Depreciation refers to an accounting method that allocates the cost of a tangible asset over its useful life. It is primarily used to reflect the gradual decline of an asset's value due to factors such as wear and tear, aging, or obsolescence. Depreciation allows businesses to accurately account for asset values on financial statements, matching expenses with revenues earned in the same period.
Businesses commonly apply various methods of depreciation, including the straight-line method, declining balance method, and units-of-production method. The straight-line method evenly distributes the asset's cost across its useful life, while the declining balance method involves higher depreciation expenses earlier and decreases over time. The units-of-production method depreciates assets based on actual usage rather than time elapsed.
Understanding depreciation is important because it reduces taxable income, directly affecting a company's profitability and tax obligations. However, depreciation does not represent any immediate cash outflow. Rather, it is recognized as a non-cash expense, reflecting asset utilization within a given accounting cycle.
Accurate depreciation calculations help businesses better manage cash flow, prepare precise financial statements, and comply with accounting standards, offering a realistic financial overview of company health for investors and stakeholders.
