I do NOT understand depreciation. Can somebody help me? I need it explained like a 5 year old.

[ctaylors6]

49. also: it's timing issue, matching revenue with expense

Say someone has a business making specialized bedding by hand. Their costs are the fabric, thread, and other materials PLUS what the business pays the people who sew the bedding. The business's profit is (1) the amount for which they sell the bedding LESS (2) the costs for materials and labor. For all the bedding they made and sold in 2011, it's easy to calculate their revenue and their expenses for 2011.

Now picture a different kind of sewing business that invests in equipment that machine sews more standard, not specialized, bedding. That machinery is made to last 10 years. If the company makes about the same number of comforters each of those 10 years, their revenue will be pretty evenly spread out over the 10 years. Straight line, simple depreciation would take the total cost of the equipment, divide by 10, and the business would expense that 1/10 amount each of the 10 years.

Assume for simplicity that the business had saved the money to buy the equipment for $100,000. The company's revenue is $12,000 per year. In year 1, without depreciation, the company would have a massive loss: $12,000 revenue - $100,000 expense. Each year after that, it would have $12,000 revenue and no expense for the equipment.

With depreciation, each year the company would have $12,000 revenue less $10,000 expense for machine, for profit of $2,000. (Of course, I'm ignoring other expenses.)

needless to say, the US tax code depreciation sections are way, way more complicated than that. There's accelerated depreciation, where the total cost is depreciated more in earlier years to better reflect the theory that as equipment ages it doesn't work as well and therefore does not produce as much. And many other rules.

Hope that helps though with a basic of depreciation!