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.
