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Depreciation
ACCOUNTS
Depreciation is the accounting practice of spreading the cost of something long-lived across the periods in which it is used, instead of charging the whole cost in the period it was bought. It is an allocation of a cost already paid, not a payment, and no money moves when it is recorded.
The problem it solves
A vehicle bought for use over six years is not a cost of the month it was purchased. Charging the whole amount at once would make that month look catastrophic and the following seventy-one months look better than they were, and the accounts would describe the timing of a purchase rather than the performance of a business.
Depreciation fixes the mismatch by writing off the cost gradually. Each period carries a share, the recorded value of the item falls by the same amount, and by the end of the expected life the cost has been fully absorbed. The item may still be working; the accounting question is only whether its cost has been recognised.
Methods and judgement
The simplest method spreads the cost evenly across the expected life, which is called straight-line. Others charge more in the early years, on the reasoning that most things lose value fastest when new. The choice affects the reported profit of individual periods and never affects the total cost, which was fixed at purchase.
Because expected life and residual value are estimates, depreciation is one of the places where judgement enters the accounts most visibly. That is not a defect, but it is a reason to look at cash generated by trading alongside reported profit: the first is unaffected by the estimate, the second is not.
Straight-line illustration, round numbers only Cost of item 6,000 Expected useful life 5 years Expected value at the end 0 Charge per year 6,000 / 5 = 1,200
Illustration only. The figures show the arithmetic of the method and describe no actual purchase.
Related terms
- Working capitalThe short-term money tied up in running the business day to day.ACCOUNTS
- Accrual basisRecording income and cost when they arise, not when money moves.BOOKKEEPING
- Double-entry bookkeepingRecording every transaction twice so the books check themselves.BOOKKEEPING
This term belongs to Reading a set of accounts.