Depreciation Explained

An article in The Wall Street Journal on December 8, 2025, had an excellent explanation of the strategies of the depreciation deduction and how companies try to deduct as little as possible for as long as possible to keep the earnings as high as possible for as long as they can.

Today, I want to provide the concept of depreciation and amortization as I explained to my accounting students.

Depreciation and amortization are accounting terms for the process of deducting the cost of major asset expenditures over a period of time. Most major asset acquisitions last for a period of years, and those costs need to be capitalized, i.e., not deducted immediately. These deductions would then be made over the estimated useful lives of those acquisitions. When the property is a tangible asset, such as a machine or building, the deduction is called “depreciation.” When the periodic deduction is for an intangible asset such as a patent or copyright, it is called amortization. Do not relate the name “depreciation” with any actual wear and tear of an asset – it is not relevant. They are only names given to that type of deduction.

The estimated useful life is nothing more than a best guess of how long that asset will be used. In some cases, guidelines are provided for classes of assets, and these are followed since they eliminate the need to justify the life that a company ascribes to that asset. Depreciation guidelines are provided by generally accepted accounting principles (GAAP) for audited financial statements, and the IRS provides guidelines for tax filing, and many other regulatory bodies have rules depending on their oversight of reports submitted to them.

In any event, regardless of the life chosen or the method, the full amount of the cost will be deducted at the end of that estimated period. In cases where the asset would have a residual value, then the cost would be reduced by that residual amount, and the periodic deductions would be based on the remaining cost.

Some rules permit different methods of depreciation, with some allowing an acceleration of the deductions at the beginning, but when the period is completed, the entire amounts deducted will be the same under every method.

For financial statement purposes, many companies would like smaller deductions at the beginning or possibly equal deductions annually over the entire period. This is because the net earnings could affect the market price of publicly traded companies or the amount of a loan if funds need to be borrowed. However, for tax purposes, there is an opposite goal because the business would want greater deductions at the beginning, which would result in lower tax payments early on, with the tax payments greater at the end of the asset’s useful life.

It is normal and desirable for companies to want to report as high a profit as possible on their financial statements while also trying to pay as little tax as possible for as long as possible. This is permitted, and the tax difference is reported on the financial statement as a deferred tax liability (or, less occasionally, as a deferred tax asset where there is a tax overpayment). The tax deferral provides added cash that can serve to reduce lending and interest costs or to shore up cash reserves. The deferral will not save any tax, but it provides “interest-free” cash and allows the payment of tax with inflated dollars.

While the rules require capitalizing the asset and taking depreciation deductions over a fixed period, they allow for variations of the depreciation method. For instance, a basic method is the straight line method, which results in equal deductions for each year. Another widely used method is called the double declining balance method, which permits larger deductions early on and smaller ones toward the end. Other methods permitted are based on hours the equipment is used, or units or pounds produced or any other method that the company feels would better match the deduction with the revenues to be generated from that asset.

Because of the permitted differences, the company would disclose the method used and the range of the useful lives in the Notes to Financial Statement section of its financial report. This is important when analyzing a company’s financial results or comparing competing companies.

The WSJ article mentioned at the beginning discusses some strategies to determine the optimal depreciation deduction.

The rules for amortization are similar but have some differences because of the inherent nature of tangible and intangible assets. The concept of depreciation can sound confusing at first, but it is a well-founded and well-used method that most people familiar with financial statements work with quite well.