The idea behind depreciation
Assets like vehicles, machines and computers wear out or lose value. Depreciation matches that cost to the periods when the asset produces revenue.
Accounting tries to pair costs with the revenue they help create. A delivery van serves customers for years, so charging its whole cost to the month you bought it would make that month look terrible and later months look too good. Spreading the cost gives a more honest picture.
Only certain things depreciate: tangible assets with a useful life of more than a year that you own and use in the business. Land does not depreciate. Inventory and supplies are expensed differently. Related background appears in comparing operating and capital expenses.
Key terms
Cost basis, salvage value, useful life and accumulated depreciation are the four terms you need.
- Cost basis. The price paid plus costs to get the asset ready, like delivery and installation.
- Salvage value. What you expect the asset to be worth at the end of its useful life.
- Useful life. How long you expect to use it, in years or units.
- Depreciable amount. Cost basis minus salvage value.
- Accumulated depreciation. The total depreciation taken so far, shown on the balance sheet as a reduction of the asset.
- Book value. Cost minus accumulated depreciation.
The balance sheet treatment is explained in what type of account accumulated depreciation is.
The main methods with examples
Straight-line spreads cost evenly. Declining-balance front-loads it. Units of production follows usage. Each gives a different pattern of expense.
Illustrative example: a $30,000 machine with a $3,000 salvage value and a 5-year life.
| Method | Year 1 expense | Pattern |
|---|---|---|
| Straight-line | $5,400 | Same each year |
| Double-declining balance | $12,000 | Larger early, smaller later |
| Units of production | Varies | Rises and falls with use |
Straight-line is ($30,000 - $3,000) / 5 = $5,400. Double-declining uses twice the straight-line rate (40 percent) on the declining book value: 40 percent of $30,000 = $12,000 in year one. For the usage method, see units of production depreciation.
Depreciation for taxes
U.S. tax returns generally use the IRS MACRS system, which sets recovery periods and allows accelerated deductions. Elections like Section 179 may allow faster write-offs.
Your tax depreciation can differ from your book depreciation. The IRS system, covered in our MACRS explainer, assigns each asset a class and recovery period, such as 5 or 7 years. Section 179 and bonus depreciation can let you deduct more in the first year, within limits.
The limits change with tax law, so check with your accountant or IRS.gov before you plan a purchase around them. Depreciation is reported on Form 4562. Never buy equipment just for the tax effect, since you still spent real money.
What depreciation does to your financial statements
It lowers net income on the income statement and reduces the asset's book value on the balance sheet, but it is added back on the cash flow statement.
Depreciation is an expense on the income statement, so profit is lower than it would be without it. On the balance sheet, accumulated depreciation reduces the asset's carrying value over time. On the cash flow statement it is added back, because no cash left the business when the expense was recorded.
That is why a company can show a small accounting profit and strong cash flow, or the reverse. See cash flow vs. profit and what goes on a cash flow statement.
Common mistakes
Frequent errors include depreciating land, expensing assets that should be capitalized, forgetting to start depreciation and using the wrong life.
- Depreciating land, which is not allowed
- Deducting a big equipment purchase in full without confirming it qualifies
- Not recording depreciation at all, so the books overstate profit and assets
- Continuing to depreciate an asset you sold or scrapped
- Mixing personal and business use without allocating
Keep an asset list with purchase dates, costs, lives and methods. Your bookkeeper or accountant can maintain a schedule. Good records also help during financing, as covered in bookkeeping habits that help financing.
Depreciation, replacement and financing
Depreciation tells you an asset is wearing out, but not whether you have cash to replace it. Plan replacement before it fails.
A $30,000 machine depreciated at $5,400 a year suggests you should be setting aside money, but the expense itself does not do that. Create a replacement fund or plan to finance the next unit when payback supports it.
Test the replacement: if the new unit saves $2,000 a month, in this illustrative example it earns back $30,000 in 15 months. Equipment financing through ROI Funder typically funds in 2 to 7 days. We consider 500+ FICO, 6+ months in business and $20,000+ monthly revenue, and show true cost and payback before you sign. See the equipment payback period calculator.
Frequently asked questions
Is depreciation a cash expense?
No. It allocates a past purchase over time. The cash left when you bought the asset or made loan payments.
Which depreciation method is most common?
Straight-line is the most common for financial statements. For taxes, most businesses use MACRS.
Can I depreciate used equipment?
Generally yes, if you bought it for business use. The basis is what you paid.
Does depreciation reduce my taxes?
It reduces taxable income, which lowers the tax you owe. It does not return the purchase price in cash.