Depreciation is accounting for the aging of assets.
Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.
Most types of tangible property (except land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable.
In other words, as a company owns and utilizes an asset, its value will most likely decrease. As discussed in the balance sheet chapter, if an asset value decreases, there must be another change to one of the other line items in the balance sheet to offset the asset reduction. Accounting rules state that the reduction in asset value can be expensed, with the idea being that the asset’s aging or wear and tear is partly due to utilization of the asset to produce or generate revenue. If the item is expensed, net income is reduced, which in turn will reduce the retained earnings in the shareholders’ equity section of the balance sheet.
Let’s take an example of an asset that has a depreciation expense of $5, 000. Depreciation expense reduces net income after taxes, as shown. Net income drives the cash flow statement, but since depreciation is a noncash expense it is added back to cash.
In the balance sheet, net income drives retained ...