Depreciation affects your tax bill and your true profit. Here's what it is, how it's calculated, and why ignoring it gives you a misleading picture of your finances.
What Is Depreciation?
Depreciation is the accounting process of spreading the cost of a long-term asset over its useful life, rather than expensing it all in the year of purchase.
When you buy a laptop for $1,500, you don't use it only in year one — you'll use it for 3–5 years. Depreciation allocates $300–500 of cost to each year, giving a more accurate picture of your actual operating cost.
This matters because: if you expensed the full $1,500 in year one, your profit would look artificially low that year and artificially high in subsequent years. Depreciation smooths this out.
What Assets Are Depreciated?
Depreciation applies to fixed assets (or non-current assets) — physical assets that:
Common examples:
Small, short-lived purchases are expensed immediately rather than depreciated (e.g. a $30 USB cable, a $15 notebook).
Common Depreciation Methods
Straight-Line Depreciation
The simplest and most common method. The asset loses the same amount of value each year.
Formula: Annual Depreciation = (Cost − Residual Value) ÷ Useful Life
Example:
Vehicle cost: $30,000
Estimated residual value at end of useful life: $5,000
Useful life: 5 years
Annual depreciation: ($30,000 − $5,000) ÷ 5 = $5,000 per year
Over 5 years, the asset's book value goes: $30,000 → $25,000 → $20,000 → $15,000 → $10,000 → $5,000.
Declining Balance / Reducing Balance
The asset loses a fixed percentage of its remaining book value each year. This front-loads depreciation — the asset loses more value in early years.
Formula: Depreciation = Book Value × Depreciation Rate
Example (25% declining balance):
Year 1: $30,000 × 25% = $7,500 depreciation → book value $22,500
Year 2: $22,500 × 25% = $5,625 → book value $16,875
Year 3: $16,875 × 25% = $4,219 → book value $12,656
This method reflects how many assets actually lose value — a car loses more value in its first year than its fifth.
Tax Depreciation vs Accounting Depreciation
Tax authorities often have their own prescribed depreciation rules, which may differ from what you use in your accounts. For example:
The depreciation on your tax return (which affects your tax bill) may differ from the depreciation in your management accounts (which affects your reported profit).
Why Depreciation Matters for Your Business
Tax: In most countries, depreciation (or equivalent capital allowances) reduces your taxable income. Buy $20,000 of equipment and over time, you'll claim back a significant portion through reduced tax.
True profit: If you ignore depreciation, your profit is overstated. You're not accounting for the cost of using your assets. A business that buys $50,000 of equipment every 5 years has a real cost of $10,000/year — ignoring that understates true operating costs.
Asset values: Your balance sheet should show assets at their current book value (cost minus accumulated depreciation), not original purchase price. A 4-year-old van bought for $30,000 is not worth $30,000 anymore.
Keeping Track of Fixed Assets
Create an asset register — a list of every depreciable asset your business owns, including:
Update it whenever you buy, sell, or write off an asset. Your accountant will need it at year-end.
Try it free
Ready to simplify your business?
Create professional invoices, track expenses, and manage your business — all in one place. Free to start, no credit card required.