Financial Education

Depreciation can be a component of both cost of sales (depreciation on manufacturing equipment) and selling, general, and administrative expenses (depreciation on sales offices). Depreciation is the allocation of the cost of assets that are expected to provide benefits over more than one accounting period.

For example, a company purchases a $450,000 piece of equipment that is expected to have a useful life of four years and a salvage value of $50,000 at the end of that time. It would not be appropriate to record the entire $450,000 (or even $400,000) as an expense on the income statement in the first year because the equipment will be used to generate revenues over its useful life of four years. Therefore, the cost of the equipment should be allocated over its useful life of four years. This allocation process is termed depreciation in the case of tangible assets such as equipment, amortization in the case of intangible assets, and depletion in the case of natural resources.

Because it would be costly to have the equipment appraised each year to determine its “depreciation” in value, and the resulting figure would still be subjective, estimation techniques are used. There are two basic types of estimation techniques, “straight-line” and “accelerated.”

For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis

See also:

Straight Line Depreciation

Intangible Assets

Reconciling Net Income to Cash Flow From Operations: Noncash Adjustments

Estimating the Average Age of a Company’s Assets

Determining the Average Useful Life of Assets