Final answer:
Depreciation is the method used to allocate the cost of a major asset over its useful life for both tax and accounting purposes. It ensures that the expense of long-term capital investments is spread over the years they provide benefits, affecting a business’s financial statements and tax obligations.
Step-by-step explanation:
Depreciation is a way of allocating the cost of a major asset, such as a piece of capital equipment, over its useful life for tax and accounting purposes. When a firm invests in capital, such as machinery or office buildings, they use depreciation to spread the expense of these long-term assets over the years they will be used. This is an essential concept in accounting as it affects a firm's financial statements and tax liabilities. Businesses must manage their capital wisely and consider how the depreciation of their assets will impact both their current and future financial positions.
Consider a company that purchases a machine with an expected life of 10 years. The cost of this machine is not fully expensed in the year of purchase but is depreciated over its useful life. Firms can also raise the financial capital needed to pay for such assets in several ways, including early-stage investors, reinvesting profits, borrowing, or selling stock.