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In accounting, depreciation is the process of reporting the expense for a big-ticket purchase incrementally over the lifespan of this newly purchased item.  Depreciation is a concept that is directly related to the matching principle.  To provide a basic example of depreciation, consider ABC Woodworks Company, a woodworking business that purchases its own custom woodworking machinery.  When ABC Woodworks Company purchases a new custom piece of machinery, this new machine is durable enough to last for several years.  In accounting terms, this means that the equipment is in use over several reporting periods, not just the one in which the machine was purchased.  For this reason, it would be misguided to report the entire cost of this purchase as a single expense in the reporting period in which the purchase was made.  Remember, the matching principle states that revenues should be reported along with the expenses that were incurred in order to earn them.  When ABC Woodworks uses the machine to help generate revenues for a year, surely part of the cost of the machine should count as an expense, just not all of it.  Since the machinery generates revenue over several years, the matching principle dictates that the expense should be divided over these years as well.

As stated above, the business will not only be using the equipment in the year that it was purchased, but for several years subsequent to the purchase.  For this reason, it would be incorrect for the ABC Woodworks Company to report the expense as the total cost of the equipment in a single reporting period on a financial statement.  Not only would this be inaccurate, it would also make the ABC Woodworks Company’s business appear to be less financially stable than it really is.  Depreciation would rightfully suggest that it is more accurate to report only the costs of the machinery that were incurred in the given fiscal year.  In this case, only one year’s worth of the cost of the new machine should be reported.  There are several methods for calculating this figure, each with varying degrees of simplicity and accuracy.

Since the equipment will be used for more than one year, it is in everyone’s best interest for the company’s statement to reflect this.  To do otherwise would make a company look artificially less financially healthy than it really is.  For example, let’s go back to the ABC Woodworks Company example and say that it bought its new custom machine at total cost of $3,000,000.  Reporting this purchase all at once will severely impact the company’s balance sheets and make them look roughly $3,000,000 less profitable than they really are.  Additionally, the company realistically will not pay this $3,000,000 all at once.  Rather, they will pay part of this total over time until it is paid off.  So rather than report the $3,000,000 purchase all at once, the company only reports what the machine cost them in loan payments for a given year.  By spreading out the expense to reflect the lifetime of the item in question, the company is able to provide a far more accurate representation of its profitability.  To do otherwise would make the company appear less appealing to investors, which ultimately winds up hurting both the company and the potential investors.  Using methods of depreciation, an entity is able to provide investors with a far more accurate portrayal of its financial health by reporting certain large expenses over time.

So far, the equipment example has one glaring flaw for the sake of simplicity: it does not assume a resale value.  In other words, the example above suggests that by the time it is paid off, the ABC Corporation will have destroyed their new equipment beyond the point of selling it for any price whatsoever, a situation that is highly unlikely in the real world.  Realistically, the ABC Corporation would be able to resell their used machinery for scrap if nothing else.  This final sale price is something that must be taken into consideration when calculating depreciation in the real world.

Depreciation is a fundamental concept in accounting.  Related to the matching principle, its goal is to reflect a company’s inner workings and financial health as accurately as possible.  By spreading out the cost of an expensive purchase over an item’s lifetime, a company is able to provide a more accurate depiction of its expenses on a financial statement.  To do otherwise would result in less accurate statements that show the company to be less stable than it really is.  By understanding depreciation, companies are better equipped to provide investors with accurate statements.

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Source by Jeremy Saul