Depreciation Explained: How to Write Off an Asset Over Its Life

What depreciation does and why it exists

Depreciation matches the cost of an asset to the years it produces income. It is an accounting entry, not a cash payment.

When you buy a delivery van, you pay the cash up front, but the van serves the business for years. Accounting rules say the expense should follow the benefit, so the cost is recorded gradually. Each period you reduce the asset's book value and record a depreciation expense on the income statement.

Two things to remember. First, depreciation does not move cash. The cash left your account when you bought the asset. Second, land is generally not depreciated, but buildings, vehicles, machinery, computers and furniture are. For the basics, see what depreciation is.

The three inputs: cost, useful life and salvage value

Every depreciation method needs the asset's cost, how long you expect to use it, and what it will be worth at the end.

• Cost basis. The purchase price plus costs to get it ready for use, such as delivery and installation.
• Useful life. The number of years (or units of output) you expect the asset to serve the business.
• Salvage value. The estimated resale or scrap value at the end of its life. It can be zero.

The depreciable amount is cost minus salvage value. A $30,000 machine with a $3,000 salvage value has $27,000 to depreciate. Useful life is an estimate, so use your experience with similar equipment and check with your accountant.

Straight-line: the same amount every year

Straight-line divides the depreciable amount evenly over the useful life. It is the simplest method and the most common for financial statements.

Example (illustrative): a machine costs $30,000, has a $3,000 salvage value and a 9-year life.

Annual depreciation = ($30,000 - $3,000) / 9 = $3,000 per year.

Each year the book value falls by $3,000 until it reaches $3,000 at the end of year nine. The pattern is predictable, which makes budgeting and bookkeeping easy. Use it when the asset delivers roughly the same value every year, such as office furniture or a building improvement.

Declining balance and units of production

Declining balance takes bigger deductions early in an asset's life. Units of production ties depreciation to actual use, such as miles driven or items made.

Declining balance. You apply a fixed percentage to the remaining book value each year. With a 20% rate on the same $30,000 machine, year one is $6,000, year two is 20% of $24,000, or $4,800, and so on. It suits assets that lose value quickly or become obsolete, like computers and vehicles.

Units of production. Suppose a press is expected to make 900,000 parts over its life and makes 90,000 this year. With $27,000 depreciable, this year's expense is 10% of that, or $2,700. It works for equipment whose wear depends on volume. Learn more in the units of production method.

There are other methods, including sum-of-the-years'-digits, but these three cover most small business needs.

Tax depreciation is its own set of rules

For taxes, the IRS has its own schedules, with MACRS as the standard system. Your tax deduction can differ from the depreciation on your books.

In the United States, most business property is depreciated for tax purposes under the Modified Accelerated Cost Recovery System, called MACRS. It assigns assets to recovery classes and uses set tables. See our overview of the MACRS depreciation method.

The tax code also contains provisions that let businesses deduct some or all of an asset's cost in the first year, and the limits and eligible property change over time. Do not rely on a figure you read in a blog post, including this one. Check the current IRS guidance and ask your accountant what applies to your purchase this year.

Keep the purchase invoice, the date the asset was placed in service and a fixed asset list. Those records support every deduction.

Recording depreciation in your books

Each period, debit depreciation expense and credit accumulated depreciation. The asset's original cost stays on the balance sheet.

A typical year-end entry for the $3,000 straight-line example:

1. Debit Depreciation Expense $3,000. This lowers profit on the income statement.
2. Credit Accumulated Depreciation $3,000. This is a contra-asset account that reduces the asset's net book value.

The balance sheet shows the machine at cost, less accumulated depreciation, equals net book value. When you sell or retire the asset, compare the sale price with net book value to find a gain or loss. See what type of account accumulated depreciation is and review how journal entries work.

Depreciation, cash flow and equipment funding

Depreciation lowers taxable profit but not your bank balance. Plan the cash for the purchase separately from the deduction.

New owners sometimes assume a large first-year deduction means the equipment is effectively cheaper. The deduction reduces taxes owed, but you still paid the full price. If you financed the purchase, you also owe the monthly payments.

Compare the equipment's yearly earnings against its yearly cost: payments plus upkeep. If a $30,000 machine adds $2,500 a month in profit and the financing payment is $800, the numbers work. Equipment financing through ROI Funder is available to businesses with 500+ FICO, 6+ months in business and $20,000+ monthly revenue, with funding typically in 2 to 7 days. Use the payback period calculator before you commit.