Depreciation Definition in Accounting & How to Calculate

What is Depreciation in Accounting?

In accounting, depreciation is the process of allocating the cost of a tangible fixed asset over its useful life. It reflects the gradual decrease in the asset’s value due to wear and tear, age, or obsolescence.

Depreciation allows businesses to match the expense of using an asset with the revenue it helps generate, providing a more accurate picture of profitability. Common examples include machinery, vehicles, office equipment, and buildings.

Depreciation is recorded as an accounting entry, typically debiting a depreciation expense account and crediting accumulated depreciation. This ensures that financial statements reflect both the cost of assets and the expense associated with using them.

How to Calculate Depreciation

There are several methods to calculate depreciation, but the most common include:

1. Straight-Line Depreciation: Spreads the cost evenly over the asset’s useful life.

Formula:

Depreciation Expense = (Cost of Asset – Residual Value) / Useful Life

2. Declining Balance Method: Applies a fixed percentage to the asset’s remaining book value each year, resulting in higher depreciation in earlier years.

3. Units of Production Method: Bases depreciation on the actual usage or production output of the asset.

Calculating depreciation accurately ensures proper expense recognition, helps in tax reporting, and gives a realistic view of asset value over time.

Example of Depreciation in Practice

A company purchases machinery for €50,000, with an estimated useful life of 5 years and no residual value. Under straight-line Depreciation, the company will record an annual expense of €10,000.

‍

‍

This table shows how Depreciation reduces the book value of the asset until it reaches zero.

Why Does Depreciation Matter?

Depreciation affects financial statements and asset valuation by systematically allocating the cost of a tangible asset over its useful life.

On the income statement, depreciation is recorded as an expense, reducing net income even though it does not involve an actual cash outflow. This allows businesses to match the cost of using an asset with the revenue it helps generate.

On the balance sheet, depreciation decreases the book value of assets through accumulated depreciation, reflecting a more realistic net book value rather than the original purchase cost.

In the cash flow statement, depreciation is added back to net income because it is a non-cash expense, ensuring that cash flow accurately represents available funds.

By accounting for depreciation, companies provide a truer picture of both profitability and the declining value of their assets, which is essential for investors, management, and other stakeholders evaluating financial health.