Depreciation expense is an accounting classification used to reduce the amount of profits earned by a business when computing net income. Depreciation expense is recorded as an expense account on the income statement, not a liability account on the balance sheet, although it's closely associated with the balance sheet account of accumulated depreciation, which is a contra-asset used to reduce the net value of a business' fixed assets.
Depreciation is a concept in accounting used to measure a reduction in the value of fixed assets, such as buildings, equipment, leasehold improvements, and vehicles. As these fixed assets are used in the course of a business' operations, they experience wear and their future value is reduced. This reduction in value is known as depreciation. Depreciation is typically measured over the estimated useful life of the fixed asset. Under U.S. Generally Accepted Accounting Principles (GAAP), some fixed assets, such as land, are not expected to decrease in value and are not depreciated.
Depreciation expense is measured based upon the original cost of the fixed asset, the estimated useful life of the fixed asset, the method of depreciation, and the estimated residual value of the fixed asset after the useful life has been completed. Estimated useful lives are generally measured in either a period of time, typically several years, or in units of production, such as mileage for a vehicle or units produced for a machine. GAAP allows for business to use several different methods of depreciation, such as straight-line or accelerated depreciation.
Depreciation expense records the value of depreciation that has been moved from the balance sheet and onto the income statement during the period. When fixed assets depreciate, a journal entry is made to credit, or increase, the amount of accumulated depreciation associated with the fixed asset. Simultaneously, an equivalent debit is made to increase the amount of depreciation expense for the period. Depreciation expense can be thought of as the "cost" of wear and tear on fixed assets.
Very similar to the concept of depreciation is amortization. Amortization is the term used for the depletion of value for intangible assets, such as trademarks, computer software or loan reduction payments. Like depreciation expense, amortization expense is an income statement account that records the cost of amortization during the period. Amortization expense is also offset by a balance sheet account, accumulated amortization.
For taxation purposes in the United States, the same basic concepts of depreciation expense and accumulated depreciation remain. However, the Internal Revenue Service has set depreciation periods and rates that companies must use to depreciate assets for income tax purposes. As a result, there are often significant differences between depreciation expense for income tax purpose and the depreciation expense shown on a company's income statement.
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