Why Do Companies Depreciate Assets?

Companies depreciate assets to systematically spread the cost of a tangible asset over its useful life. This practice is a fundamental accounting concept that allows businesses to allocate the initial large expenditure of acquiring an asset across the periods that benefit from its use. Instead of recording the full cost in the year of purchase, depreciation reflects the gradual consumption of its economic value over time. It applies to items expected to provide benefits for more than one year.

Accounting Principles and Financial Reporting

Depreciation plays an important role in presenting an accurate financial picture of a company to stakeholders, such as investors and creditors. It adheres to the matching principle of accounting, which requires that expenses be recognized in the same period as the revenues they help generate.

By depreciating an asset, a business allocates a portion of its cost to each accounting period in which the asset contributes to revenue. For instance, if a machine produces goods for five years, its cost is spread across those five years, rather than being fully expensed at purchase. This ensures expenses are matched with revenue, providing a clearer representation of profitability.

Depreciation also impacts asset valuation on the balance sheet. It reflects the gradual decrease in an asset’s economic value due to wear and tear, age, or obsolescence. Accumulated depreciation reduces the asset’s book value on the balance sheet, preventing assets from being overstated.

On the income statement, depreciation is recorded as an expense, reducing net income. This systematic allocation prevents large, immediate profit reductions that would occur if an asset’s entire cost were expensed upfront, smoothing financial performance. Consistent application of depreciation provides a more accurate and stable view of a company’s financial health.

Tax Benefits and Deductions

Depreciation serves as a tax benefit for businesses by reducing their taxable income. It is a non-cash expense, meaning it does not involve an actual outflow of cash in the current period. While cash was spent when the asset was acquired, the annual depreciation expense does not require a new cash payment.

Deducting depreciation from revenue lowers a company’s net profit for tax purposes, resulting in a reduced tax liability. This reduction in taxable income is often called a “tax shield.” The cash saved from lower tax payments can be retained by the business, improving its cash flow.

Governments allow depreciation deductions as an incentive for businesses to invest in new assets and stimulate economic activity. For example, bonus depreciation provisions encourage investment, allowing businesses to deduct a larger percentage of an eligible asset’s cost in its first year of service. The Tax Cuts and Jobs Act of 2017 increased bonus depreciation, though it has been phasing out.

Depreciable Assets

Depreciable assets are tangible items owned by a business, used in its operations to generate revenue. To be considered depreciable, an asset must have a useful life longer than one year and be expected to wear out, decay, or become obsolete over time.

Common examples of depreciable assets include buildings, machinery, equipment, vehicles, and office furniture. A delivery truck, for instance, experiences wear and tear, and its value declines over its operational life, making it eligible for depreciation. Computers and other technology are also depreciable as they become outdated.

In contrast, certain assets are not depreciable. Land, for example, is not depreciated because it has an indefinite useful life and does not wear out. Other non-depreciable assets include inventory, investments like stocks and bonds, and personal property not used for business. Intangible assets, such as patents and copyrights, are amortized rather than depreciated, which is a similar process for allocating their cost over time.