Depreciation

When a business buys equipment that will last several years, it would be misleading to record the whole cost as an expense in the year of purchase. The equipment helps generate revenue throughout its life, so its cost is gradually charged to the income statement over that period.

The simplest method is straight-line depreciation. If a machine costs 50,000, is expected to last five years and will be worth 5,000 at the end, the depreciable amount is 45,000. Spread evenly, that gives depreciation of 9,000 a year.

Other methods charge more depreciation in the early years, reflecting the fact that many assets lose value faster when new. Land is not depreciated, because it does not wear out.

Depreciation is a non-cash expense. The cash was spent when the asset was bought; depreciation simply allocates that cost over time. This is why it is added back when calculating cash flow from operations. Tax rules often have their own depreciation methods, which can differ from those used in financial statements.