What exactly is depreciation, anyway?

Most businesses need to purchase some kind of durable equipment in order to operate. Equipment that lasts longer than one year is called a fixed asset (property used in a productive capacity which will benefit the enterprise for longer than one year). These assets assist in the generation of revenue over time. For instance, an oven that lasts several years may be used to bake many loaves of bread each day. The oven is integral to the sale of each loaf of bread.

Property such as ovens, furniture, computers, vehicles, and buildings contribute to the operating capacity of a company over many years. Because of this long-term contribution, fixed assets are treated differently than many other business expenses. The purchase price of these fixed assets is typically expensed over a period of years, rather than in the year the purchase was made. This business expense is known as depreciation (the process of deducting the purchase price of a fixed asset over several accounting periods).

Depreciation can be understood in three ways:

• Popular definition
  A decline in the market value (what the property could be sold for today) of an asset due to wear and tear or obsolescence. A new automobile "depreciates" when you drive it off the lot.
• Tax definition
  A way to recover the cost of a fixed asset through tax deductions. Like other business expenses, depreciation expenses reduce your taxable income.
• Accounting definition
  A means of allocating a portion of a fixed asset's cost to each period that the asset helps generate revenue.

This Decision Tool focuses on depreciation for accounting purposes.