Definition
Depreciation is an accounting method. You work out how much value a long-lived machine or building loses over time, then spread that amount across the years you use it and record it as an expense in the books.
Buying a new machine doesn't mean you used it all up in the first month
Imagine you paid 1 million won for the latest smartphone. Did you use up all 1 million won of value on the first day you opened the box? Of course not. Most people use that phone every day for two or three years. A machine's value wears away slowly while you use it.
It's the same when a cafe owner buys a high-end espresso machine for 10 million won. If the owner writes the full 10 million won as an expense in the books in the first month, that month shows a huge loss, no matter how well the coffee sells. The next month, the machine's cost is 0 won, as if the owner were earning money with a free machine. The books get badly distorted.
So in accounting, an expense is recorded in pieces, matching the value lost, over the period when the machine works, sells coffee, and earns money. If you plan to use a 10 million won machine for five years, you record 2 million won a year as an expense. That way, you can see exactly how much you really earned each month.
Two common ways to reduce value
There are two main ways to work out how fast an item loses value. The first is the straight-line method, which reduces the same amount every year. It's simple and easy to understand. It's mostly used for assets whose value falls gently over time, such as buildings, factory equipment, and furniture.
The second is the declining-balance method, which takes a large amount at the start and a smaller amount as time passes. Think of a smartphone or a car, whose market value drops sharply when it's new. It's a realistic way to book a bigger expense while the machine performs best and has no breakdowns.
Whichever method you choose, the total expense recorded from the day you buy the machine until you scrap it is the same. The key principle of accounting is matching the cost of wearing out the machine to the period in which it earned revenue.
To be more precise: no money leaves your bank account
It's easy to think that cash leaves the company's bank account every year when depreciation is recorded. But the real cash goes out when you buy the item (or when you pay installments, if you bought it that way). The depreciation expense recorded afterward is just a "book expense." It spreads a payment that has already gone out across the accounting books.
So even if depreciation lowers the net profit on paper, recording it doesn't take money out of the account. Because the profit on paper is lower, the company also pays less corporate income tax to the government, a tax-saving effect. It acts like a shield that saves tax without any cash going out.
For this reason, investors who study a company's true health look closely at depreciation. It's the most important key to understanding the gap between accounting profit on paper and the cash that actually builds up in the bank.
Common misconceptions
Every time depreciation is recorded, cash actually leaves the company's bank account.
Depreciation is the money spent to buy an item (its acquisition cost) spread across the years you use it. The cash goes out when you buy it (or pay installments). Recording depreciation in the books doesn't move money. It's a "non-cash expense."
All real estate and all of a company's assets are subject to depreciation.
Assets that don't wear out over time aren't depreciated. A typical example is land, which doesn't wear out, so it is excluded from depreciation.
Where you meet it
A company buys a business car for 50 million won and reduces its book value every year for five years.
A semiconductor plant brings in a production machine worth 1 trillion won, then books hundreds of billions of won in depreciation each year to match the machine's lifespan.
In one sentence
Depreciation is an accounting method that records the value lost as an item wears out as an expense spread over its years of use, so a company's true results show up correctly.