What is depreciation, and how does it impact a company's financial statements?
View answer
Hide answer
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. It represents how much of an asset's value has been used up. Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profit margins.
Depreciation impacts a company's financial statements in the following ways:
Balance Sheet: Depreciation reduces the value of assets on the balance sheet. Each time a company records depreciation, it reduces the value of its net fixed assets (or property, plant, and equipment).
Income Statement: Depreciation is also an expense. Although it’s a non-cash expense (meaning no money is physically going out of the door), it’s still recorded on the income statement and reduces the company's net income.
Cash Flow Statement: Because depreciation is a non-cash expense, it’s added back to net income on the cash flow statement under the operations section.
Here's a simple example of how depreciation works:
Let's say a company buys a piece of equipment for $10,000. The company estimates that the equipment will have a useful life of 10 years, after which it won't be usable or valuable to the company. Using straight-line depreciation, the company will depreciate the asset by $1,000 every year (10,000 / 10 years). This means that each year, the company will record a depreciation expense of $1,000 on the income statement, and reduce the value of the equipment by $1,000 on the balance sheet.