When a company buys a delivery van, a machine or a computer, it does not treat the whole price as an expense on the day of purchase. Instead, accountants spread the cost across the years the asset is expected to be useful. That process is called depreciation. It is one of the most common concepts in accounting, and understanding it helps you read financial statements with more confidence.
What is depreciation?
Depreciation is the systematic allocation of the cost of a tangible long-term asset over its useful life. The key word is allocation. Depreciation is not meant to measure the asset’s current market value; it is a way of matching the cost of the asset with the periods in which it helps the business earn revenue. This idea comes from the matching principle: expenses should be recorded in the same period as the revenue they help produce.
Land is generally not depreciated, because it is not considered to wear out. Buildings, vehicles, machinery, furniture and equipment usually are.
The three inputs you need
- Cost: the amount paid to acquire the asset and get it ready for use, including items like delivery and installation.
- Useful life: how long the business expects to use the asset, in years or in units of production.
- Salvage value (residual value): the estimated amount the asset will be worth at the end of its useful life. It can be zero.
The difference between cost and salvage value is called the depreciable base. This is the amount that will be expensed over time.
Straight-line depreciation
The simplest and most widely used method is straight-line depreciation, which charges the same amount every year:
Annual depreciation = (Cost − Salvage value) ÷ Useful life
Suppose a bakery buys an oven for $12,000, expects to use it for 5 years and estimates a salvage value of $2,000. The depreciable base is $10,000, so the annual depreciation is $10,000 ÷ 5 = $2,000.
| Year | Depreciation expense | Accumulated depreciation | Book value at year end |
|---|---|---|---|
| 1 | $2,000 | $2,000 | $10,000 |
| 2 | $2,000 | $4,000 | $8,000 |
| 3 | $2,000 | $6,000 | $6,000 |
| 4 | $2,000 | $8,000 | $4,000 |
| 5 | $2,000 | $10,000 | $2,000 |
Notice that the book value falls steadily until it reaches the salvage value in year 5. It never goes below that.
Declining-balance depreciation
Some assets lose more of their usefulness early on, like computers or vehicles. For those, businesses may use an accelerated method such as declining balance, which applies a fixed percentage to the asset’s book value each year. A common choice is the double-declining-balance method, where the rate is twice the straight-line rate. For a 5-year life, the straight-line rate is 20%, so the double rate is 40%.
Using the oven example, year 1 depreciation would be 40% of $12,000, or $4,800. Year 2 would be 40% of the new book value of $7,200, which is $2,880, and so on. The expense is larger in the early years and smaller later. Under this method the salvage value is typically not subtracted at the start, but depreciation stops once the book value reaches the salvage value.
Units-of-production method
When wear depends on use rather than time, the units-of-production method fits better. You estimate the total output the asset can deliver (for example, kilometers driven or items produced), compute a cost per unit, and multiply by the actual usage each period. A truck expected to run 200,000 km with a depreciable base of $20,000 would be charged $0.10 per kilometer driven.
Choosing the right method
There is no single best method; the choice should reflect how the asset actually delivers its benefits. Straight-line is popular because it is easy to calculate and explain, and it suits assets that are used evenly over time, such as office furniture. Declining balance fits assets that lose efficiency or become obsolete quickly. Units of production works well for equipment whose wear depends on how much it is used. Whichever method a company chooses, it should apply it consistently from year to year so that its financial statements remain comparable.
Where depreciation shows up in the statements
- Income statement: depreciation appears as an expense each period, reducing reported profit.
- Balance sheet: the asset is shown at cost, minus accumulated depreciation, to give the book value (also called net book value or carrying amount).
- Cash flow statement: depreciation is a non-cash expense, so it is added back when cash flow from operations is calculated by the indirect method.
Common misunderstandings
The most frequent mistake is believing depreciation sets aside cash to replace the asset. It does not: the cash left the business when the asset was bought, and depreciation only spreads that cost on paper. Another confusion is treating book value as market value. A fully depreciated machine may still work well and have real resale value, while a recently bought asset can be worth far less than its book value if technology changes. Finally, depreciation estimates rely on judgment about useful life and salvage value, so reasonable companies can reach slightly different figures for similar assets.
Conclusion
Depreciation turns a large one-time purchase into a series of smaller expenses that follow the asset’s use. Once you know the three inputs and the straight-line formula, you can handle most basic problems and interpret balance sheets more easily. If you want to keep building your accounting skills, from journal entries to financial statements, you can explore the related accounting and business courses on Cursa.
