Depreciation

Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value. Businesses depreciate long-term assets for both tax and accounting purposes. For tax purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however, businesses must depreciate these assets according to IRS rules about how and when the company can take the deduction.

Depreciation is often a difficult concept for accounting students as it does not represent real cash flow. Depreciation is an accounting convention that allows a company to write off an asset's value over time, but it is considered a non-cash transaction.

For accounting purposes, depreciation expense does not represent a cash transaction, but it shows how much of an asset's value the business has used over a period. For example, if a company buys a piece of equipment for $50,000, it can either write the entire cost of the asset off in year one or write the value of the asset off over the assets 10-year life. This is why business owners like depreciation. Most business owners prefer to expense only a portion of the cost, which artificially boosts net income. In addition, the company can scrap the equipment for $10,000, which means it has a salvage value of $10,000. Using these variables, the analyst calculates depreciation expense as the difference between the cost of the asset and the salvage value, divided by the useful life of the asset. The calculation in this example is ($50,000 - $10,000) / 10, which is $4,000.

This means the company's accountant does not have to write off the entire $50,000, even though it paid out that amount in cash. Instead, the company only has to expense $4,000 against net income. The company expenses another $4,000 next year and another $4,000 the year after that, and so on, until the company writes off the value of the equipment in year 10.

Besides an accounting convention, companies also use depreciation to refer to the loss of market value. Currency and real estate are two examples of assets that can depreciate or lose value. During the infamous Russian ruble crisis in 1998, the ruble lost 26 percent of its value in one day. During the housing crisis of 2008, homeowners in the hardest-hit areas, such as Las Vegas, saw the value of their homes depreciate by as much as 60 percent.

There's more to depreciation than just the definition. Read more on Introduction to Depreciation and Depreciation: Straight-Line Vs. Double-Declining Methods.