What is the purpose of depreciation?

Depreciation provides a means to report assets on the balance sheet at a more realistic value than original purchase prices. This makes the financial statements more meaningful to users.

Depreciation has two main purposes.

-- The first is to provide for proper matching of revenues and expenses. Fixed assets provide benefits to a company throughout their useful lives. Thus, some of the expense from purchasing the assets should be recognized during each period of the assets' estimated useful lives. For example, if a farming company buys a tractor, the tractor helps to provide revenue each period. It is appropriate that some of the cost of the tractor be recognized each period to "match" it with the revenue the tractor is producing. If the tractor was not depreciated and instead was expensed in the period in which it was purchased, that period would unfairly bear all of the cost of the tractor, and net income would be understated. Future periods would receive the revenue generated by the tractor but none of the associated costs, and net income in those periods would be overstated.

-- The second purpose is to properly value fixed assets on the balance sheet and account for their devaluation over the course of their lives. If the tractor in the above example was purchased for $20,000, after one year of use it would no longer be worth $20,000. It might only be worth $15,000, for example.

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Depreciation is an application of the matching principle in accounting and is designed to reflect the fact that some assets are used to generate profits over multiple accounting periods. Using depreciation the cost of an asset is spread out (or "written off") over the number of periods you expect it to be of use (called the asset's "Useful Economic Life"). Some people, including some Accountants, will tell you that depreciation is an attempt to show the reduction in the value of the asset. This is wrong. If you want to show the value of an asset then you revalue it.