2. Define depreciation.
Depreciation is an accounting method used to spread the cost of a tangible asset over its useful lifespan. It reflects how physical wear, tear, and obsolescence reduce an asset's value over time, allowing businesses to match the expense of a purchase with the revenue it generates. [1, 2]
Key Concepts
- Non-Cash Expense: It does not involve a direct outflow of cash; instead, it is a recorded deduction that lowers a company's taxable income.
- Useful Life: The estimated period an asset is expected to be usable and productive for a business.
- Salvage Value: The estimated residual worth of an asset at the end of its useful life. [1, 3, 4, 5, 6]
Common Calculation Methods
- Straight-Line Method: Spreads an equal amount of depreciation evenly across each year of the asset's life$\text{Annual Expense} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$
- Declining Balance Method: An accelerated method that applies a constant percentage to the asset's remaining book value, resulting in higher depreciation expenses in the earlier years. [7, 8]
For more details on how these calculations are structured for taxation and financial reporting, consult the Investopedia Depreciation Guide.
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