Depreciation refers to the reduced value of something over time due to wear and tear. Many items, from appliances to major construction machinery, lose value over time and eventually must be replaced.
Large items can affect the balance sheet, income statements, and taxes for businesses and individuals, but because many of the items last many years, they must be reported over multiple years. The method of allocating cost over the useful life of an asset each year is referred to as depreciation.
In the tax context, businesses and individuals must decide how to depreciate some assets over time because they take a tax deduction for the asset. The Internal Revenue Service (IRS) has strict rules for how different types of assets must be depreciated with some being depreciated in one year and some like buildings as long as 40 years. The ideal is for an asset to be depreciated according to how it actually loses value, but this calculation would be hard to make for many assets. Given that depreciation reduces taxable income, it is subject to much abuse. So the IRS generally implements rules on how assets must be depreciated.
In the accounting context, businesses want their profits to seem high or low for a variety of reasons. Large purchases on equipment like machinery can vastly change the profitability in a given year. Businesses without restraint could report an asset all in one year or over many more years than the asset will be used based on what their interests are. So, national and international standards govern how items must be depreciated over time such as generally accepted accounting principles (GAAP).
There are many ways the IRS and accountants calculate depreciation which varies based on the type of asset. The most common way to calculate depreciation is the straight-line-method where the asset is depreciated evenly over its useful life. For example, if a company purchased a generator for $10,000 with a useful life of ten years, the company would depreciate the generator $1,000 each year for ten years. Declining balance method is also popular where an asset depreciates based on a percentage equal to the useful life of the asset. With the generator example, the company would take a 10% deduction each year under this method. This often is more accurate because items like cars lose much more value in their first year than their last useful year.
[Last updated in January of 2022 by the Wex Definitions Team]