Depreciation, most simply described, is the loss in value of an item over time. Typically this term is in reference to larger items that have an expected period of use of several years. For accounting purposes, this item is an asset that needs to be reflected on the balance sheet during that expected lifetime.
The Internal Revenue Service, in Publication 946, defines depreciation as: "an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property." To learn more about depreciation, go to IRS Publication 946.
For self-employed individuals, depreciation provides for a more accurate financial picture of your business. For items that have a multiple-year life, using a cash method of determining the value of a business would underestimate its value. By taking into account the depreciated value of various assets, a balance sheet more closely reflects the business's actual position.
One final note regarding depreciation is that it is a noncash item. It does not show up on a cash flow statement, only on the balance sheet.
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