Depreciation is an accounting term and refers to a financial feature that allows companies to account for certain expenses on a balance sheet in a beneficial way. Also, depreciation is how real estate property may be expressed on a balance sheet. When a physical asset declines in value, the result is known as depreciation. Sometimes, assets can depreciate too severely and create a buying opportunity. Other times, the value of assets become so depressed that they become worth next to nothing.
When a company uses capital, or spends money, it reports that activity on a quarterly or yearly financial statement as an expense. If the money is directed toward acquiring an asset, for instance, a piece of industrial equipment, it may be treated as depreciation rather than being grouped as an expense. This holds true because of the matching principle, and it applies whether the physical asset is paid in full or financed with equity or debt.
The matching principle has to do with time duration. Most likely, the piece of equipment purchased may be used to produce revenues, but the sales generated will not likely be limited to the quarter or year that the balance sheet reflects. Subsequently, the company can value the equipment based on the anticipated longevity of that particular product.
Identifying depreciating assets on a financial statement works to a company's advantage. In order to be sure that a company is not taking advantage of this accounting feature, investors may want to compare the way that one business accounts for a depreciating asset versus a competing entity in the same sector. This adds to investor confidence that a company's bottom-line earnings are in fact what they appear to be and not a result of clever accounting.
In real estate, property owners have the freedom to label certain assets as having a depreciating value. A benefit is that, when filing yearly tax returns, property owners can write off depreciated assets as accounting deductions. As a result, the total value of income that is taxed decreases, and income for the period rises.
Real estate depreciation is also an accounting function. The value of buildings, either commercial or residential, can drop over time in response to harsh weather conditions or other factors. As a result, this depreciation can be included on a financial statement as an expense. Grounds surrounding physical assets are not considered as depreciating property, however.
