Depreciation Expense

Definition

Depreciation expense is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents the gradual decline in the value of an asset as it is used in business operations, allowing the cost to be spread out and matched with the revenues it helps generate.

5 Must Know Facts For Your Next Test

1. Depreciation expense is a non-cash expense, meaning it does not involve an outflow of cash but rather a systematic allocation of the asset's cost.
2. The amount of depreciation expense recorded each period is determined by the asset's cost, estimated useful life, and the chosen depreciation method.
3. Depreciation expense is reported on the income statement and reduces a company's reported net income, but it does not affect the company's cash flow.
4. Accumulated depreciation is reported on the balance sheet as a contra-asset account, reducing the carrying value of the related fixed asset.
5. Proper recording of depreciation expense is crucial for accurately reflecting a company's financial performance and asset values.

Review Questions

• Explain how depreciation expense is calculated and its impact on a company's financial statements.
  • Depreciation expense is calculated by dividing an asset's cost by its estimated useful life. The resulting amount is then recorded as an expense on the income statement, reducing the company's reported net income. However, depreciation expense is a non-cash expense, meaning it does not involve an outflow of cash. Instead, it systematically allocates the asset's cost over its useful life, with the accumulated depreciation being reported as a contra-asset on the balance sheet, reducing the carrying value of the related fixed asset.
• Describe the relationship between depreciation expense and the statement of cash flows.
  • While depreciation expense is reported on the income statement and reduces a company's net income, it does not affect the company's cash flow. This is because depreciation is a non-cash expense. When preparing the statement of cash flows using the indirect method, the depreciation expense is added back to net income to arrive at the company's cash flow from operating activities. This is because depreciation expense is a non-cash item that needs to be accounted for when reconciling net income to the actual cash generated from operations.
• Analyze how changes in a company's depreciation policies can impact its financial reporting and decision-making.
  • A company's choice of depreciation method and estimated useful life for its assets can significantly impact its financial statements and, consequently, its decision-making. For example, if a company chooses to use a shorter useful life or an accelerated depreciation method, it will report higher depreciation expense in the early years of an asset's life, leading to lower reported net income. This can affect the company's profitability ratios, tax liabilities, and even the perceived value of the business. Conversely, a longer useful life or a straight-line depreciation method will result in lower depreciation expense and higher reported net income in the short term. These choices can influence a company's investment decisions, financing strategies, and even its perceived financial health by investors and creditors.

Related terms

Useful Life: The estimated period of time over which an asset is expected to be used and contribute to a company's operations.

Straight-Line Depreciation: A method of calculating depreciation expense where the asset's cost is divided equally over its useful life.

Accumulated Depreciation: The total amount of depreciation that has been recorded against an asset over its useful life.