Before reading this explanation of ‘Depreciation’, please read ‘Capital Expenses vs Operating Expenses‘.
To explain depreciation, think of a machine you might buy to help you make baskets to sell; lets say the machine costs $10,000 and you use this machine for 10 years before the machine will be too old, and you will have to buy a new one. In accounting, we would say that this machine loses all of its value over 10 years or it depreciates by $1000 per year. So in the Profit and Loss Statement you would show a non-cash or below the line cost called Depreciation and if it was over a 1 year period, the machine depreciation cost would be $1000.
So depreciation is the amount of value that a tangible asset has been deemed to decline over a specified period of time.
Some assets depreciate more quickly than others depending on how they are used, and how fast they deteriorate.
There are different techniques for calculating depreciation, the main ones are ‘straight line’ depreciation and ‘unit of production’ depreciation. The example above of the Machine losing $1000 per year over 10 years is an example of ‘straight-line’ depreciation because the asset depreciates by the same amount each year. The ‘Unit of Production’ method applies to assets that are used in the production of units. For example, if we know a particular machine will be able to make 1,000,000 widgets over the course of its useful life, then to calculate the depreciation we would look at how many widgets were made in the specified period of time and allocate the cost accordingly. The fast the widgets are produced – the more the depreciation and the fast the asset loses value.
Most physical or tangible assets that you or a business might buy will depreciate, or lose value over time, with ‘land’ being an important exception.