Depreciation: Definition, Methods, Formulas & Examples
Why Depreciation Matters
When a company buys a $500,000 piece of equipment expected to last 10 years, it doesn’t make sense to record the full cost as an expense on day one. That would crush earnings in year one and overstate them for the next nine. Depreciation solves this by matching the asset’s cost to the periods it helps generate revenue — a core principle under accrual accounting.
For investors and analysts, depreciation is critical because it directly affects operating income, net income, asset values on the balance sheet, and tax liability. Companies with heavy physical assets — manufacturing, airlines, utilities — carry enormous depreciation charges that shape how you should read their financials.
The Core Formula
The cost includes the purchase price plus any costs to get the asset ready for use (shipping, installation, testing). The salvage value (or residual value) is what the company expects the asset to be worth at the end of its useful life. The difference is the total amount that gets depreciated over time.
Depreciation Methods
1. Straight-Line Depreciation
The simplest and most common method. It spreads the depreciable amount evenly across each year of the asset’s useful life.
Example: A delivery truck costs $80,000, has a $10,000 salvage value, and a 7-year useful life. Annual depreciation = ($80,000 – $10,000) ÷ 7 = $10,000 per year.
2. Double Declining Balance (DDB)
An accelerated method that front-loads depreciation into the early years. Useful when an asset loses value quickly — think computers or specialized equipment.
Notice this method ignores salvage value in the annual calculation (though you stop depreciating once you hit salvage value). The depreciation rate is double the straight-line rate, applied to the declining book value each year.
3. Units of Production
This method ties depreciation to actual usage rather than time — ideal for assets where wear correlates directly with output, like a printing press or mining equipment.
4. MACRS (Tax Depreciation)
The Modified Accelerated Cost Recovery System is the depreciation method required by the IRS for U.S. tax purposes. It uses predefined recovery periods (3, 5, 7, 10, 15, 20, 27.5, or 39 years depending on asset class) and accelerated rates. MACRS typically generates higher depreciation deductions in early years, reducing taxable income faster than straight-line.
Comparing Depreciation Methods
| Method | Pattern | Best For | Common Use |
|---|---|---|---|
| Straight-Line | Equal expense each year | Assets that lose value evenly | Financial reporting (most common) |
| Double Declining Balance | Higher expense early, lower later | Tech, vehicles, fast-obsolescence assets | Financial reporting (accelerated) |
| Units of Production | Varies with usage | Manufacturing equipment, mining assets | Heavy industry |
| MACRS | IRS-defined accelerated schedule | All depreciable assets for tax | U.S. tax returns only |
How Depreciation Flows Through the Financial Statements
| Statement | Impact |
|---|---|
| Income Statement | Depreciation expense reduces operating income and net income |
| Balance Sheet | Accumulated depreciation reduces the net book value of fixed assets |
| Cash Flow Statement | Added back to net income in operating activities (non-cash charge) |
| EBITDA | Excluded — the first “D” in EBITDA stands for depreciation |
Depreciation vs. Amortization vs. Impairment
Depreciation and amortization are systematic, scheduled allocations of cost — depreciation for tangible assets, amortization for intangible assets. Impairment, by contrast, is a one-time write-down triggered when an asset’s market value drops below its carrying value. Think of depreciation as planned decline and impairment as an unexpected hit.
Example: Straight-Line Depreciation Schedule
A manufacturing company purchases CNC machinery for $200,000 with a $20,000 salvage value and a 10-year useful life.
| Year | Depreciation Expense | Accumulated Depreciation | Net Book Value |
|---|---|---|---|
| 0 (Purchase) | — | — | $200,000 |
| 1 | $18,000 | $18,000 | $182,000 |
| 2 | $18,000 | $36,000 | $164,000 |
| 3 | $18,000 | $54,000 | $146,000 |
| 5 | $18,000 | $90,000 | $110,000 |
| 10 | $18,000 | $180,000 | $20,000 |
Annual depreciation = ($200,000 – $20,000) ÷ 10 = $18,000. At the end of year 10, the net book value equals the salvage value.
Key Takeaways
- Depreciation allocates the cost of tangible assets over their useful life — it’s a non-cash charge that reduces earnings but not cash flow.
- Straight-line is the most common method for financial reporting; MACRS is required for U.S. tax filings.
- Accelerated methods (DDB, MACRS) front-load expenses, reducing taxable income in early years.
- Depreciation is to physical assets what amortization is to intangible assets.
- Comparing depreciation to capex reveals whether a company is investing enough to maintain its asset base.
Frequently Asked Questions
Is depreciation a real expense or just an accounting entry?
It’s a real economic cost — assets do lose value through use and obsolescence — but it’s a non-cash expense. The cash was spent when the asset was purchased. Depreciation allocates that cost across the periods the asset helps generate revenue, following the matching principle of accrual accounting.
What is the difference between depreciation and amortization?
The concept is the same — spreading a cost over time. Depreciation applies to tangible assets (equipment, buildings). Amortization applies to intangible assets (patents, software). Both are non-cash charges excluded from EBITDA.
Why do companies use different depreciation methods for books and taxes?
Straight-line depreciation produces smoother, more predictable earnings for investors — which is what companies want on their financial statements. MACRS generates larger deductions early on, reducing tax bills sooner. Using both simultaneously is perfectly legal and standard practice.
Can land be depreciated?
No. Land is not depreciated because it has an unlimited useful life and doesn’t wear out or become obsolete. When a company buys property that includes land and a building, it must allocate the purchase price between the two and only depreciate the building portion.
What happens when an asset is fully depreciated?
Once accumulated depreciation equals the depreciable amount (cost minus salvage value), no further depreciation is recorded. The asset stays on the balance sheet at its salvage value until it’s sold, scrapped, or otherwise disposed of.