What is depreciation?

Depreciation refers to the allocation of the cost of a tangible asset over its useful life, which is a fundamental concept in accounting and financial reporting. When a company purchases a physical asset like machinery, vehicles, or buildings, that asset has a finite lifespan during which it contributes to revenue generation. Instead of expensing the entire cost of the asset in the year it is purchased, depreciation spreads this cost out over the asset’s useful life. This process aligns the expense recognition with the generated revenue, adhering to the matching principle in accounting.

By systematically reducing the reported value of the asset on the balance sheet and matching the expense with the revenues it helps produce, companies can present a more accurate financial picture. This method also reflects the wear and tear, obsolescence, or decline in the value of the asset over time.

Understanding depreciation is crucial for various stakeholders, including investors and analysts, as it directly impacts profitability, taxable income, and asset valuation decisions.