Economic depreciation implies that an asset loses its value over time. But accounting depreciation has more to do with cost allocation than with loss of value. When equipment is purchased, there is a time period in which it will be used. Accountants use depreciation to ensure that the costs of revenue are matched to the revenue those costs helped to bring in for each time period.
In effect, we are allocating the cost of the equipment to the periods in which we used the equipment, even though we may have already paid for the equipment long ago. Accountants do this by figuring out how long the asset is likely to be in use, taking the appropriate fraction of its total cost, and counting that amount as an expense on the income statement. Most capital expenditures are depreciated (land is an example of one that isn’t).
Depreciation is typically found in the operating expenses portion of an income statement. However, unlike many operating expenses, depreciation is a non-cash expense in that money does not change hands when this expense is incurred: the cash has probably already been paid when the equipment was purchased.
Let’s assume we start a delivery company and in the first full month of operation we do $10,000 worth of business. At the start of that month, our company bought a $36,000 truck to make the deliveries. Now assume we’re expecting the truck to last three years. We depreciate it at $1,000 a month (using the simple straight line depreciation approach). The first two months of a greatly simplified income statement would look like this:
(Excerpts from Financial Intelligence, Chapter 8 – Costs and Expenses)
Depreciation is an example of the matching principle. In general, depreciation is the “expensing” of a physical asset, such as a truck or a machine, over its estimated useful life. Accountants have to follow GAAP, of course, but GAAP allows plenty of flexibility. No matter what set of rules the accountants follow, estimating will be required whenever an asset lasts longer than a single accounting period. The job for the financially intelligent manager is to understand those estimates and to know how they affect the financials.