Depreciation is the accounting process of allocating the cost of a long-term asset across the years it is used, rather than expensing the full purchase price in the year it was bought. It reflects the economic reality that assets lose value over time through use and wear.
When a business buys a delivery truck for $60,000, it does not receive $60,000 worth of value on the purchase date. It receives value spread over the 5 or 6 years the truck will be in service. Recording the full $60,000 as a year-one expense would make year one look significantly less profitable than it actually is and make subsequent years look more profitable than they are.
Depreciation matches the cost to the periods that benefit from the asset.
Tangible assets with a useful life greater than one year are generally depreciable:
Assets that cannot be depreciated include land, inventory (which is expensed through COGS when sold), and assets used for personal purposes.
Straight-line depreciation is the most common. It spreads the cost evenly across the asset's useful life.
FORMULA
(Cost - Salvage Value) / Useful Life in Years
A $60,000 truck with a $5,000 salvage value and a 5-year useful life: ($60,000 - $5,000) / 5 = $11,000 per year.
Declining balance depreciation front-loads the expense, recognizing more depreciation in early years and less later. The double-declining balance method applies twice the straight-line rate to the remaining book value each year.
Units of production depreciation ties depreciation to actual usage rather than time. Useful for machinery where wear depends on output rather than the calendar.
MACRS (Modified Accelerated Cost Recovery System) is the method required by the IRS for US tax purposes. It uses predetermined recovery periods and methods for different asset classes.
Depreciation applies to tangible assets. Amortization applies the same concept to intangible assets: patents, trademarks, software licenses, and non-compete agreements. The mechanics are identical; the terminology differs based on the type of asset.
Businesses often maintain two depreciation schedules: one for financial reporting (using straight-line or another GAAP method) and one for taxes (using MACRS or Section 179 expensing). The two rarely match. The difference creates a deferred tax liability or asset on the balance sheet.
Section 179 allows businesses to expense certain asset purchases in full in the year of purchase rather than depreciating them. Bonus depreciation allows additional first-year deductions. Both can reduce taxable income significantly in high-capital-expenditure years.
A depreciation schedule is a table tracking every depreciable asset, its original cost, its useful life, its accumulated depreciation to date, and its current book value. Keeping this schedule current is essential for accurate financial statements and tax filing.
