expenses are recorded gradually, not all at once.
There are several depreciation methods.
The straight-line method spreads the cost evenly each year.
The declining balance method records higher depreciation early on and lower amounts later.
The units-of-production method bases depreciation on how much the asset is used. Companies choose the method that best reflects how the asset provides value over time.
Depreciation is a non-cash expense, meaning no money leaves the business when it is recorded. It is an accounting adjustment, but it has real effects on reported profit, taxes, and financial analysis.
Depreciation affects profitability, tax calculations, asset values, and long-term financial planning. It helps investors understand how quickly assets lose value and how capital spending affects future performance.
Companies choose the method that best matches how the asset provides value. If an asset provides equal value every year, the straight-line method is used. If an asset loses value faster early in its life — such as technology hardware — an accelerated method like declining balance may be more accurate. The goal is to reflect economic reality as closely as possible.
Depreciation reduces net income on the income statement, even though no cash is spent that year. On the balance sheet, it reduces the asset’s carrying value over time. On the cash flow statement, depreciation is added back because it is a non-cash expense. These adjustments help investors understand true cash performance.
Depreciation helps reveal when major assets may need replacement. If a company shows high depreciation expenses, it may need significant future investment. Analysts compare depreciation to capital expenditures to see whether a company is maintaining and replacing assets at a sustainable pace.
A company buys equipment for $100,000 with a useful life of 10 years. Using straight-line depreciation, it records $10,000 of depreciation each year. This reduces reported profit but does not affect cash flow.
