Depreciation is considered a non-cash expense. This is because it does not include the full amount of the asset's cost in the first year of service. Since capital equipment helps the company to generate cash flows for more than one year, it is written off against net income in increments.
Only equipment that is defined as capital equipment can be depreciated. Examples of capital equipment include trailers, trucks and tractors. Presumably, these assets are used for more than one year. As a result, due to accounting convention, they cannot be written off of net income in one year. The incremental write-off each year of the asset's useful life is referred to as depreciation.
The accounting convention that requires capital equipment to be written off over time is referred to as the matching principle. The matching principle is designed to match revenues to expenses as closely as possible. Since capital equipment is used for more than one year, the only way to match the revenues made with capital equipment to the expense of capital equipment is through depreciation.
One of the most popular methods used to depreciate capital equipment is referred to as the straight-line method. The straight-line methods depreciates an equal portion of the asset's cost each year of the asset's useful life. The three variables used in the calculation are useful life, salvage value and the original cost of the asset. The useful life of the asset is the number of years it will create revenue for the company. The salvage value is the value of the capital equipment after its useful life. The original cost of the equipment is the amount paid for the equipment, not the market value of the equipment.
As an example, assume you purchased a new tractor for $10,000. According to the vendor, the tractor is expected to have a useful life of three years. The local scrap yard will buy the tractor at the end of its useful life for $1,000. The useful life of the asset is three years, the original cost of the capital equipment is $10,000 and the salvage value is $1,000. Subtract the salvage value of the tractor from the cost of the tractor and then divide the answer by the useful life of the asset. The answer for this example is $10,000 minus $1,000 divided by three or $3,000. The annual depreciation expense for the tractor is $3,000.