As a small business owner, you’ll likely need to make expensive purchases at some point. Perhaps you’ll need a screen press machine for your apparel business, a new truck to transport your equipment to job sites, or simply some office furniture. But how do you handle these purchases for accounting purposes?
With wear and tear, your screen press or new truck won’t be as valuable in five years as it is today. So, you’ll need to recognize the asset’s depreciation, or gradual loss of value as time passes. Depreciation can feel like a complex concept, but understanding it is crucial for accurate financial recordkeeping. This guide offers a detailed examination of depreciation, its benefits, and three ways to calculate it.
What is depreciation?
Depreciation is an accounting method spreading the cost of an asset over time or usage rather than recording and deducting the full amount in the year it was purchased. It is a non-cash expense on your income statement, reducing the value of an asset on your balance sheet over its useful lifespan.
For example, let’s say you purchase a screen press machine (or computer or piece of office equipment) for $10,000. While you will pay in full upfront, it wouldn’t make sense for your financial statements to show the same value five years later because it’s a depreciable asset. It has a certain number of years of productive life before it starts to degrade and lose functionality. As the asset gets closer to the end of its productive life, it loses value.
Depreciation doesn’t apply to everything you own. It only applies to what are known as fixed assets—long-term, tangible items a business uses to operate. These items are generally considered capital expenditures. Examples are machinery, vehicles, office furniture, computers, and buildings.
Fixed assets are never sold to customers (so inventory doesn’t qualify) and typically last five or more years. Land generally isn’t considered a depreciable asset as it can have an indefinite useful life.
Smaller items, like office supplies or inexpensive tech, don’t depreciate, as they likely won’t be used for more than one year. Even if they are used for several years (like a handheld calculator), they won’t meet the cost threshold established by the IRS. Often referred to as the "capitalization threshold,” the IRS allows businesses to immediately expense anything that costs $2,500 or less per item or invoice.
Depreciation vs. amortization
Depreciation applies only to tangible (physical) assets. So, how does your business account for the loss in value of intangible property? That’s where amortization comes into play.
Like depreciation, amortization spreads the cost of an asset over time—but it applies to different types of assets.
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Depreciation is used for tangible assets—physical things you can touch, like equipment, vehicles, or buildings.
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Amortization is used for intangible assets—non-physical items like patents, trademarks, copyrights, or goodwill.
Both methods help businesses match the cost of an asset to the revenue it helps generate over its lifetime. They also reduce net income each year, even though you’re not spending any cash after the initial investment. You can think of depreciation as actual wear and tear, and amortization as value simply fading over time.
The main functions of depreciation
Depreciation serves two broad purposes: It presents a clear and accurate picture of your business’s financial position in line with standard accounting practices, and it provides tax benefits.
Fixed-asset depreciation ensures expenses associated with using an asset are reported in the same year as the revenue the asset helped generate. This is a key accounting principle. Depreciation also ensures your business is reporting the correct book value of an asset. A piece of equipment purchased for $10,000 five years ago will be worth less today, and your financial statements need to reflect that.
Additionally, depreciation is an annual income tax deduction. Recording a depreciation expense reduces your taxable income, thereby reducing the amount of tax you owe. For example, a $10,000 screen press machine may lose 20% of its value each year. As a result, you could deduct $2,000 in tax depreciation expenses each year from your tax return, reducing your overall tax bill.
What is a depreciation schedule?
A depreciation schedule is a visual chart or table outlining how an asset’s value will decrease over time. Since different items depreciate at different rates, a schedule shows:
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The asset’s initial cost
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The method of depreciation used
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How much of the cost is written off each year
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The accumulated depreciation amount
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The asset’s remaining value at the end of each year or period
No need for specific software here unless you’re managing a large amount of fixed assets. Excel sheets work for small businesses.
This schedule helps businesses track and plan for the gradual expense of their fixed assets, as well as determine when it’s time for replacements or capital improvements. For example, computers might depreciate over three years, vehicles over five to 10 years, and buildings over 27.5 or 39 years, depending on use. These timelines aren’t arbitrary. For tax purposes, the IRS requires businesses to use the Modified Accelerated Cost Recovery System (MACRS), which assigns a “useful life” to different asset types.
While the IRS rules must be followed for tax depreciation, businesses can use their own reasonable estimates for useful life when preparing financial statements.
How to calculate depreciation
There are three common depreciation methods: Straight-line, declining balance, and units of production. Whichever depreciation method you use, you’ll record your depreciation expense on the income statement to show the reduction in the asset’s value over time. Depreciation stops either when the asset’s book value reaches its salvage value (its estimated worth at the end of its useful life) or when the asset is sold, scrapped, or otherwise disposed of—whichever comes first.
Here’s how each depreciation method works:
Straight-line depreciation
This is the simplest and most commonly used method for calculating depreciation, ideal for fixed assets with predictable and stable usage. It spreads the cost of an asset evenly over its expected useful life. The formula factors in the asset’s purchase cost, its salvage value (the estimated value at the end of its useful life), and the number of years you expect to use it:
(Cost of asset − Salvage value) ÷ Useful life (in years) = Annual depreciation expense
For example, you buy office furniture for $5,000. You expect it to last five years and have a salvage value of $500. Using the formula above, the annual depreciation expense would be:
(5,000 − 500) ÷ 5 = 900
This means you’ll reduce the asset’s book value by $900 each year and deduct $900 as an expense on your income statement.
Declining balance depreciation
This accelerated depreciation method depreciates more of the asset’s cost in the early years and less in later years, which is useful for assets like technology that lose value or become outdated quickly. The most common form is the double declining balance method, which uses twice the straight-line depreciation rate:
Book value at beginning of year x (2 ÷ Useful life) = Annual depreciation expense
For example, you buy a computer for $2,000 with an expected useful life of five years. It has no salvage value. Considering the formula above, for the first year, you would divide two by the number of years of useful life (5), resulting in 0.4. Multiply that number by the computer’s book value at the beginning of the first year ($2,000). That gets you $800:
2,000 x (2 ÷ 5) = 800
For the second year, you’d have the same formula, except the book value at the beginning of that year would have dropped to $1,200 ($2,000-$800).
1,200 x (2 ÷ 5) = 480
Your annual deduction expense for the second year is $480. Continue with these calculations through the remaining three years.
Units of production depreciation
This depreciation method ties depreciation to use rather than the passage of time. That makes it ideal for machinery or vehicles where usage varies and the depreciation rate changes accordingly. The formula considers the asset’s cost, salvage value, and the total estimated units of output:
(Cost - Salvage value) ÷ Total estimated units of output = Depreciation expense per unit
Say you buy a machine for $10,000 with a salvage value of $1,000 and expect 100,000 units of production. Considering the formula above, you would subtract the salvage value ($1,000) from the cost of the machine ($10,000), leaving you with $9,000. Then divide that number by the total output units you expect from it (100,000). That gives you 9¢:
(10,000 - 1,000) ÷ 100,000 = 0.09
So, the depreciation expense is 9¢ per unit produced. When calculating depreciation for a given year, multiply this rate by the number of units you actually produce that year.
What is depreciation FAQ
What is depreciation in simple terms?
For accounting and tax purposes, depreciation allows for the spread of the cost of a large purchase over time rather than recording and deducting the full amount in the year that it was purchased. It provides a clearer financial picture as it reflects how the asset loses value due to aging.
What is an example of depreciation?
Here’s an example of depreciation: You buy a computer for your business for $5,000 and expect it to last three years. Though there’s an immediate cash outflow of $5,000, the cost won’t hit the accounting books in full in the first year. Instead, you evenly spread the cost out over three years, at $1,667 each. This is an example of depreciation calculated using the straight line method.
Is it better to expense or depreciate?
In most cases, if a purchased item is inexpensive, like office supplies, and won’t last longer than one year, you would simply expense the item. Specifically, you would follow the IRS threshold of $2,500 or above to determine whether to depreciate. If the item is larger and costs more than $2,500, such as a large printer, computer, or vehicle, you could use a depreciation formula to calculate the annual depreciation expense, which you can use both for your internal accounts and when filing taxes.
