Depreciation represents the periodic expensing of the cost of a tangible asset.
When a company purchases a fixed asset, the company capitalizes the cost of the asset on the balance sheet rather than directly expensing the cost on the income statement. However, fixed assets lose value as they age. Depreciation is thus a method for recognizing this decline in an asset’s value over time.
To calculate depreciation, an accountant must have three pieces of information: the asset’s cost, an estimate of the asset’s useful life, and an estimate of the asset’s residual value.
There are two general methods for calculating depreciation expense: the straight-line depreciation method and the accelerated depreciation method. With straight-line depreciation, the company recognizes an equal amount of depreciation expense each period. With accelerated depreciation, the company recognizes a greater amount of depreciation expense in the earlier years and a lesser amount of depreciation expense in the later years of an asset’s useful life.
Most public companies use the straight-line method for financial reporting, although U.S. GAAP allows the use of other methods. For tax purposes, most companies use an accelerated depreciation method as it provides a greater tax benefit.
Deprecation expense for each asset is aggregated into an account called accumulated depreciation. Accumulated depreciation is an account which offsets the asset’s cost. Thus, companies carry assets on their books net of depreciation.
Depreciation is a non-cash expense and must be added to income when calculating operating cash flow.
