What is depreciation? Meaning, methods and examples

Published Wednesday 1 April 2026

Table of contents

• What is depreciation?
• Purpose of depreciation: three main functions
• What can be depreciated?
• Choosing a depreciation schedule
• How to calculate depreciation
• Depreciation calculation examples
• How depreciation is recorded
• Managing depreciation with confidence
• FAQs on depreciation

Key takeaways

• Record depreciation as a real business expense to accurately calculate your true costs and avoid overestimating profits, since assets that wear down will eventually need replacement.
• Use depreciation deductions to reduce your tax bill by gradually claiming the entire value of qualifying fixed assets like equipment, vehicles, and buildings over their useful life.
• Choose straight-line depreciation for most assets to spread costs evenly across their lifespan, or use diminishing value depreciation when you want larger tax deductions in the early years.
• Set up automated depreciation tracking in your accounting software to handle calculations and journal entries automatically, ensuring accurate financial records and compliance with tax requirements.

What is depreciation?

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

Accounting for depreciation means tracking this decline in your books. The process can get complex, so consider working with a professional.

Depreciation accounting serves several important purposes for your business.

Purpose of depreciation: three main functions

Depreciation accounting serves three main purposes for your business:

• Understanding true costs: Wear and tear is a real expense that affects profitability.
• Reducing your tax bill: You may be able to claim asset value as a deduction.
• Estimating business value: Asset values directly affect what your business is worth.

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

Depreciation is a real business cost because assets that wear down eventually need to be replaced. To understand how profitable your business is, you need to account for this expense.

Depreciation accounting helps you figure out how much value your assets lost during the year. That number goes on your profit and loss statement and gets subtracted from your 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.

Download the free profit and loss template to help you track all your costs.

2. Depreciation and tax

Depreciation can lower your tax bill. If you don't account for it, you may end up paying more tax than necessary. You may be able to gradually claim the entire value of an asset as a tax deduction.

There are rules around how quickly you can depreciate certain assets from a tax perspective. Check with your tax office or accountant for guidance specific to your situation.

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

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

Your assets are listed on your balance sheet in what's called the fixed asset register. Make sure you update the register whenever you calculate depreciation.

Assets are often used to secure loans. As they drop in value, they offer less security, and you may find it harder to get finance.

Track your assets with the free balance sheet template.

Now that you understand the purpose of depreciation, let's look at which assets qualify.

What can be depreciated?

Only fixed assets can be depreciated for most businesses. There's a difference between tax-deductible expenses and depreciable assets.

Consumables like stationery are tax-deductible, but you must claim them in the year you bought them. Fixed assets, on the other hand, are depreciated over multiple years.

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
• Some leased items

Intangible assets like patents and copyrights can also be depreciated (called amortisation), where their value gradually shrinks as they near expiry. However, according to international accounting standards, an intangible asset with an indefinite useful life is not amortised but is instead tested annually for impairment.

Assets that can't be depreciated include inventory and land. According to international accounting standards, land is considered to have an unlimited useful life and is therefore not depreciated, with some exceptions like quarries or landfill sites. Inventory is handled separately under inventory accounting.

Once you know which assets can be depreciated, you need to determine how long they'll last.

Choosing a depreciation schedule

A depreciation schedule estimates how long an asset will last before it loses all value. A computer might only last three years, while a factory kiln could last 30.

Your tax office likely has recommended depreciation schedules for common business assets. While many business owners follow these, formal accounting standards advise that an asset's useful life should be reviewed at least annually to ensure estimates remain accurate.

An asset's value can be adjusted to zero at any time if it's:

• Lost or stolen
• Damaged beyond repair
• Sold, traded, or combined into a new asset

With your depreciation schedule set, you can calculate the actual depreciation amounts.

How to calculate depreciation

Once you've set a depreciation schedule, you need to decide how an asset's value will decline. Will it lose most of its value early, or at the same rate every year?

There are several methods for calculating depreciation. Here are the three most common approaches:

Straight-line depreciation

Straight-line depreciation spreads the cost evenly across an asset's useful life. This method reflects the expected pattern of consumption of the asset, which is why international standards prohibit methods based on revenue generation. The asset loses the same amount of value each year until it reaches zero.

How it works: Divide the asset's purchase price by its expected lifespan. An asset worth $5,000 with a five-year lifespan depreciates by $1,000 each year.

Diminishing value depreciation

Diminishing value depreciation (also called declining balance) front-loads the expense. The asset loses a higher percentage of its value in the first few years, then the rate gradually slows.

This method can be useful when an asset loses most of its productivity early in its life, or when you want larger tax deductions sooner.

Units of production depreciation

Units of production depreciation bases the calculation on actual usage rather than time. Some assets wear out based on how much work they do, not how old they are.

Examples:

• A delivery vehicle depreciates based on kilometres driven.
• A packaging machine depreciates based on units produced.

This method works well when usage varies significantly from year to year.

Let's see how these methods work in practice.

Depreciation calculation examples

Here are two common scenarios for small businesses.

Straight-line example: delivery van

Your business buys a delivery van for $30,000. You expect it to last six years with no resale value.

1. Divide the purchase price by the useful life: $30,000 ÷ six years = $5,000
2. Record $5,000 as a depreciation expense each year
3. After six years, the van's book value reaches $0

Diminishing value example: computer equipment

Your business buys computer equipment for $4,000. You use a 40% diminishing value rate.

• Year 1: $4,000 × 40% = $1,600 depreciation (book value now $2,400)
• Year 2: $2,400 × 40% = $960 depreciation (book value now $1,440)
• Year 3: $1,440 × 40% = $576 depreciation (book value now $864)

The depreciation expense decreases each year as the asset's book value shrinks.

After calculating depreciation, you need to record it in your accounting system.

How depreciation is recorded

A depreciation journal entry records the loss of asset value in your accounting system. Each period, you record two things:

• Debit depreciation expense: This increases your expenses on the profit and loss statement.
• Credit accumulated depreciation: This reduces the asset's book value on the balance sheet.

Accumulated depreciation is the total depreciation recorded against an asset since you bought it. It appears on your balance sheet, where it is formally defined as the difference between the gross and the net carrying amounts of the asset.

Most accounting software handles these entries automatically. When you set up an asset and its depreciation schedule, the software calculates and records the journal entries for you each period.

With the basics covered, here's how to put it all together.

Managing depreciation with confidence

Depreciation is manageable once you understand the basics. Tracking it properly helps you understand your true costs, potentially lower your tax bill, and accurately value your business.

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

Xero's fixed asset management tools handle depreciation calculations, update your books automatically, and generate reports you can share with your accountant. Get one month free to see how it works for your business.

An accountant or bookkeeper can also provide guidance tailored to your situation.

FAQs on depreciation

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

What is depreciation in simple words?

Depreciation is the decrease in an asset's value over time due to wear, age, or obsolescence. It lets you spread the cost of expensive items across the years you use them.

Is depreciation good or bad for my business?

Depreciation is generally beneficial. It helps you understand your true costs, can reduce your tax bill, and matches expenses to the periods when assets generate revenue.

What's the difference between depreciation and amortisation?

Depreciation applies to physical assets like vehicles and equipment. Amortisation applies to intangible assets like patents, copyrights, and software licences. Both spread costs over an asset's useful life.

Do I need an accountant to handle depreciation?

Not necessarily. Accounting software like Xero can automate depreciation calculations and journal entries. However, an accountant can help you choose the right method and ensure compliance with tax rules.

Can I depreciate assets I lease or rent?

It depends on the lease terms. Some leased assets can be depreciated if your business controls the asset and bears the risks of ownership. Check with your accountant or tax advisor for guidance on your specific situation.