What is depreciation? How it works, methods and tax

Published Monday 30 March 2026

Table of contents

• What is depreciation?
• How depreciation works
• What can be depreciated?
• Purpose of depreciation: 3 main functions
• Examples of depreciation in business
• Choosing a depreciation schedule
• Methods of calculating depreciation
• Manage depreciation with confidence
• FAQs on depreciation

Key takeaways

• Record depreciation by spreading an asset's cost across its useful life rather than expensing it all at once, which gives you a more accurate picture of your yearly costs and profits.
• Claim depreciation as a tax deduction to reduce your taxable income by treating a portion of each asset's cost as a business expense each year.
• Use straight-line depreciation for most business assets as it's the simplest method, spreading the cost evenly across the asset's useful life until it reaches zero value.
• Track your asset values on your balance sheet through a fixed asset register to maintain accurate business valuations and understand your borrowing capacity.

What is depreciation?

Depreciation is the gradual loss of value that business assets experience over time. A work computer, for example, depreciates from its original purchase price down to $0 as it moves through its productive life.

You track this declining value in your business's books using specific accounting methods. This practice aligns with accounting principles that require businesses to disclose information about depreciable assets and depreciation. This helps you understand your true costs, claim tax deductions, and accurately value your business. Most small businesses can handle the basics with the right software or professional support.

How depreciation works

Depreciation works by spreading the cost of an asset across its useful life, rather than recording the full expense when you buy it. This matches the expense to the period when the asset helps generate income.

The basic principle behind how depreciation is recorded in your accounts works like this:

• When you buy an asset: you record it at its purchase price on your balance sheet. This process aligns with accounting standards that require organisations to capitalise these assets when first acquired, rather than expense them.
• Each year: you move a portion of that cost to your profit and loss statement as a depreciation expense
• Over time: the asset's value on your balance sheet decreases until it reaches zero or its salvage value

This approach gives you a more accurate picture of your costs and profits each year. It also reflects the reality that assets wear out gradually, not all at once.

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.

The difference is timing. Consumables like stationery get deducted in the year you buy them. Depreciable assets spread their cost across multiple years because they help generate income over a longer period.

What are fixed assets?

A fixed asset is something that helps you generate income over more than a year. Common examples include:

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

You don't always have to own an asset to depreciate it, as some leased items may be depreciable. For example, special rules apply to leasehold improvements, which are depreciated over the shorter of the improvement's useful life or the remaining lease term.

Intangible assets like patents and copyrights can also be depreciated (called amortisation). Their value gradually shrinks as they near their expiry date.

Assets excluded from depreciation: Land and other assets that hold their value are excluded from depreciation. Inventory is also excluded and handled separately under inventory accounting.

Purpose of depreciation: 3 main functions

Depreciation accounting serves three key purposes for your business:

• Cost tracking: helps you understand the true cost of doing business, because wear and tear is an expense
• Tax savings: may reduce your tax bill by spreading asset costs across multiple years
• Business valuation: helps you estimate the current value of your business and its assets

1. Depreciation as an expense (cost of doing business)

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 your revenue when calculating profit.

Accounting for depreciation helps you accurately estimate your costs and understand your true profit.

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

2. Depreciation and tax

Depreciation reduces your taxable income by letting you claim a portion of an asset's cost as a business expense each year. For example, under Internal Revenue Service (IRS) rules for 2025, the maximum section 179 expense deduction is $2,500,000 for qualifying property. Over time, you may be able to claim the entire value of an asset against your tax.

Each country has rules about how quickly you can depreciate certain assets. Check with your tax office or accountant to understand the rates that apply to your business.

3. Valuing your business (depreciation on the balance sheet)

As assets lose value, so can your business. A transport company with old trucks may not be worth as much as one with new trucks, for example.

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

Assets are often used to secure loans. Maintaining accurate asset values helps you understand your borrowing capacity.

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

Examples of depreciation in business

These examples show how depreciation works for common business assets.

Example 1: Business vehicle You buy a delivery van for $30,000 with an expected useful life of five years and no salvage value. Using straight-line depreciation:

• Annual depreciation: $30,000 ÷ 5 years = $6,000 per year
• After year one, the van's book value is $24,000
• After year five, the van's book value is $0

Example 2: Computer equipment You purchase laptops for your team totalling $4,500 with a three-year useful life. Using straight-line depreciation:

• Annual depreciation: $4,500 ÷ 3 years = $1,500 per year
• Each year, you record $1,500 as a depreciation expense on your profit and loss statement

Example 3: Manufacturing equipment You buy a machine for $50,000 that you expect to produce 100,000 units over its lifetime. Using units of production depreciation:

• Depreciation per unit: $50,000 ÷ 100,000 units = $0.50 per unit
• If you produce 15,000 units in year one, your depreciation expense is $7,500

Choosing a depreciation schedule

A depreciation schedule sets out how long an asset is expected to last (its useful life) and how its value declines over that period. An asset's useful life for depreciation may differ from its economic or physical life; for instance, if a company policy is to trade vehicles every three years, that becomes its useful life for accounting. A computer might only last three years, while a kiln in a factory could last 30.

Most tax offices publish depreciation schedules for common business assets. Many small business owners simply follow these recommendations to keep things straightforward.

An asset's value can be adjusted to zero at any time if it's lost, stolen, or damaged. You can also sell, trade, or combine assets.

Methods of calculating depreciation

You also need to decide how an asset's value will decline over its lifespan. Will it lose most of its value early, or at the same rate every year?

There are several methods for calculating depreciation. The right choice depends on how the asset is used and how quickly it loses value. Here are the three most common approaches:

Straight-line depreciation

Straight-line depreciation spreads the cost evenly across an asset's useful life. It is the most widely used depreciation method in the US because it is easy to apply. The asset loses the same amount of value each year until it reaches zero.

For example, a $5,000 asset with a five-year lifespan would depreciate by $1,000 each year.

Diminishing value depreciation

Diminishing value depreciation (also called reducing balance) applies a higher depreciation rate in the early years. The rate gradually slows as time goes on.

This method suits assets that lose most of their value quickly, like technology or vehicles.

Units of production depreciation

Units of production depreciation bases the calculation on actual usage rather than time. This method suits assets where wear depends on how much work they do.

For example, you might depreciate a delivery vehicle based on kilometres travelled, or a packaging machine based on the number of products it processes.

Manage depreciation with confidence

Depreciation can be straightforward. Most businesses simply follow the depreciation schedule provided by the tax office, and accounting software handles the calculations automatically.

Once you set up depreciation in your software, the numbers flow straight through to your financial reports and tax return. An accountant or bookkeeper can provide advice if you need it.

Xero's accounting software tracks your asset values automatically, calculates depreciation for you, and ensures the expenses appear correctly in your tax return. Get one month free and see how Xero simplifies depreciation for your business.

FAQs on depreciation

Here are answers to common questions about depreciation for small businesses.

What is an example of depreciation?

A simple example is a $10,000 piece of equipment with a five-year useful life. Using straight-line depreciation, you'd record $2,000 as a depreciation expense each year until the asset's book value reaches zero.

Can I depreciate assets I'm leasing?

It depends on your situation. Some lease arrangements transfer enough ownership rights for you to depreciate the asset. The treatment varies by lease type. Check with your accountant to understand how your specific lease should be treated.

What happens if I sell a depreciated asset?

When you sell a depreciated asset, you compare the sale price to the asset's current book value. If you sell for more than the book value, you record a gain. If you sell for less, you record a loss. Both can affect your tax position.

Do I need an accountant to handle depreciation?

It depends on your situation. Accounting software like Xero can handle depreciation calculations automatically once you set up your assets. An accountant can also help with complex situations, tax planning, or choosing the right depreciation method.

Where does depreciation appear in my financial statements?

Depreciation appears in two places. The depreciation expense shows on your profit and loss statement, reducing your reported profit. The accumulated depreciation appears on your balance sheet, reducing the book value of your assets over time.