Depreciation definition explained

The accounting definition of depreciation is often one that confuses a lot of people. In this post, the meaning of depreciation will be explained to you in simple language using a simple example – that of a banana.

If you want to skip the reading, here is a quick video (2:58) that shows you what depreciation is and how it works.

The easiest way to think about what depreciation is to look at this banana. On day 1 when I buy this banana, it’s yellow. Then after a few days, it deteriorates until it’s rotten.

You’ll see that after each day as it deteriorates, it loses its value.

That means I won’t be able to sell it to someone else for as much money as I originally bought it based on how it now looks.

Day 1, I’ll probably be able to sell it to someone for 50c, the next, probably for 45c, and then after for 35c, then 20c, and finally, no one will buy it.

See there’s a difference between the days, from the first to the second, there’s a 5c difference, 2nd to 3rd 10c, then 15c and 20c.

The amounts by which this banana is losing its value is called depreciation.

Depreciation is used to account for things like deterioration and wear and tear that would reduce the worth of something.

Except depreciation in accounting for your tax isn’t applied to bananas but rather to certain things that you own (aka assets) which meet a criteria (I just used the banana to show you the concept).

The IRS lists rules for depreciation such as that you must own it, use it in the business and its useful life would be more than one year.

So something like a car is ok, furniture can be depreciated, but not bananas!

Why do we need depreciation?

Well, when you buy an asset, say a car - you don’t expense it, even if you’ve spent money, instead, you record it as an asset, something you own. This means it doesn’t show up in your profit and loss directly, even if you’ve spent the money to buy it.

If it’s been used, it has lost some of its value (that is, you’re unlikely to get as much money if you sold it now) and therefore, you need to record this as an expense because it has cost your business money.

You’re unable to get as much income from the car that you purchased it for originally so this reduction must be accounted for somewhere AND… This is depreciation expense. This is when your ‘car’ appears in your profit and loss.

So that’s the meaning of depreciation, a decline in value of an asset usually through wear and tear, being obsolete and deterioration.

Next: The easy-to-understand meaning of accounts receivable (with examples)

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