What Is Depreciation?

When a business purchases a long-term asset (used for more than one year), it classifies the asset based on

whether the asset is used in the business’s operations. If a long-term asset is used in the business’s

operations, it will belong in property, plant, and equipment or intangible assets. In this situation, the asset is

typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet

and its allocated costs are expensed on the income statement over the asset’s economic life.

Long-term assets that are not used in daily operations are typically classified as an investment. For example, if

a business owns land on which it operates a store, warehouse, factory, or offices, the cost of that land would

be included in property, plant, and equipment. However, if a business owns a vacant piece of land on which

the business conducts no operations (and assuming no current or intermediate-term plans for development),

the land would be considered an investment.

Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time

that the business believes it will use the asset to help generate revenue.

Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the

cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when

you purchase or acquire a long-term asset, it must be recorded at the historical (initial) cost, which includes all

costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

1. Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as

property, plant, and equipment) at cost, and record the amount as notes payable, accounts payable, or an

outflow of cash.

2. At the end of the period, make an adjusting entry to recognize the depreciation expense. Depreciation

expense is the amount of the asset’s cost to be recognized, or expensed, in the current period. Companies

may record depreciation expense incurred annually, quarterly, or monthly.

Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s

estimated useful life.