Depreciation is an accounting term that refers to the reduction in value of an asset over time. This can happen for a variety of reasons, including wear and tear, obsolescence, or the passage of time.
For example, a company might purchase a piece of machinery for use in its manufacturing process. Over time, the machinery will become less effective and will need to be replaced. The cost of the machinery can be spread out, or "depreciated," over its useful life, so that the expense is recognized gradually rather than all at once. This allows the company to better match the cost of the asset with the revenue it generates.
Here's an example of how depreciation might work:
A company buys a new machine for $100,000. The machine is expected to have a useful life of 10 years, after which it will be obsolete and will need to be replaced. To calculate the annual depreciation expense, the company divides the cost of the asset by its useful life: $100,000 / 10 years = $10,000 per year.
Each year, the company will record a depreciation expense of $10,000 on its financial statements. This expense will be used to reduce the value of the asset on the company's balance sheet. After 10 years, the machinery will have a value of zero on the company's balance sheet, and the company will need to replace it with a new machine.