What does depreciation refer to in financial terms?

Depreciation in financial terms is the systematic allocation of a fixed asset's cost to expense over its useful life. This process allows businesses to spread out the cost of an asset that will provide benefits over several periods, rather than expensing the entire cost in the year of purchase.

This matching principle is foundational in accrual accounting, as it ensures that the financial statements reflect not only the current financial position but also the costs associated with generating revenue during a specific period. As a fixed asset like machinery or an office building is used, its value decreases due to wear and tear, obsolescence, or other factors. Thus, allocating this cost as an expense aligns the accounting records with the revenues generated by that asset.

Understanding depreciation is crucial for both financial reporting and tax purposes, as it affects a company's taxable income and how its financial performance is viewed by investors and stakeholders.