Depreciation

Depreciation spreads the cost of a long-lived asset across the years it is used. A machine costing 100,000 with a ten-year life is recorded as 10,000 of expense annually.

The purpose is matching costs to the revenue they produce. Expensing the whole 100,000 in the year of purchase would show a loss that year and inflate profits for the next nine.

The key feature is that no money actually leaves. Cash went out at purchase; only the books are reduced each year. That is why depreciation is added back when calculating cash flow.

The method changes reported profit. Front-loaded and straight-line approaches produce different figures for the same company in the same year, which is why accounting policy is worth checking.

It is not a fictional cost, though. Equipment wears out and must eventually be replaced. Any measure that excludes depreciation needs that replacement accounted for somewhere else.