Depreciation
The systematic allocation of a tangible asset's cost over its useful life, reducing its book value on the balance sheet each period.
Depreciation is the accounting process of systematically allocating the cost of a tangible long-lived asset over its estimated useful life, recognizing the gradual consumption of the asset's economic value through use, wear, and obsolescence. Rather than expensing the full cost of a major asset purchase in the period of acquisition, depreciation spreads the cost over the periods in which the asset generates economic benefit.
For example, a machine costing $100,000 with a 5-year useful life and $10,000 salvage value would be depreciated over 5 years. Using straight-line depreciation: ($100,000 − $10,000) ÷ 5 = $18,000/year in depreciation expense. The asset's net book value decreases from $100,000 to $82,000 after year 1, reaching $10,000 at end of year 5.
Common depreciation methods: Straight-Line — equal amounts each period (most common for financial reporting, easy to calculate). Declining Balance / Double Declining Balance (DDB) — higher depreciation in early years, declining over time (accelerated, front-loads expense). Sum-of-Years Digits (SYD) — another accelerated method. Units of Production — depreciation based on actual usage/output (common for machinery with variable usage patterns).
For tax purposes, the IRS specifies MACRS (Modified Accelerated Cost Recovery System) depreciation — with asset class lives and recovery periods (3, 5, 7, 15, 20, 27.5, 39 years) that differ from financial statement useful lives, creating book-tax differences and deferred tax assets/liabilities.
Bonus depreciation and Section 179 expensing allow immediate deduction of qualifying asset costs for tax purposes, creating significantly larger timing differences between book and tax depreciation.
Depreciation is a non-cash expense — it reduces net income without reducing cash. This is why EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) adds back depreciation to approximate operating cash flow, and why capital-intensive businesses can show high EBITDA despite low net income.
FAQs
What is the difference between depreciation and amortization?
Both spread an asset's cost over time, but depreciation applies to tangible (physical) assets like equipment, vehicles, and buildings, while amortization applies to intangible assets like patents, software licenses, and customer relationships. Both are non-cash expenses that reduce net income and asset book values but don't involve cash outflows in the period recognized.
Do all assets depreciate?
Not all tangible assets depreciate: land does not depreciate (it has an indefinite useful life and typically appreciates), art and collectibles generally don't depreciate under GAAP. Some intangible assets with indefinite useful lives (certain trademarks, goodwill in most cases) are tested for impairment rather than amortized. Only assets with finite useful lives are subject to systematic depreciation or amortization.
What is accelerated depreciation and why would a company use it?
Accelerated depreciation methods (DDB, SYD, MACRS) recognize more depreciation expense in early years and less in later years. Companies use accelerated methods for tax purposes to maximize early-year deductions, reducing taxable income sooner and improving present value of tax benefits. For financial reporting, straight-line is more common as it produces smoother earnings. The difference creates deferred tax liabilities on the balance sheet.
Related Terms
Amortization
The systematic allocation of an intangible asset's cost or a loan's principal over a defined period.
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization — a proxy for operating cash generation used in valuation and financial analysis.
Intangible Assets
Non-physical assets with economic value including patents, trademarks, copyrights, software, customer relationships, and brand names.
Capital Expenditure
Funds spent acquiring, upgrading, or maintaining long-term physical assets for business operations.
