Depreciation is when any asset is deemed to have reduced in value. No tangible asset can last indefinitely and therefore at some point, the asset will no longer be usable and will have to be recorded as a loss on the income statement. Depreciation allows a firm to allocate a percentage of that loss to different periods.
One of the reasons for using depreciation is so that when a very expensive asset such as a factory is no longer useful and is worthless, the company does not have to record a massive loss in a single period which would drastically affect performance. Depreciation allows this large loss to be allocated to lots of different periods in small amounts.
A business example of depreciation is if a company was to buy a new factory for $10 million and the useful life of that factory was 25 years, each year the factory would have effectively depreciated by $400,000 ($10,000,000 / 25) and this would be recorded as a loss each year rather than having no change in value and then a $10 million loss in year 25.
The typical real-world example of depreciation is whenever you buy a new car, it is deemed to have depreciated by up to 50% as soon as you drive it away from the dealer. Even though the car has not changed, it is worth less.
Related Terms