Definitions

Depreciation – Explained + Examples



Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents the reduction in value of the asset due to wear and tear, obsolescence, or other factors. Depreciation is important because it allows businesses to spread the cost of an asset over its useful life rather than deducting the entire cost in the year the asset is acquired. This helps to match the cost of the asset with the revenue it generates, which is required for accurate financial reporting. There are several methods of depreciation, including straight-line, declining balance, and sum-of-the-years’ digits. The method used depends on the nature of the asset and the company’s accounting policies. Depreciation is commonly used in financial statements, tax returns, and other financial reports to accurately reflect the value of assets and the profitability of a business.

Examples of depreciation:

  1. A company purchases a delivery van for $30,000 with an expected useful life of five years. Using the straight-line method, the company can depreciate the van by $6,000 per year ($30,000 ÷ 5). At the end of five years, the van will have a book value of zero.
  2. A manufacturing firm invests $1 million in a new piece of equipment with a useful life of 10 years. The company decides to use the declining balance method, which allows for a higher rate of depreciation in the early years of an asset’s life. The company depreciates the equipment at a rate of 20% per year, resulting in a depreciation expense of $200,000 in the first year, $160,000 in the second year, and so on.
  3. A restaurant buys new kitchen equipment for $50,000 with a useful life of 7 years. The company decides to use the sum-of-the-years’ digits method, which results in a higher depreciation expense in the early years of an asset’s life. The company can depreciate the equipment by $14,285 in the first year, $12,245 in the second year, and so on.
  4. A company purchases a building for $500,000 with an expected useful life of 40 years. The company can depreciate the building using the straight-line method, resulting in a depreciation expense of $12,500 per year ($500,000 ÷ 40). At the end of 10 years, the building will have a book value of $375,000.

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