Does depreciation track the actual market value of an asset?

No. Depreciation is simply an allocation of the asset's cost over time, not a valuation method. A building might appreciate in market value, but accountants will still depreciate it on the books.

Can all business assets be depreciated?

No. Only tangible assets with a limited useful life can be depreciated. Land is the classic exception; it has an unlimited useful life, so it is never depreciated.

What is Accumulated Depreciation?

Accumulated depreciation is a contra-asset account that keeps track of the total depreciation recorded on an asset since it was purchased. While 'depreciation expense' shows the cost used up in a single year, accumulated depreciation shows the running total.

What is depreciation and how do you calculate it?

Depreciation is how accountants spread out the cost of a large, long-term purchase (like a delivery van or a factory machine) over the years it is actually used by the business. Instead of recording a massive expense all at once on the day it is purchased, a company records a smaller portion of that expense each year.

Think of buying a massive bottle of shampoo that lasts for 12 months. It wouldn't make sense to say you consumed the whole bottle on day one. You use a little bit each month. Depreciation does exactly this for business assets, reflecting how much of the asset's value has been used up over time.

The Straight-Line Method

The most common and straightforward way to calculate depreciation is the straight-line method. This method assumes the asset loses an equal amount of value each year. To calculate it, you need three numbers: the initial cost of the asset, its salvage value (what you can sell it for at the end of its life), and its useful life (how many years you expect to use it). The formula is: $(Cost - Salvage Value) / Useful Life$ .

Why Depreciation Matters

Depreciation is built on a core accounting concept called the matching principle. This principle states that business expenses must be matched with the revenues they help generate in the same time period. If a pizza oven helps make pizzas for ten years, its cost should be spread across those ten years of pizza sales, rather than taking a massive profit hit in year one and showing inflated profits in years two through ten.

Where Students Slip Up

A very common mistake is confusing depreciation with a cash expense. Students often think that a depreciation expense means the company is writing a check for that amount each year. It is important to remember that depreciation is a non-cash expense. The cash was already paid when the asset was initially purchased; depreciation is simply an accounting adjustment to track the asset's use over time.

Worked through

A bakery purchases a new delivery van for $30,000. The owner expects the van to be useful for 5 years, after which it can be sold for$ 5,000 (its salvage value). Calculate the annual depreciation expense using the straight-line method.

First, we identify our variables: Cost = $30,000, Salvage Value =$ 5,000, and Useful Life = 5 years. Next, we find the depreciable base by subtracting the salvage value from the cost: $30,000 -$ 5,000 = $25,000. This is the total amount of value the van will lose over its time at the bakery. Finally, we divide this depreciable base by the useful life:$ 25,000 / 5 = $5,000. The bakery will record a depreciation expense of$ 5,000 each year for 5 years.

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Where this comes from: OpenStax Principles of Financial Accounting, Chapter 10 · Khan Academy: Depreciation and Amortization unit