Depreciation |
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WIKI ANALYSIS| This article is part of WikiProject Definitions. Consider editing to improve it. View articles referencing this definition. |
Depreciation is the decrease in value of a tangible asset or assets over time
Depreciation is an accounting term used to rectify the cost of tangible assets with the decrease in value over their useful life (from normal use, wear and tear, or just the passage of time). It is reported as an expense on the income statement (usually as "depreciation" though often lumped together with amortization or sometimes in an overarching category like "other"). However, since it is a non-cash expense, depreciation is never actually paid for (no cash changes hands) and, as such, is added back to the total cash from operating activities on the cash flow statement. Thus, depreciation actually increases a company's free cash flow while decreasing earnings.
There are different methods of depreciating assets and each will provide different values for the asset over time. As such, there is some controversy over how companies choose to depreciate their assets, as different methods will provide different values. Some common methods of depreciation include straight-line depreciation, declining balance depreciation, and unadjusted depreciation. Regardless of what method of depreciation is chosen by the company, the total value of depreciation over the asset's lifetime will be the same. That is, the different methods simply provide different schedules for depreciation.
It should be noted that depreciation is not the spreading of an asset's cost over a period of time, but rather as a means of accounting for the item's decrease in value following initial purchase. The purchase of the item itself is calculated as an expense on the income statement at the time of purchase.
Example
- Company XYZ buys twenty new computers for $500 each, incurring a total cost of $10,000. The computers are expected to depreciate $100 in value each year after purchase. The year of the purchase, the full $10,000 cost of the machines goes on the income statement (likely as a non recurring expense). Since this was an actual cash expense, this money is paid to the vendor who sold XYZ the computers. Each year over the next five, as the computers depreciate in value, a depreciation expense of $2000 is listed on the income statement (20 * $100). However, since this money is not actually paid to anyone, the company still possess this cash and must therefore add this total back to the total cash from operating activities on the cash flow statement.
