What is depreciation?

Depreciation is quite important in the business context, but before we discuss that, perhaps an example of something that most people are familiar with will help. 

A car is an asset that loses its value over time, such that a car might cost $20,000 when it is new, but the second owner might pay as little as $10,000 for the car after it has been used for a year or two. Car values tend to depreciate quite rapidly, and one aspect of a new car decision is doing research on how fast or slow the depreciation is for a particular model. We might pay a little more for a car that depreciates slowly with the knowledge that we can probably sell it or trade it in for more than other models. 

In a business, what is of the most importance is the assets that we use to make a product or provide a service. These assets depreciate, too. If I buy a fleet of trucks to deliver my product, they are going to lose value over time. The value they lose is the depreciation, and that is considered one of the business's expenses to create and deliver that product.

When we are looking at our profit, how much money we have made after taking off for all the expenses, called the cost of goods sold (COGS), we must pay taxes on the net amount. Since depreciation is an expense, it comes off the profit and allows businesses to pay less in taxes. 

There are a few different ways to handle depreciation, all in accordance with IRS guidelines. Reviewing a particular situation with an accountant is always best, since different ways of handling depreciation have different tax consequences. What is important, though, is to understand the concept and how it can be applied to a specific business to minimize taxation.