Depreciation refers to the systematic reduction in the value of a fixed asset over its useful life. Fixed assets are long-term tangible assets such as buildings, equipment, and vehicles that a company uses to produce goods or provide services.
When a company acquires a fixed asset, the cost of the asset is recorded as an asset on the balance sheet. However, the asset’s value is not realized in a single accounting period but over its useful life. Therefore, the cost of the asset is allocated over its useful life through depreciation.
Depreciation is a non-cash expense, which means that it does not require any cash outflow. Instead, it reduces the value of the asset on the balance sheet and is recorded as an expense on the income statement, which reduces the company’s taxable income.
There are different methods of calculating depreciation, including straight-line depreciation, declining balance depreciation, and sum-of-the-years’-digits depreciation. Straight-line depreciation is the simplest and most commonly used method, where the cost of the asset is divided by its useful life to arrive at an annual depreciation expense.
Depreciation is important in accounting because it reflects the decline in the value of fixed assets over time and helps to match the cost of the asset with the revenue it generates. It is also an important consideration in determining the book value of assets and in calculating the taxes owed by a company.