Depreciation explained: methods, examples and accounting

Published Thursday 2 April 2026

Table of contents

• What is depreciation?
• Purpose of depreciation
• What can be depreciated?
• Examples of depreciation in action
• Choosing a depreciation schedule
• Methods of calculating depreciation
• How to track depreciation in your accounting
• Managing depreciation for your small business
• FAQs on depreciation

Key takeaways

• Track depreciation as a real business expense on your profit and loss statement to accurately calculate your true costs and avoid overestimating profits.
• Use depreciation to reduce your taxable income and lower your tax bill by claiming the declining value of business assets over their useful life.
• Choose the right depreciation method for each asset: straight-line for consistent value decline, diminishing-value for assets that lose value quickly, or units-of-production for usage-based wear.
• Set up depreciation tracking in your accounting software to automatically calculate asset value changes and update your financial reports in real time.

What is depreciation?

Depreciation, a concept formalised in international standards like the 1975 Depreciation Accounting standard, is the gradual loss of value in a business asset over time. As equipment, vehicles and other assets age or wear out, their worth decreases from the original purchase price towards zero.

A work computer is a good example. You might buy it for $1,500, but after three years of daily use, it's worth far less. Depreciation accounting tracks this decline and reflects it in your financial records.

This area of accounting can get complex, so consider working with a professional.

Purpose of depreciation

Depreciation serves three main functions in your business finances. Understanding these helps you make better decisions about costs, taxes and business value.

• Tracking true costs: Wear and tear is a real expense that affects profitability
• Reducing your tax bill: Depreciation can lower your taxable income
• Estimating business value: Asset values directly affect what your business is worth

Depreciation as an expense

To understand how profitable your business is, you need to know all your costs. Depreciation is one of those costs because assets that wear down eventually need to be replaced.

Depreciation accounting helps you work out how much value your assets lost during the year. That number appears on your profit and loss statement and gets subtracted from revenue when calculating profit.

If you don't account for depreciation, you'll underestimate your costs and think you're making more money than you really are.

You can download our free P&L template to work out all of your costs.

Depreciation and tax

Depreciation reduces your taxable income, which can lower your tax bill. For example, the Internal Revenue Service (IRS) provides a special depreciation allowance of 40% for certain qualified property placed in service in early 2025. If you don't account for it, you may end up paying more tax than necessary.

You can often claim the full value of an asset as a tax deduction over time. However, tax rules determine how quickly you can depreciate certain assets. Check with your tax office or accountant for guidance specific to your situation.

Valuing your business

Asset values directly affect your business worth. A transport company with old trucks may not be worth as much as one with new trucks.

Your assets appear on your balance sheet in what's called the fixed asset register. Update this register whenever you calculate depreciation.

Assets are often used to secure loans. As they drop in value, they offer less security, which can make it harder to get finance.

You can download our free balance sheet template to help you keep track of your assets.

What can be depreciated?

Fixed assets are the main category of items you can depreciate. While most business expenses are tax-deductible, not all are depreciable.

Here's the difference:

• Consumables like stationery: Deduct in the year you buy them
• Fixed assets like equipment: Depreciate over their useful life

What are fixed assets?

A fixed asset is something that helps you generate income over more than a year. According to the IRS, to be depreciable, an asset must be used in your business, have a determinable useful life and be expected to last more than one year. Common examples include:

• tools and machinery
• computers and office furniture
• vehicles
• buildings

You don't always have to own them. Some leased items may be depreciable too.

Intangible assets like patents and copyrights can also be depreciated (called amortisation). These non-physical assets are valuable to your business, but that value shrinks as they near expiry. However, under international accounting standards, an asset with an indefinite useful life is not amortised but is instead tested annually for impairment.

Some assets can't be depreciated. Land doesn't lose value, so it's not depreciable. This is a formal rule in financial reporting, as accounting standards like Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) explicitly state that land should not be depreciated. Inventory is handled separately under inventory accounting.

Examples of depreciation in action

Here are three common examples for small businesses.

Example 1: Office computer You buy a laptop for $1,500 with an expected lifespan of three years. Using straight-line depreciation, it loses $500 in value each year. After three years, its book value is $0.

Example 2: Work vehicle You purchase a delivery van for $30,000, expecting it to last five years. Using straight-line depreciation, it depreciates by $6,000 per year. After five years, the book value is $0, though you might sell it for its residual value.

Example 3: Manufacturing equipment You buy a machine for $10,000 that can produce 100,000 units. Using units-of-production depreciation, each unit produced reduces the machine's value by $0.10. If you produce 20,000 units in year one, depreciation for that year is $2,000.

Choosing a depreciation schedule

A depreciation schedule determines how long an asset will last and how its value declines over time. You need to estimate each asset's useful lifespan before you can calculate depreciation.

Lifespans vary widely. A computer might last three years, while a factory kiln could last 30. Your tax office typically publishes depreciation schedules for common asset types, and most small business owners follow these recommendations.

You can adjust an asset's value to zero at any time if it's lost, stolen or damaged. Assets can also be sold, traded or combined into a new asset.

Methods of calculating depreciation

Once you know an asset's lifespan, you need to choose how its value will decline. Will it lose value at the same rate every year, or lose most of its value early?

There are several methods for calculating depreciation. Three of the most common are:

Straight-line depreciation

Straight-line depreciation spreads the cost evenly over an asset's useful life. The asset loses the same amount of value every year until it reaches zero.

For example, a $5,000 computer expected to last five years would depreciate by $1,000 each year.

Diminishing-value depreciation

Diminishing-value depreciation front-loads the expense. An asset loses a higher percentage of its value in the first few years, with the rate gradually slowing over time. For US tax purposes, this is typically done using the Modified Accelerated Cost Recovery System (MACRS) for property placed in service after 1986.

This method can be useful when an asset loses most of its usefulness early, like technology that quickly becomes outdated.

Units-of-production depreciation

Units-of-production depreciation bases the calculation on usage rather than time. Some assets are better measured by the work they do than by how long they last.

For example, you might depreciate:

• a vehicle based on kilometres travelled
• a packaging machine based on products boxed

This method works well when wear and tear depends more on use than on age.

How to track depreciation in your accounting

Recording depreciation involves making regular entries in your books that reflect the declining value of your assets. Here's how it works.

Each period, you record a depreciation expense on your profit and loss statement. This reduces your reported profit by the amount your assets have declined in value.

At the same time, you update your balance sheet to show the reduced value of your assets. This happens through an account called accumulated depreciation.

Accounting software simplifies this process. With Xero, you can:

• set up assets with their purchase price and expected lifespan
• choose a depreciation method
• let the software calculate and record depreciation automatically
• see updated asset values in real-time reports

Your accountant or bookkeeper can help you set up depreciation correctly and review your records at tax time.

Managing depreciation for your small business

Understanding depreciation helps you track true costs, reduce your tax bill and know what your business is worth.

Most small businesses simply follow the depreciation schedule provided by the tax office. Once you set it up in your accounting software, the calculations happen automatically and flow through to your tax return.

Xero handles depreciation calculations for you and updates your financial reports in real time. Try Xero free for one month and see how easy managing depreciation can be. An accountant or bookkeeper can also provide advice along the way.

FAQs on depreciation

Here are answers to some common questions about depreciation.

Can I change my depreciation method after I start using it?

Generally, you should stick with the same method for consistency. However, you may be able to change methods in certain circumstances. Check with your accountant or tax office for guidance.

What happens to depreciation when I sell an asset?

When you sell a depreciated asset, you compare the sale price to its book value. If you sell for more than book value, you may have a taxable gain. If you sell for less, you may be able to claim a loss.

Do I need to depreciate assets I lease?

It depends on the type of lease. Some leased assets can be depreciated, while others cannot. Your accountant can help you determine the correct treatment for your situation.

What's the difference between depreciation and amortisation?

Depreciation applies to physical assets like equipment and vehicles. Amortisation applies to intangible assets like patents and copyrights. Both spread the cost of an asset over its useful life.

How does depreciation appear in Xero?

Xero tracks your fixed assets and calculates depreciation automatically based on the method you choose. Depreciation expenses appear on your profit and loss report, and asset values update on your balance sheet.