When a business buys equipment, reporting the full value as an expense right away could make even profitable companies appear as if they're losing money. Thus, companies often use depreciation—an accounting method that spreads these big-ticket expenses over time.

Depreciation isn't an accounting trick. It reflects the reality that assets lose value over time through use and obsolescence. Take Microsoft Corporation's (MSFT) reported plan to spend $80 billion on AI-enabled data centers in the mid-to-late 2020s. Rather than showing an enormous hit to net income—on its own, these expenses would have almost zeroed out MSFT's net income of $88.1 billion in 2024—depreciation allows the company to divide that cost across the equipment's expected life span.

Below, we take you through what you need to know about this important practice.

Depreciation Overview

When companies make major investments in 澳洲幸运5官方开奖结果体彩网:physical assets, how should they record these massive expenses? Rather than taking the full hi♐t upfront, depreciation lets businesses spread these costs across the years they'll use the equipment.

Here's a breakdown of the main concepts involved:

• Tangible asset: Depreciation applies to physical assets expected to last for more than one year (often called fixed assets or capital assets). Land is not depreciated since it's considered to have an unlimited useful life.
• Useful life: This is the estimated period of time that the equipment will be productive for the business, which isn't necessarily how long the equipment will last. Instead, it's the period it's expected to be used by that specific business. Useful life is often dictated by accounting standards or tax regulations.
• Cost: This includes the purchase price and any expenses to get the asset ready for use (e.g., shipping, installation, and set up)
  

Depreciation moves these costs from the company's 澳洲幸运5官方开奖结果体彩网:balance sheet (wher🍷e assets are recorded) to its income 🥃statement (where expenses are tracked).

Why Depreciation Is Important

Here are theও core reasons depreciation is a crucial part of modern accounting methods:

• The matching principle: This longstanding principle in accounting means that expenses should be recognized in the same period as the revenues they help generate.
• A better depiction of a company's financial position: Likewise, it provides a more accurate representation of a company's financial position and performance.
• Tax benefits: Depreciation is a tax-deductible expense. This reduces taxable income and, therefore, the amount of tax a company owes.
• Managing company assets: Depreciation helps businesses track the value of their assets and plan for future replacements.

Depreciation in Accounting

While a company might spend cash upfront to buy equipment, the depreciation expense appears spread out across multiple financial statements, reflecting how that equipment's value decreases through use.

Companies normally must follow 澳洲幸运5官方开奖结果体彩网:generally accepted acc🎉ounting principles issued by the Financial Accounting Standards Board when recording depreciation. These🌱 standards require matching expe🐈nses with related revenue. So, if a machine helps make products for five years, its cost should be spread across those five years rather than hitting the books all at once.

Setting Depreciation Thresholds

Most businesses set minimum amounts to determine whether they'll depreciate an asset or expense it right away. A small business might set this threshold at $500, while larger corporations often use higher limits like $5,000 or $10,000. It's simply not worth the time and accounting costs to depreciate everything a c🌳ompany buys for these purposes.

How Assets Are Valued

These aspects of depreciation are used to track an asset's value over time:

• 澳洲幸运5官方开奖结果体彩网:Accumulated depreciation: This represents the total amount depreciated since the purchase was made. So, if a $50,000 machine depreciates $10,000 annually, its accumulated depreciation would be $30,000 after three years.
• Carrying Value (or book value): This represents what's left after subtracting accumulated depreciation from the original cost. In our example, the machine's carrying value would be $20,000 after three years.
• Depreciable base (or depreciable cost): It's not the original cost (purchase price plus delivery, etc.) used for calculating depreciation, but the depreciation base. It's calculated as follows: Cost - Salvage Value = Depreciable Base.
• Depreciation rate: This is the annual percentage at which an asset is depreciated over its useful life. For example, if a company expects an asset to depreciate $1,000,000 over its lifetime and the annual depreciation is $200,000, the depreciation rate is 20%.
• Salvage value (or residual value): This is what the company expects to receive for the asset if it's sold, scrapped, or traded in. Generally, the longer the useful life, the lower the residual value; sometimes, the salvage value is zero.
  

Carrying Value vs. Market Value

While carrying value tracks depreciation on the books, it often differs significantly from what an asset would actually sell for—its 澳洲幸运5官方开奖结果体彩网:market value. Consider Microsoft's data centers: Their carrying value might show steady depreciation over time, but their market value could be higher because of the surging demand for AI infrastructure, or lower if newer, more efficient technology makes them obsolete faster than expected. Thus, the gap between the carrying value and the market value can be substantial.

Depreciation and Taxes

Companies also use depreciation to cut their tax bi꧟lls with the Internal Revenue Service. For example, when Microsoft invests $80 billion in AI infra♏structure, it will deduct portions of those purchases each year, lowering its corporate tax bill.

The tax code generally requires companies to spread these deductions across multiple years, matching how they expect to use the asset. (澳洲幸运5官方开奖结果体彩网:Section 179 of the tax code offers businesses some flexibility—in some🌞 cases, they can deduct the entire cost🍌 of qualifying equipment in the first year.)

These are the criteri𝓡a the IRS has set for what can be depreciated:

• Be owned by the business (not leased)
• Be used for business or income-producing activities
• Have a useful life that can be calculated
• Be expected to last more than a year
• Not fall under excluded categories, such as intangible property (these are generally 澳洲幸运5官方开奖结果体彩网:amortized) or equipment used for building the capital improvements
  

Types of Depreciation With Calculation Examples

Companies can choose from several methods to depreciate their assets. To demonstrate, we'll use the example of a company purchasing a $50,000 computer server with an expected useful life of five years and a $5,000 salvage value.

Straight-Line Method

The straight-line method൲ is the simplest and most common. It spreads the cost evenly across an asset's life. Using the above figures, we get the following:

• Total depreciation: $45,000 ($50,000 - $5,000 salvage value)
• Annual depreciation: $9,000 ($45,000 ÷ 5 years)
• Depreciation rate: 20% (1 ÷ 5 years = 0.20 or 20% per year)
  

Declining Balance

The 澳洲幸运5官方开奖结果体彩网:declining balance method accelerates depreciation by using th෴e straight-line percentage (20% in our example) and applying it to the remaining balanc💜e:

• Year 1: $10,000 ($50,000 × 20%)
• Year 2: $8,000 ($40,000 × 20%)
• Year 3: $6,400 ($32,000 × 20%)

Double-Declining Balance

This method🥂 doubles the declining balance rate (20%), front-loading even more deprec💃iation:

• Year 1: $20,000 ($50,000 × 40%)
• Year 2: $12,000 ($30,000 × 40%)
• Year 3: $7,200 ($18,000 × 40%)

Sum-of-the-Years' Digits (SYD)

The SYD method also accelerates depreciation but is calculated differently. For a five-year asset, add years 1+2+3+4+5 = 15. Then𓆉 use these fractions against the depreciable amount ($45,000):

• Year 1: $15,000 ($45,000 × 5/15), using the highest number first
• Year 2: $12,000 ($45,000 × 4/15), second largest number
• Year 3: $9,000 ($45,000 × 3/15), and so on

Units of Production

This method accounts for usage rather than time. If the server is expected to process 1 million computations in its lifetime𝓀, you♌ might get something like the following:

• Depreciation per computation = $45,000 ÷ 1,000,000 = $0.045
• If it processes 300,000 computations in Year 1, depreciation would be $13,500 (300,000 × $0.045)
  

The Bottom Line

Understanding depreciation is crucial for investors because it impacts both a company's reported earnings and its tax obligations. When companies make major investments—whether in AI infrastructure, airline fleets, or manufacturing equipment—depreciation determines how these costs appear in financial statements over time. Different depreciation methods can significantly affect reported profits, especially in capital-intensive industries.