What is depreciation? Types and examples

The topic of depreciation can be tricky for anyone who is not an accountant. 

After all, the idea of an asset depreciating in value may not sound like good news for small business owners. 

However, the various benefits that depreciation can provide often become clear to SMBs once their tax bill arrives. 

Even if the accounting team spearheads all things depreciation, small- and medium-sized business owners should familiarize themselves with the basics of depreciation and understand how it impacts asset values and company financial statements. 

What is depreciation?

Depreciation is a standard accounting practice of allocating the cost of an asset over its useful life. 

It relies on the belief that businesses purchase many items that are useful for more than just one year. However, those assets will lose value over time as they become outdated or incur regular wear and tear. 

An example people are often familiar with is purchasing a new vehicle. As soon as you drive it off the lot and continue to put miles on it, it becomes less valuable than when it was initially purchased. 

Thus, depreciation expense allows businesses to reduce the value of an asset each year to account for its obsolescence or wear and tear. This annual expense reflects the asset’s actual usage and may help to reduce the business’s tax liability. 

The impact of depreciation on business finances

As previously mentioned, depreciation can provide attractive tax advantages. However, this does come with the tradeoff of a lower net income reported on the profit and loss statement. 

Each year, the depreciation expense decreases the business’s taxable income, which could lower its tax burden. All else being equal, the larger the depreciation expense, the more it could reduce a business’s tax bill. 

Depending on the useful life of the asset, this means businesses could continue enjoying tax-related benefits on the purchase even several years later.  But, the business will also record lower profits in the meantime because of it. 

Notably, depreciation is often considered a “non-cash expense” because it doesn’t reflect actual cash outflows in the years following the initial purchase. However, it is treated as an expense in accounting records for tax-related purposes. 

What kind of assets can depreciate?

According to the IRS, small businesses can depreciate the following assets: 

• Machinery
• Equipment
• Buildings
• Vehicles
• Furniture

Notably, this list does not include land, which is not considered a depreciable asset. The value of land typically appreciates over time. 

SMBs are also unable to claim depreciation on personal property. While this may seem obvious, there are certain scenarios where the lines can be blurred, like when a business owner uses their personal vehicle for work purposes. In this case, only the portion used for business reasons can be depreciated. 

In any case, the IRS lays out a list of requirements that businesses must meet to depreciate property. This can help businesses further understand what qualifies as a depreciable asset. Such requirements include: 

1. The business must own the property (even if it’s financed)
2. The asset must be used to generate taxable income
3. The asset must have a defined useful life
4. The useful life of the asset must be longer than one year

Types of depreciation

There are a few methods of depreciation, including: 

• Straight-line
• Double declining balance
• Units of production

The formula used to calculate depreciation will vary depending on the chosen method, which will also impact the expense amount that’s recorded. 

Businesses generally have a choice over which depreciation method they will use. However, there are varying elements and characteristics of each method that make them better suited to certain situations. Here’s a closer look at each: 

Straight-line method

The most common and straightforward way to calculate depreciation expense is the straight-line method. 

This is best for assets that consistently wear out over time, as the depreciation expense will be the same each year until the end of its useful life. 

Here’s the formula for the straight-line depreciation method: 

Again, the application of this method is quite simple in practice. If a business purchases a piece of equipment that costs $45,000, with an estimated useful life of eight years and a salvage value of $0, the depreciation expense each year would be: 

Depreciation expense = (45,000 – 0) / 8

= 45,000 / 8

= $5,625

‍

Based on this calculation, the depreciation schedule would look like: 

‍
Double declining balance method

This depreciation method is a bit more involved than the straight-line method. It is best for assets that quickly lose value after purchase, allowing businesses to write off a larger portion of their value early on in their useful life and less in the later years. Thus, the yearly depreciation expense will decrease over time. 

The formula for the double-declining balance method is as follows: 

‍Where the rate of deprecation is: 

= (100% / Useful life) * 2

As the name might suggest, the calculation assumes that the asset will depreciate at double the rate of the straight-line method. 

If a business purchases a delivery van for $35,000, with an estimated useful life of 8 years and a salvage value of $3,500, it would first need to calculate the deprecation rate. This would be: 

Rate of depreciation  =  (100% / 8) * 2

=  (1 / 8) * 2

=  0.125 * 2

=  0.25

‍

Using the depreciation rate of 25%, there’s a simple calculation to find the depreciation expense for the first year: 

Depreciation expense  =  35,000 * 0.25

=  8,750

‍

In the following year, the lower starting book value would result in a lower depreciation expense, which would continue to decline over the years until reaching the salvage value, as illustrated in the following depreciation schedule:

	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8
Beginning book value	Depreciation expense formula Depreciation expense = (Number of units produced / Life in number of units) * (Cost – Salvage value) In this scenario, let’s consider the business purchasing a piece of equipment for $20,000 that has no salvage value and an estimated total production of 50 million units.  In the first year, it produces 4 million units, which would result in the following depreciation expense:  Depreciation expense  =  (4,000,000 / 50,000,000) * (20,000 – 0) =  0.08 * 20,000 =  1,600 ‍ Thus, the depreciation expense will vary from year to year based on the actual production of the asset. Over time, the depreciation schedule might look something like this:  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Production (in millions of units) 4 8 6 10 12 6 2 2 Beginning book value 20,000 18,400 15,200 12,800 8,800 4,000 1,600 800 Depreciation expense 1,600 3,200 2,400 4,000 4,800 2,400 800 800 Ending book value 18,400 15,200 12,800 8,800 4,000 1,600 800 - Understanding the depreciation schedule As exhibited in the tables above, a depreciation schedule simply allows businesses to stay on top of planned depreciation expenses over the useful life of an asset.  It’s a simple resource used for internal record-keeping and decision making to understand how depreciation will impact accounting records to inform financial planning and budgeting decisions.  The schedule might look slightly different from business to business depending on the depreciation method chosen and other internal requirements.  How is depreciation recorded? When a business buys a depreciable asset in a given year, it won’t record the full purchase price as an expense on the income statement during that reporting period.  Instead, the transaction will be recorded on the balance sheet as a debit to the asset account (like Property, Plant and Equipment) and a credit to the cash or accounts payable account.  At the end of the reporting period, the business will claim depreciation expense for any relevant assets using one of the accepted methods.  Depreciation journal entry example The following journal entry corresponds to the initial asset purchase of a piece of machinery costing $25,000:  Account Debit Credit Property, plant and equipment $25,000 Accounts payable $25,000 Then, using the straight-line method with $0 salvage value and 10 years of useful life, the journal entry for recording depreciation expense at the end of the year would look like:  Account Debit Credit Depreciation expense $2,500 Accumulated depreciation $2,500 Gain better visibility into your business’s finances Depreciation can be a powerful tool for businesses to spread the cost of an asset over its useful life, offering tax, accounting, and financial planning advantages.  For additional support managing business finances, turn to BILL. As an all-in-one financial operations platform, BILL helps businesses create and send invoices, pay bills, manage expenses, and access credit from within the same system.  Join BILL today to see how the platform can help you streamline accounts payable, accounts receivable, and spend management.  Start using BILL today Sign up Bailey Schramm Bailey Schramm is a freelance writer who creates content for BILL. She graduated summa cum laude from the University of Wyoming with a B.S. in Finance. Bailey combines her expertise in finance and her 4 years of writing experience to provide clear, concise content around complex business topics. 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