What is Depreciation?

What is Depreciation?

When a company or individual purchases property, the value of that property might change over time. For example, a car purchased for $1000 might only be worth $500 three years later. Many people and even a few accountants might mistakenly believe the change in value of that asset represents “depreciation.”

From a dictionary standpoint, they might be right. From an accounting standpoint, however, it’s not quite that simple. Depreciation is a complex topic that not only involves the value of a tangible asset, but how that asset’s value is taxed.

Value vs. Cost

The conventional understanding of depreciation has to do with a tangible asset’s value. When an asset is said to “depreciate,” it means that its value decreases over time. In fact, referring to something that depreciates as an “asset” is likely somewhat of a misnomer, since depreciation tends to imply property as a liability rather than something of lasting value.

This is different from the accounting convention, since the value of an asset at any given time isn’t as relevant as the amount paid for it. The expense of an asset has tax ramifications. How much something is worth between when it is bought and when it is sold isn’t as important.

Value vs. Expense

When and how the purchase of an asset can be deducted from a company or individual’s tax liability, on the other hand, is highly relevant, since any purchase that is deductible isn’t necessarily subject to taxation. While not every purchase is deductible and both companies and individuals are required to follow certain rules when it comes to “depreciating” an asset over time, the value of rendering large amounts of a company’s income un-taxable by using it to purchase equipment, facilities or other necessities cannot be denied.

Ultimately, one of the best ways to remember the accounting form of depreciation vs. the conventional definition is to consider the fact that accountants use “depreciate” as a verb, while the average person thinks of “depreciation” as a noun.

Perception vs. Real Numbers

One of the reasons “depreciating” an asset over time is so popular is because it gives businesses an option.

If a company, for example, decides to deduct the entire cost of a $1000 purchase, it can reduce its tax liability considerably and do it all at once. Depending on the applicable rules, this might give them a considerable advantage in year one.

On the other hand, if a company decides to “depreciate” (used as a verb) the value of an asset over time, they are only required to deduct a portion of the asset’s value in any given year. This can serve to increase their net income, at least as that income relates to their balance sheet. This can give a company other kinds of advantages, for example, if they are applying for a loan or if the company is up for sale.

Civilians aren’t expected to understand the nuances of accounting, especially in this age of spreadsheets, computerized finance and the seeming ubiquity of business in every aspect of life. At the same time, learning the basic differences between the accounting versions of concepts and their everyday definitions can be a powerful way to understand the fundamentals of business.