What Is Depreciation? What Is FDI? Definition, Examples & How It Works

Understanding depreciation in accounting: a practical guide

Depreciation is an accounting method that allocates the cost of a physical asset over its useful life. Rather than recognizing the full purchase price as an expense when it buys the asset, companies spread out portions of that cost across accounting periods in which they earn revenue from that asset. This method aligns costs with the revenues they are aiding to create, resulting in more accurate financial statements.

Essentially, depreciation acknowledges that physical assets — such as machinery, vehicles, buildings or office equipment — lose value over time due to wear-and-tear, obsolescence or usage. By making the entry for depreciation, companies can demonstrate how much of an asset’s cost is ‘used up’ the company during a period. The residual unallocated cost is recorded on the balance sheet as book value, typically net of accumulated depreciation.

Key terms to know

• Cost: The purchase price, plus all expenses required to ready the asset for use (shipping, installation, etc.).
• Useful life: An estimate of how long the asset will be productive for the business.
• Salvage (residual) value: A projection of what the asset can be sold for at the end of its useful life.
• Accumulated depreciation: The sum of the depreciation that has been charged for an asset since it was put into service.
• Book value: The asset’s cost reduced by the accumulated depreciation

Common depreciation methods

Straight-line method

The straight-line method allocates the depreciable amount (cost minus salvage value) evenly throughout the asset's useful life. This is the easiest and most popular method. The annual depreciation expense is computed as:

Annual depreciation = Cost-demand (Salvage value-useful life

For example: A machine costs $50,000; Salvage value is $5,000; Useful life is 9 years. Annual depreciation = ($50,000 – $5,000)/9 = $5,000

Declining balance method

This is an accelerated method, recording more depreciation during the early years and less in the later ones. A more common one is double-declining balance, which doubles that straight-line rate. So depreciation is applied to book value at the start of period, not original cost; and typically there is no salvage value subtracted when applying percentage — salvage value comes into play when switching to straight-line towards end.

Units of production method

Stronger than time-based) Best for Some Specific Ones. Depreciation is dependent upon actual units produced or hours used. Annual depreciation = ( Cost - Salvage value ) x (Units produced this period / Total expected units over life))

The method chosen (capitalizing or expensing) depends on how an asset is consumed. Straight-line applies to assets in more basic steady use, declining balance best fits how things lose value (hard/soft) quickly at the start and levels out/decreases over time, and includes units of production as something with variable usage patterns.

Practical example and journal entries

For example, a delivery van is purchased for $30,000 with an expected life of 5 years and a salvage value of $5,000. With straight-line depreciation the annual expense is = ($30,000 - $5,000) / 5 = $5,000. Every year, the company debits Depreciation Expense and credits Accumulated Depreciation for $5,000. Accumulated depreciation increases each year and decreases the van's book value on the balance sheet.

Why depreciation matters

Matching principle: The depreciation of an asset matches the expense incurred to produce revenue evenly over time, resulting in more accurate profitability measurements.

Tax consequences: Implementation of depreciation deductions in many tax systems reduces the taxable income. Tax depreciation rules can differ from financial reporting methods, and as a result businesses often maintain separate accounting records for tax purposes.

Capital planning: Having information on accumulated depreciation and book value allows management to determine the timing of repairs, replacement, or disposal of assets.

Common misconceptions

Depreciation is not equivalent to market value: An asset’s book value can differ considerably from what it might sell for in the open market. Breakdown of depreciation follows accounting rules and estimates; market value depends on demand and conditions.

Depreciation is for tangible assets only: Intangible assets, such as patents, trademarks, or software, are usually amortized rather than depreciated; they share the same concept but aren’t technically considered depreciation.

Estimation of useful life and salvage value by companies

When estimating useful life and salvage value, it requires judgement. Manufacturers typically take guidance from manufacturers, best practices in the industry, historical experience (how long does it last?), estimated usage, maintenance plans and technological changes. Since estimates impact both reported expense and book value they may be re-evaluated on a prospective basis if circumstances change.

Impact on financial analysis

Analysts modify reported numbers to compare different companies that have varied depreciation strategies. Accelerated depreciation records more expenses sooner, reducing profits initially but increasing cash flow if tax policies permit it to be deducted more rapidly. In contrast, straight-line yields more consistent profit shapes. In capital-intensive industries, the choice of depreciation policy can have a material impact on both margins and asset turnover ratios.

Disposal and impairment

When an asset is sold or retired, the company eliminates the asset cost and accumulated depreciation from the books; any difference between proceeds and book value are recorded as a gain or loss. Impairment, on the other hand, is when an asset’s recoverable amount—and thus its value—falls below its book amount; log that loss now to show diminished future benefits.

Conclusion

Depreciation is an essential accounting mechanism to match costs with revenues, maintain the correctness of financial statements, and provide information to management regarding investments in long-term assets. By knowing the methods, assumptions and implications, writers, business owners and financial readers will find it easier to read company performance and make better decisions about asset management and reporting.