Depreciation
Depreciation is the systematic allocation of a tangible asset's cost over its useful life. Rather than expensing a machine or building all at once, a business records a portion of the cost as an expense each period the asset helps generate revenue.
Depreciation spreads the cost of a tangible non-current asset — machinery, vehicles, buildings, equipment — over the periods that benefit from its use. It applies the matching concept: because the asset generates revenue for years, its cost should be expensed over those same years rather than entirely in the year of purchase. Depreciation is an allocation of cost, not an attempt to measure the asset's market value.
The most common method is straight-line depreciation: (cost − residual value) ÷ useful life. A machine costing $50,000 with a $5,000 expected residual value and a 10-year life produces a $4,500 depreciation expense each year. The reducing-balance (declining-balance) method instead applies a fixed percentage to the asset's carrying amount, front-loading the expense into the early years. Each period's charge increases accumulated depreciation, and the asset's book value (carrying amount) equals cost minus accumulated depreciation.
Depreciation affects both financial statements: it reduces reported profit on the income statement and reduces the asset's carrying amount on the balance sheet, yet it is a non-cash expense — no cash leaves the business when it is recorded. That is why depreciation is added back when deriving cash flow from operations. Land is not depreciated, since it has an indefinite useful life, and some frameworks allow revaluation of assets, which changes the depreciable base going forward.
Depreciation is tested across several professional exams. The ACCA Financial Accounting (FA) exam covers depreciation methods, revaluations, and disposals; the CMA Part 1 exam tests depreciation of property, plant, and equipment under U.S. GAAP; and the FE Mechanical exam includes depreciation and book value calculations in its engineering economics section.
Key takeaways
- Depreciation allocates a tangible asset's cost over its useful life to match expense against the revenue the asset generates.
- Straight-line depreciation equals (cost − residual value) ÷ useful life; reducing-balance methods front-load the expense.
- Book value equals cost minus accumulated depreciation — it is not the asset's market value.
- Depreciation is a non-cash expense, which is why it is added back in the operating section of the cash flow statement.
- Land is not depreciated because it has an indefinite useful life.