Financial Glossary
Depreciation
Depreciation is the systematic allocation of the cost of a tangible long-lived asset over its estimated useful life, matching the asset's economic consumption to the periods it generates revenue. Common methods include straight-line (equal annual expense), declining-balance (accelerated: higher expense early in life), and units-of-production (expense proportional to actual use). For tax purposes, the IRS prescribes asset class lives and allows accelerated methods including bonus depreciation and Section 179 expensing. Depreciation reduces taxable income and book net income but is a non-cash charge, so it is added back in cash flow statements and EBITDA calculations.
Problem & Application
A campground owner purchases a dump station and electrical infrastructure upgrade for $120,000. Under straight-line depreciation over a 15-year useful life, the annual depreciation expense is $8,000, reducing taxable income by that amount each year. If the owner instead elects accelerated bonus depreciation (assuming eligibility under current tax law), a substantial portion or all of the $120,000 cost may be deducted in the first year, creating a large near-term tax reduction. The cash-tax benefit depends on the owner's marginal rate. A sole proprietor in a 32% combined federal and state bracket saves roughly $38,400 in year-one taxes under full expensing versus spreading the same deduction over 15 years. Choosing the right method requires modeling cash tax timing alongside depreciation's impact on reported profitability, since a lender reviewing the financials will add back depreciation to assess debt service capacity, while a tax advisor will recommend the method that optimizes after-tax cash flow.
In Short
Proper depreciation accounting helps businesses manage asset values, optimize tax deductions, and maintain accurate financial reporting.