What Kind of Cost Is Depreciation in Accounting?

Depreciation is an accounting method that systematically allocates the cost of a tangible asset over its useful life. Instead of expensing the entire cost of a long-term asset in the year it is purchased, depreciation spreads this cost across the periods when the asset contributes to generating revenue.

Depreciation as a Non-Cash Expense

Depreciation is categorized as a non-cash expense, which means it reduces a company’s reported profit without involving an actual outflow of cash in the period it is recorded. For example, if a business buys a machine for $10,000, the $10,000 cash outflow happens upfront. This differs from cash expenses like salaries or rent, which involve immediate cash payments. It is a necessary entry in accrual accounting, which recognizes expenses and revenues when they are incurred or earned, regardless of when cash changes hands.

Impact on Financial Statements

Depreciation affects all three primary financial statements, providing a comprehensive view of a company’s financial standing. On the income statement, depreciation is recorded as an operating expense, which reduces gross profit and, consequently, net income. This reflects the portion of the asset’s cost “used up” during the accounting period.

On the balance sheet, depreciation lowers the book value of assets. This is achieved through an account called “accumulated depreciation,” a contra-asset account that offsets the asset’s original cost, reflecting its wear, tear, or obsolescence over time. For instance, if a $50,000 asset has accumulated depreciation of $10,000, its book value is $40,000.

On the cash flow statement, depreciation is added back to net income in the operating activities section. This adjustment is made because depreciation reduced net income on the income statement but did not involve an actual cash outflow. Adding it back helps reconcile net income with the actual cash flow generated from operations.

Why Businesses Account for Depreciation

Businesses account for depreciation for several reasons, primarily to adhere to accounting principles and gain a more accurate financial picture. The matching principle in accounting guides this practice, requiring that expenses be recognized in the same period as the revenues they help generate. For example, if a machine helps produce goods over five years, its cost is matched to the revenue generated over those five years through depreciation, rather than expensing its entire cost in the purchase year. Depreciation also aids in accurate asset valuation on the balance sheet, reflecting the declining value of assets as they are used. Beyond financial reporting, depreciation offers tax benefits as a deductible expense, reducing a business’s taxable income and lowering its overall tax liability.

Key Elements in Depreciation Calculation

Calculating depreciation requires three fundamental components, regardless of the specific method used. The first is the cost of the asset, which includes the initial purchase price along with any additional expenses incurred to get the asset ready for its intended use, such as sales tax, transportation, and setup fees. The second element is the useful life of the asset, representing the estimated period it is expected to be productive and provide economic benefits. Businesses estimate this period for accounting, while the IRS provides specific useful lives for tax purposes. The third component is the salvage value, also known as residual value. This is the estimated amount a business expects to receive for the asset at the end of its useful life, either through sale or disposal. If an asset is expected to have no value at the end of its useful life, its salvage value can be considered zero.