Depreciation Explained for Small Business Owners
Depreciation is how a business spreads the cost of a long-lived asset, such as a van, a machine or a laptop, over the years it is used. It affects your profit, your tax bill and the value of your balance sheet, yet many owners leave it entirely to the accountant. This explainer covers what it is, the main methods, a worked example and where tax rules differ from the books.
Key takeaways
- Depreciation is an accounting expense that spreads an asset's cost over its useful life. It is not a cash payment.
- Straight-line charges the same amount each year. Declining balance charges more early on. Units of production charges by usage.
- Tax depreciation often follows different rules from book depreciation. In the US, Section 179 and bonus depreciation can let you deduct most of an asset's cost in year one.
- Land is never depreciated. Buildings, vehicles, equipment, furniture and computers are.
Suppose you buy a $30,000 delivery van in January. If you expensed the whole amount that month, January would show a huge loss and the next five years would show profits inflated by a van that was apparently free. Neither picture is true. The van helps you earn money for years, so accounting spreads its cost across those years. That spreading is depreciation.
Getting it right matters for three reasons: your profit figure is more honest, your balance sheet shows what your assets are roughly worth, and your tax return depends on it.
What gets depreciated
An asset is depreciated when it meets three tests: you own it, you use it in the business, and it has a useful life of more than a year. Typical examples are vehicles, machinery, computers, furniture, fixtures and buildings. Three things do not get depreciated:
- Land, because it does not wear out.
- Inventory, which is expensed through cost of goods sold when it sells.
- Low-value items, which most businesses expense immediately under a capitalization threshold. In the US, the IRS de minimis safe harbor lets most small businesses expense items costing up to $2,500 each without capitalizing them. Other countries set their own limits.
Intangible assets such as patents and software licenses are spread over their lives too, but that process is called amortization and follows slightly different rules.
The four numbers you need
| Input | Meaning | Example |
|---|---|---|
| Cost | Purchase price plus delivery, installation and anything needed to get it working | $30,000 van including delivery and signage |
| Salvage value | What you expect to sell it for at the end | $5,000 |
| Useful life | How long you expect to use it, in years or units | 5 years, or 150,000 miles |
| Method | The pattern used to spread the cost | Straight-line, declining balance or units of production |
Cost minus salvage value is the depreciable base, the amount you will actually expense over the life. For the van, that is $25,000.
Method 1: straight-line
The simplest and most common method for books. Divide the depreciable base by the useful life.
Annual depreciation = (cost − salvage value) ÷ useful life
For the van: ($30,000 − $5,000) ÷ 5 = $5,000 a year, or about $417 a month. After three years, accumulated depreciation is $15,000 and the van's book value (cost minus accumulated depreciation) is $15,000.
Straight-line fits assets that deliver roughly even value every year: furniture, buildings, fittings, most office equipment.
Method 2: declining balance
Declining balance charges a fixed percentage of the remaining book value each year, so the expense is heavy early and light later. The most common version is double declining balance, which uses twice the straight-line rate. For a 5-year asset the straight-line rate is 20%, so the double rate is 40%.
Worked example: the same van, double declining balance
Year 1: 40% × $30,000 = $12,000. Book value falls to $18,000. Year 2: 40% × $18,000 = $7,200. Book value $10,800. Year 3: 40% × $10,800 = $4,320. Book value $6,480. Year 4: 40% × $6,480 would be $2,592, but that would take book value below the $5,000 salvage value, so the charge is limited to $1,480 and book value stops at $5,000. Year 5: nothing left to depreciate. The total expensed is still $25,000; the timing is just front-loaded.
Declining balance suits assets that lose value fast or are most productive when new: vehicles, computers, some machinery. Note that the salvage value is not subtracted up front in this method; it acts as a floor instead.
Method 3: units of production
When wear depends on use rather than time, depreciate per unit of output: miles driven, hours run, items produced.
Rate per unit = (cost − salvage value) ÷ total expected units
If the van is expected to last 150,000 miles, the rate is $25,000 ÷ 150,000, about $0.167 per mile. A year with 30,000 miles produces $5,000 of depreciation; a quiet year with 18,000 miles produces $3,000. This method matches expense to activity, which is useful for equipment-heavy businesses, but it requires tracking usage.
Book depreciation versus tax depreciation
The methods above are for your management accounts and financial statements. Tax authorities usually prescribe their own rules, and the two rarely match. Many small businesses keep two schedules: one for the books, one for the tax return. Your accountant reconciles them.
United States
- MACRS (the Modified Accelerated Cost Recovery System) is the standard tax method. It assigns assets to classes with set recovery periods: 5 years for cars, light trucks and computers, 7 years for office furniture and most equipment, 27.5 years for residential rental property and 39 years for nonresidential buildings. Salvage value is ignored.
- Section 179 lets a business deduct the full cost of qualifying equipment and software in the year it is placed in service, up to an annual limit. The limit has been raised several times and was increased substantially by 2025 legislation; check the current figure in IRS Publication 946 before planning around it.
- Bonus depreciation allows an additional first-year deduction on qualifying new and used property. The percentage has changed repeatedly in recent years, so confirm the rate that applies to the year you buy.
Other countries
The UK does not use accounting depreciation for tax at all; instead it gives capital allowances, including an Annual Investment Allowance that lets businesses deduct the full cost of most plant and machinery up to a limit, currently 1 million pounds. Canada uses capital cost allowance classes with set rates. Australia offers simplified depreciation rules for small businesses with set thresholds. In every case, the rates and limits move with each budget, so check the current rules for your country before buying a major asset at year end for the tax saving.
Common mistake
Buying equipment in December purely for the tax deduction. A deduction only saves you the tax on that amount, so a $20,000 purchase might save $4,000 to $6,000 in tax while costing $20,000 in cash. Buy the asset because the business needs it, then take whatever accelerated deduction is available.
How depreciation shows up in your accounts
- Profit and loss: depreciation is an operating expense, reducing profit. It is often shown separately because it is non-cash.
- Balance sheet: the asset is shown at cost, with accumulated depreciation deducted to give net book value.
- Cash flow statement: depreciation is added back to profit, because no cash left the business when it was recorded. This is why a business can show a small profit and a much larger operating cash flow.
When you sell or scrap the asset, you compare the sale price with the book value. Selling the van after three years for $17,000 when its book value is $15,000 produces a $2,000 gain; selling it for $12,000 produces a $3,000 loss. Tax treatment of gains on assets that were depreciated quickly can be different, and in the US part of the gain may be taxed as ordinary income through depreciation recapture.
Setting up a depreciation schedule in five steps
- List every asset over your threshold. Record the description, purchase date, cost including installation, and expected salvage value.
- Assign a useful life and a method for the books. Use straight-line unless the asset clearly loses value faster when new.
- Record the tax class and method separately, following your country's rules or your accountant's advice.
- Post depreciation monthly. Most accounting software can automate the journal entry once the schedule is set up.
- Review annually. Remove disposed assets, record gains or losses, and adjust useful lives if an asset is wearing out faster or slower than expected.
Pro tip
Keep a simple fixed asset register in a spreadsheet even if your accounting software handles depreciation. Lenders, insurers and buyers of the business will ask for it, and it is the fastest way to answer "what is all this equipment actually worth?"
Straight-line
- Simple to calculate and explain
- Even expense makes monthly profit comparable
- Standard for buildings and furniture
Declining balance
- Matches assets that lose value fast
- Lower profit in early years
- Slightly more work to track
Your depreciation checklist
- Set a capitalization threshold and write it into your bookkeeping rules
- Build a fixed asset register with cost, date, life, salvage and method
- Choose straight-line for most assets and declining balance for vehicles and computers
- Ask your accountant which tax method and first-year deductions apply this year
- Automate the monthly depreciation entry in your accounting software
- Review the register at year end and record disposals
Frequently asked questions
Is depreciation a cash expense?
No. The cash left when you bought the asset. Depreciation is the accounting entry that spreads that cost over the years of use. That is why it is added back when calculating operating cash flow.
Can I choose any useful life I want?
For the books, you estimate it reasonably based on how long you expect to use the asset. For tax, most countries assign lives or rates by asset class, and you must follow those.
What happens if I use an asset for business and personal purposes?
You generally depreciate only the business-use share. A vehicle used 70% for business gets 70% of the depreciation. Keep a usage log, as tax authorities commonly ask for one.
Should I take the biggest first-year deduction available?
Often, but not always. A large deduction in a low-profit year may be partly wasted, while spreading it could offset higher-taxed profits later. Ask your accountant to model both before the end of the tax year.
Related reading
The bottom line
Depreciation spreads the cost of long-lived assets across the years they help you earn. Straight-line, declining balance and units of production are just different patterns for that spreading, and the total is always the same. Keep a clean asset register, post depreciation monthly, and treat tax depreciation as a separate conversation with your accountant, because the rules differ by country and change nearly every year.
