Depreciation is the method of allocating the cost of a tangible asset over its useful life, rather than expensing the whole cost at once. The most common approach is straight-line depreciation: (Cost − Salvage Value) ÷ Useful Life. It matches expense to the years an asset is actually used and reduces taxable income.
What Is Depreciation?
Depreciation spreads the cost of a tangible asset over the years it's expected to be useful, rather than taking the full hit upfront. (The equivalent concept for intangible assets like patents is amortization, same idea, different name.)
What Does Depreciation Apply To?
- Buildings
- Machinery
- Vehicles
- Furniture
- Computer equipment
Straight-Line Depreciation Formula
Annual Depreciation = (Asset Cost − Salvage Value) ÷ Useful LifeThe most common method
Worked example
An asset costs $50,000, has a 5-year useful life, and a $10,000 salvage value:
($50,000 − $10,000) ÷ 5 = $8,000 per yearRecorded each year for 5 years
Each year you record $8,000 of depreciation expense on the income statement and reduce the asset's value on the balance sheet by the same amount.
Depreciation Methods
| Method | How it works |
|---|---|
| Straight-line | Equal expense each year, simplest, most common |
| Declining balance | Faster depreciation in early years |
| Units of production | Based on actual usage, not time |
| Sum-of-the-years' digits | Another accelerated method |
Depreciation & Financial Statements
- Income statement: recorded as an expense, reducing profit.
- Balance sheet: reduces the recorded value of assets.
- Cash flow statement: added back in operating activities, it's a non-cash expense.
Remember: depreciation is an accounting method, not a valuation. An asset's book value can differ from its market value.
Depreciation FAQ
How do you calculate depreciation?
The straight-line method is (Cost − Salvage Value) ÷ Useful Life. A $50,000 asset with $10,000 salvage over 5 years depreciates $8,000 per year.
What's the difference between depreciation and amortization?
Depreciation applies to tangible assets (machinery, vehicles); amortization applies to intangibles (patents, software). The concept, spreading cost over useful life, is the same.
Is depreciation a cash expense?
No. Depreciation is a non-cash expense, no money leaves the business when it's recorded, which is why it's added back on the cash flow statement.
Why does depreciation matter?
It matches expense to the periods an asset is used, lowers taxable income, and gives a more accurate picture of profitability and asset value over time.
