Depreciation

Definition

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. It represents the gradual decline in an asset's value due to wear and tear, age, and obsolescence. Depreciation is a critical concept in understanding how a company recognizes sales, expenses, and the relationship between the balance sheet and income statement.

5 Must Know Facts For Your Next Test

1. Depreciation is an expense that appears on the income statement, reducing a company's reported net income.
2. The amount of depreciation expense recognized each period is determined by the asset's cost, estimated useful life, and depreciation method.
3. Capitalization is the process of recording an expenditure as an asset on the balance sheet, which allows the cost to be depreciated over time.
4. The relationship between the balance sheet and income statement is demonstrated through the recording of depreciation, as the asset value on the balance sheet decreases while the expense is recognized on the income statement.
5. Depreciation affects a company's operating cash flow, as it is a non-cash expense that is added back to net income when calculating cash flow from operations.

Review Questions

• Explain how depreciation is recognized on a company's income statement and how it impacts the reporting of sales and expenses.
  • Depreciation is recognized as an expense on the income statement, reducing the company's reported net income. This is because the cost of a tangible asset is allocated over its useful life through the depreciation process. As the asset is used in the company's operations, a portion of its cost is recognized as an expense, which impacts the reporting of both sales and other expenses on the income statement. Depreciation is a non-cash expense that must be considered when analyzing a company's financial performance and profitability.
• Describe the relationship between the balance sheet and the income statement in the context of depreciation, and how this relationship is reflected in the statement of cash flows.
  • The balance sheet and income statement are interconnected through the recording of depreciation. When a company capitalizes an expenditure as an asset on the balance sheet, the cost of that asset is then depreciated over time and recognized as an expense on the income statement. This reduces the asset's value on the balance sheet as it is consumed. The statement of cash flows then reflects the impact of depreciation, as it is a non-cash expense that is added back to net income when calculating cash flow from operations. Understanding this relationship is crucial for analyzing a company's financial position, performance, and cash flow.
• Evaluate how depreciation affects a company's operating cash flow and free cash flow to the firm, and discuss the importance of these metrics in financial analysis.
  • Depreciation is a non-cash expense that is added back to net income when calculating a company's operating cash flow. This is because depreciation represents the allocation of an asset's cost over time, but does not involve an actual cash outflow. As a result, operating cash flow, which is a measure of the cash generated from a company's core business activities, is higher than net income due to the addback of depreciation. Free cash flow to the firm, which represents the cash available for reinvestment or distribution to shareholders and creditors, is also impacted by depreciation, as it is calculated using operating cash flow. Understanding the role of depreciation in these key financial metrics is crucial for evaluating a company's financial health, liquidity, and long-term viability.

Related terms

Capitalization: The process of recording an expenditure as an asset on the balance sheet rather than expensing it immediately on the income statement.

Amortization: The systematic allocation of the cost of an intangible asset, such as a patent or software, over its useful life.

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