Do You Understand Depreciation? – The Basics

In an accountant’s reporting systems, depreciation of a business’s fixed assets such as its buildings, equipment, computers, etc., is not recorded as a cash outlay. When an accountant measures profit on the accrual basis of accounting, they count depreciation as an expense. Buildings, machinery, tools, vehicles, and furniture have limited useful life. Except for actual land, all fixed assets have a limited lifetime of usefulness to a business. Depreciation is the method of accounting that allocates the total cost of fixed assets to each year of their use in helping the business generate revenue.

Part of the total sales revenue of a business includes recovery of cost invested in its fixed assets. In a real sense, a business sells some of its fixed assets at the sales prices it charges its customers. For example, when you go to a grocery store, a small portion of the price you pay for eggs or bread goes toward the cost of the buildings, the machinery, bread ovens, etc. A business recoups part of the cost invested in its fixed assets each reporting period.

It’s not enough for the accountant to add back depreciation for the year to bottom-line profit. The changes in other assets and liabilities also affect cash flow from profit. The competent accountant will factor in all the changes determining cash flow from profit. Depreciation is only one of many adjustments to the net income to determine cash flow from operating activities. Amortization of intangible assets is another expense recorded against a business’s assets for the year. It’s different in that it doesn’t require cash outlay in the year being charged with the expense. That occurred when the business invested in those tangible assets.