Definition:

Depreciation is the accounting method of allocating the cost of a tangible asset over its useful life. It represents how much of an asset's value has been used up over time.

Examples

1. A company buys a delivery truck for $50,000. If the truck has a useful life of 10 years, the company might depreciate it by $5,000 each year using the straight-line method.
2. A manufacturing firm purchases machinery for $100,000 with a useful life of 5 years. Using the double-declining balance method, the depreciation expense will be higher in the earlier years.

Formula:

Straight-Line Depreciation = (Cost of Asset - Salvage Value) / Useful Life

How to use the metric:

Depreciation is used to allocate the cost of an asset over its useful life, which helps in matching the expense with the revenue generated by the asset. It is recorded as an expense on the income statement, reducing taxable income.

Limitations:

1. Depreciation methods are based on estimates of useful life and salvage value, which can be subjective.
2. It does not account for the actual market value of an asset, which may fluctuate over time.
3. Different methods can lead to different financial results, affecting comparability between companies.

Applies to:

Depreciation is applicable in industries with significant investments in tangible assets, such as manufacturing, transportation, and construction, where assets like machinery, vehicles, and buildings are used.

Doesn't apply to:

Depreciation does not apply to industries that primarily deal with intangible assets, such as software development or consulting, where assets like intellectual property or human capital are more prevalent. Additionally, land is not depreciated as it does not have a finite useful life.

Summary:

Depreciation is a key accounting concept used to allocate the cost of tangible assets over their useful lives. It helps in accurately reflecting the expense associated with using an asset, thereby aligning costs with revenues. While useful, it relies on estimates and does not reflect actual market values, which can limit its accuracy and comparability.