What Kind of Expense Is Depreciation?

Depreciation is a concept in accounting that helps businesses reflect the consumption of their long-term assets. It is an accounting method used to allocate the cost of a tangible asset over its useful life, rather than expensing the entire cost in the year it was purchased. This process recognizes that assets like machinery or buildings lose value and utility over time due to wear and tear, obsolescence, or usage. By systematically spreading the asset’s cost, depreciation provides a more realistic view of a company’s financial performance over multiple accounting periods.

The Core Concept of Depreciation

Depreciation is a non-cash expense, meaning it does not involve an actual cash outflow. When a business purchases a long-term asset, the cash payment occurs upfront. Depreciation then gradually reduces the asset’s recorded value over its operational life. This accounting entry is designed to match costs with revenues, not to deplete cash reserves.

The underlying reason for recording depreciation as an expense is the matching principle in accrual accounting. This principle requires that expenses be recognized in the same period as the revenues they help generate. For instance, a machine purchased to produce goods will contribute to revenue generation over several years. Instead of recording the entire cost of the machine as an expense in the year it was bought, depreciation allocates a portion of that cost to each year the machine is used to produce those revenues. This ensures financial statements accurately reflect profitability by aligning the asset’s cost with the income it helps create, avoiding distortion from expensing large purchases all at once.

Assets That Depreciate

Depreciation applies to tangible assets that have a determinable useful life and are used in a business or for income-producing activities. These assets are expected to last more than one year and whose value declines over time. Common examples of depreciable assets include buildings, machinery, equipment, vehicles, and office furniture. Land, however, is not depreciated because it has an unlimited useful life and does not wear out or become obsolete.

For an asset to be depreciable, it must be owned by the business, used for business or income-producing purposes, have a useful life that can be estimated, and be expected to last longer than one year. Assets acquired for personal use are not depreciable for business purposes. Certain assets are not depreciated. Inventory, held for sale, and financial assets like stocks and bonds, are not depreciated; instead, inventory costs are expensed as cost of goods sold when sold. Intangible assets, such as patents or copyrights, are also not depreciated; their cost is allocated over their useful lives through a similar process called amortization.

How Depreciation Appears on Financial Statements

Depreciation impacts a company’s primary financial statements. On the Income Statement, depreciation is recorded as an operating expense. This expense reduces the company’s reported net income and, consequently, its taxable income. The amount of depreciation expense is deducted from revenues to arrive at a company’s profit, reflecting the portion of the asset’s cost consumed during that specific period.

On the Balance Sheet, depreciation is reflected through a contra-asset account called Accumulated Depreciation. This account holds the total amount of depreciation that has been charged against an asset since its purchase. Accumulated depreciation is subtracted from the asset’s original cost to arrive at its “book value” or “carrying value.” As depreciation is recorded each period, the accumulated depreciation balance increases, causing the asset’s book value to decrease over time.

The Cash Flow Statement treats depreciation differently because it is a non-cash expense. For companies using the indirect method to prepare their cash flow statements, depreciation expense is added back to net income in the operating activities section. This adjustment is made because depreciation reduced net income but did not involve an actual outflow of cash. Adding depreciation back provides a clearer picture of the cash generated from a company’s operations, as it effectively reverses the non-cash reduction to net income.