What is Depreciation?

In the accounting method known as depreciation, the cost of a tangible asset is written off over its useful life.

Depreciation is similar to amortization, except it is used on tangible assets, whereas amortization is for intangible assets.

With depreciation, if a tangible asset has a usefulness that will last at least 5 years, the cost of that asset is written off incrementally for the duration of that asset.

An Example of Depreciation

For example, if a company purchases new equipment for $100,000 which will last for 10 years, the company will write off the expense incrementally at $10,000 per year.

This means that companies can artificially boost net income by expensing only a portion of the cost.

Moreover, let's imagine that the equipment can be scrapped at the end for $20,000. That means that the depreciation expense will be less than $10,000 per year. It will now be:

depreciation expense = ($100,000 - $20,000) / 10 = $8,000

So now the accountant, instead of writing off the entire $100,000 in the year that it was purchased, can expense only $8,000 against net income each year until the last year.