Definition:

Depreciation refers to spreading out the cost of a physical asset over its useful lifespan. It is paired with the idea of Capital Expenses (CAPEX) which is how we record the purchase of assets with long lives.

Amortization does the same thing for intangible assets. Together they are often shown as D&A in the financial statements.

Example:

You import some machinery for your business that costs $12,000. This is the CAPEX value that is recorded on the Balance Sheet.

If the useful lifespan of this machine is 10 years, your depreciation expense per year would be $1,200 (or $100 per month). This $100 is charged to the income statement each month as D&A.

Why it matters:

It is important that the income statement (P&L) reflects the true cost of providing products and services.

It would be wrong to charge the full cost of the machine in the month you bought it, as customers in future months also benefit. This would overstate the costs of serving those customers in that month.

At some point in the future the machine will need replacing, so to not charge the cost of the machine in later months would also be wrong, as it would overstate the profitability of those customers.

Depreciation solves both problems by allocating a fair share of the cost over time. It reduces the value of the machine on the balance sheet each month, and charges the same amount to the Income statement D&A cost category.