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Depreciation Definition

Depreciation expense is the cost allocated to a fixed asset during a period. Many people think this is a way to “expense” assets over time, but that’s not really true. It is recorded as an expense on the income statement, but it isn’t an expense of the asset. Instead, it is allocating the cost of the asset over its useful life.

What is Depreciation?

Depreciation is a systematic reduction in the recorded value of an asset over its useful life by expensing it gradually. This accounting practice is applied to fixed assets, which generally decline in utility over several years. Depreciation aims to distribute expense recognition over the period when a business anticipates earning revenue from the asset's use.

For instance, if an organization buys a truck for $50,000 with an expected useful life of five years, it allocates $10,000 to depreciation expense annually. This even allocation over time is known as the straight-line method. Alternatively, using an accelerated depreciation method front-loads expenses, reducing reported income early in the asset's life. The units of production method bases depreciation on actual asset usage.

Capitalization Limit

To streamline accounting for depreciation, assets are only capitalized if the amount paid exceeds a set threshold, such as $5,000. Expenditures below this threshold are automatically expensed.

Accounting for Depreciation

A typical depreciation entry involves a debit to depreciation expense and a credit to accumulated depreciation. Accumulated depreciation, a contra asset account, offsets the fixed assets line item in the balance sheet. Disposing of a fixed asset involves crediting the associated asset and debiting accumulated depreciation to remove them from the books.

The Impact of Depreciation on Cash Flows

Depreciation expense recognition is unrelated to cash flows and is considered a noncash expense. Cash flows related to a fixed asset only occur during acquisition and eventual sale.

A B C D E F G H I J K L M N O P Q R S T U V W X Y Z
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