Financial metrics
Depreciation
Depreciation is an accounting method used to allocate the cost of a tangible physical asset over its useful life, reflecting how much of its value has been used up.
What is Depreciation?
When you buy a large physical asset for your business, such as a delivery van or heavy machinery, you do not record the entire purchase price as an expense in a single month. Instead, you use depreciation to spread that cost over the years the asset helps you generate income. This matching principle ensures your profit and loss statement accurately reflects the cost of doing business over time. Depreciation applies exclusively to tangible assets you can touch. Intangible assets follow a similar but distinct process called amortisation. As the asset ages, its recorded value on your balance sheet decreases, while a portion of its original cost is recognised as an expense in your general ledger. This systematic reduction gives you a clearer picture of your actual financial health.
(Asset Cost - Salvage Value) / Useful Life
This calculation gives you the annual depreciation expense. You record this same amount every year until the asset reaches its salvage value.
How Depreciation works
The process begins when you acquire a tangible asset for long-term use in your business. First, you must determine the total initial cost, which includes the purchase price and any fees required to make the asset usable. Next, you estimate how long the asset will remain productive, known as its useful life. You also need to predict its salvage value, which is the amount you expect to sell it for at the end of its useful life. With these three figures, you select a depreciation method. The straight-line method is the most common and divides the cost evenly across the years. Finally, you record a journal entry at the end of each accounting period to log the depreciation expense and reduce the asset value.
- Identify the total acquisition cost of the physical asset being purchased.
- Estimate the useful life or the total years the asset will remain productive.
- Determine the salvage value you expect to receive when disposing of the asset.
- Choose a calculation method to allocate the expense systematically over time.
- Post regular journal entries to record the expense and update your balance sheet.
Worked example
Gulf Logistics LLC buys a new forklift for 25,000. The company expects to use the forklift for five years and estimates it can sell the machine for 5,000 at the end of that period. To calculate the straight-line depreciation, they subtract the 5,000 salvage value from the 25,000 purchase price, leaving a depreciable base of 20,000. They then divide this 20,000 by the five-year useful life. The result is an annual depreciation expense of 4,000. Each year, Gulf Logistics records a 4,000 expense on their profit and loss statement, reducing their taxable profit.
Why it matters for your business
Understanding depreciation is vital because it directly impacts your reported profitability and tax liabilities. If you expense a massive purchase immediately, your business will look artificially unprofitable that month and overly profitable in subsequent years. Proper depreciation smooths out these costs, giving you an accurate view of your actual margins. It also ensures your balance sheet does not overstate the value of aging equipment. You can easily post these regular journal entries in Paper & Pen to keep your general ledger accurate. Tracking asset values helps you plan for future replacements before equipment breaks down completely.
See also
Questions
Common questions
What is the difference between depreciation and amortisation?
Can I claim depreciation on land?
What happens if an asset breaks before its useful life ends?
Related terms
- Amortisation Amortisation is the accounting practice of gradually writing off the initial cost of an intangible asset over its useful life to match expenses with generated revenues.
- Journal entry A journal entry is a formal accounting record that logs a business transaction by showing the date, the accounts affected, and equal debit and credit amounts.
- Balance sheet A balance sheet is a financial statement that reports a company's assets, liabilities, and shareholder equity at a specific point in time to provide a snapshot of its overall financial health.
- Profit and loss statement A profit and loss statement is a financial report that summarises a company's revenues, costs and expenses during a specific period to show whether it generated a profit or incurred a loss.
- General ledger A general ledger is the master accounting record of a business, containing all financial transactions categorised by account to track assets, liabilities, equity, revenue and expenses.
- Break-even point The break-even point is the exact moment when a business generates enough revenue to cover all its fixed and variable costs, resulting in neither a profit nor a loss.