Question

What is the purpose of depreciation in reporting on assets and periodic income?

Answer 1

Definition of 'Depreciation'

Definition: The monetary value of an asset decreases over time due to use, wear and tear or obsolescence. This decrease is measured as depreciation.

Effect of depreciation on assets

Depreciation represents the specific use of a company’s assets in an accounting period. When companies make large purchases, they will record the items as assets. Assets represent long-term value for a company’s facilities, vehicles and equipment. Expensing these items when purchased would create distorted net income. Therefore, accounting principles prefer that these items be recorded as assets with a corresponding expense recorded when the company uses each item.

In other words:

The purpose of depreciation is to match the cost of a productive asset (that has a useful life of more than a year) to the revenues earned from using the asset. Since it is hard to see a direct link to revenues, the asset's cost is usually allocated to (assigned to, spread over) the years in which the asset is used. Depreciation systematically allocates or moves the asset's cost from the balance sheet to expense on the income statement over the asset's useful life. In other words, depreciation is an allocation process in order to achieve the matching principle; it is not a technique for determining the fair market value of the asset.

When a business purchases a physical asset with a useful life of longer than a year -- a building, for example, or a vehicle -- it doesn't report the full cost as an upfront expense. That's because accounting rules require that the expense be spread over the useful life of the asset. That's done through depreciation. Say your business bought a new truck for $30,000 cash, and it estimates that the truck has an estimated useful life of 10 years. Under the most common depreciation method, called the straight-line method, your company would report no upfront expense but a depreciation expense of $3,000 each year for 10 years.

Effect of depreciation on income

A depreciation expense has a direct effect on the profit that appears on a company's income statement. The larger the depreciation expense in a given year, the lower the company's reported net income -- its profit. However, because depreciation is a non-cash expense, the expense doesn't change the company's cash flow

Profit is simply all of a company's sales revenue and any other gains minus its expenses and any losses. A $3,000 depreciation expense, then, has the effect of reducing profit by $3,000. It's important to note, however, that "profit" is really just an accounting creation. With the truck in the previous example, your business spent the money upfront. All of the money was gone as soon as you bought the truck. But as far as your profit-and-loss calculations are concerned, you didn't really give up any value. Instead, you just traded $30,000 worth of cash for $30,000 worth of truck. As time passes and you "use up" that value by using the truck, you turn the cost into an expense through depreciation.