What is Depreciation?

Depreciation is the process of charging the cost of a fixed asset to expense over a period of time. It is used to gradually charge the capitalized cost of an asset to expense over its useful life. The intent is to recognize the cost of the asset over the period when it is contributing to the generation of revenue, so that there is some matching of revenue and expense.

Is Depreciation a Source of Cash?

When a depreciation charge is made, the entry is a debit to the depreciation expense account and a credit to the accumulated depreciation account. Since this entry does not alter the cash balance, depreciation is considered a noncash expense. From this perspective, depreciation is not a source of funds. However, the expense does reduce the amount of taxable income that a business reports, which shrinks the amount of income tax that it must pay. From this perspective, depreciation is an indirect source of funds. If a business was not going to report taxable income anyways, then depreciation is not an indirect source of funds.

Example of How Depreciation is a Source of Funds

Micron Metallic acquires a stamping machine for $300,000. It has a useful life of 10 years, so the company depreciates it over 10 years, at $30,000 per year. This $30,000 annual depreciation charge is a noncash expense, since the charge has no impact on cash (though the initial purchase of the machine had a $300,000 negative impact on cash). In the firm’s Year 1 tax return, it claimed the $30,000 of depreciation as a tax deduction. Micron is subject to a 21% flat corporate tax rate, so it saves $6,300 (calculated as $30,000 x 21%) by claiming the expense. As a result, the depreciation has saved Micron from making an income tax expenditure of $6,300, which can be construed as a source of funds.