What is depreciation?

Depreciation refers to the process of allocating the cost of a tangible fixed asset over its useful life. This accounting method acknowledges that fixed assets, such as machinery, vehicles, and buildings, lose value as they age and as they are used in operations. By applying depreciation, businesses can reflect an asset’s decline in value on their financial statements, which gives a more accurate picture of the company’s financial status and helps in calculating profit by matching expenses with revenues generated from the use of those assets.

Understanding this concept is crucial because it impacts both the income statement and the balance sheet. On the income statement, depreciation expense reduces taxable income, while on the balance sheet, it affects the book value of the assets. The reduction in value is calculated based on various methods, such as straight-line or declining balance methods, which determine how much should be expensed each accounting period. Hence, the choice stating that depreciation is the reduction in value of an asset over its useful life accurately captures its essence and purpose in accounting.