What are depreciation expenses? Methods, tax benefits, and impact on financial statements

When your company purchases long-term assets like machinery, vehicles, or buildings, you need to account for their cost over time. Depreciation expenses allow you to allocate the cost of an asset over its useful life, reflecting its decline in value on your income statement.

This supports accurate financial reporting while lowering your taxable income. According to data from the Federal Reserve Bank of St. Louis, U.S. corporations depreciated nearly $1.45 trillion in assets in 2021, highlighting the massive scale and importance of depreciation in business accounting.

Here, we explain depreciation expenses, how to calculate them, their impact on financial statements, and the tax benefits of depreciation. We’ll also review the common methods for calculating depreciation and discuss how you can choose the most appropriate method for your company’s fixed assets.

What is depreciation expense?

Depreciation expense refers to the portion of an asset’s cost recognized as an expense over time. This non-cash expense reflects the gradual reduction in an asset's value due to wear, obsolescence, or use. By recognizing depreciation, you match an asset’s cost with the revenue it generates, in line with the matching principle in accounting.

On the income statement, depreciation expenses are recorded as a non-cash expense, reducing net income. On the balance sheet, depreciation is recorded as accumulated depreciation, which reduces the net book value of the asset over time.

Consider an example. Let’s say your company purchases machinery for $50,000 with a useful life of 5 years and no residual value (i.e., the asset’s value at the end of its useful life). You would calculate the annual depreciation expense as:

Depreciation expense = ($50,000 cost – $0 residual value) / 5 years = $10,000 per year

This depreciation expense reflects the gradual reduction in the book value of the asset.

Depreciation expense vs. accumulated depreciation

Depreciation expense is the portion of the asset’s cost recorded annually on the income statement. In contrast, accumulated depreciation is the total depreciation taken on the asset to date. It’s a contra asset recorded on the balance sheet, reducing the asset's book value.

A key difference is that you’d record depreciation expense annually, while accumulated depreciation is cumulative and tracks the total depreciation over the asset's life.

Main methods of calculating depreciation

There are three primary methods used to calculate depreciation expenses. Each method suits different asset types and usage patterns:

1. Straight-line depreciation method

The straight-line method allocates depreciation evenly over an asset’s useful life.

Depreciation Expense = (Cost of Asset – Residual Value) / Useful Life

Example:

A company purchases equipment for $100,000 with a 5-year useful life and no residual value. Calculated via the straight-line method, the annual depreciation expense is:

($100,000 – $0) / 5 = $20,000 per year

This method is most commonly used for long-term assets such as buildings and office furniture.

2. Declining balance depreciation method

The declining balance method is an accelerated depreciation method that recognizes higher depreciation expenses in the early years of an asset's life. The double-declining balance (DDB) method is a common variation that uses double the rate of the straight-line depreciation method.

You can calculate DDB depreciation by halving the asset’s useful life and multiplying by its beginning book value for the accounting period:

Depreciation Expense = (2 / Useful Life) * Beginning Book Value

Example:

For a $100,000 asset with a 5-year useful life, the first-year depreciation under DDB is:

(2 / 5) * 100,000 = 40,000

This method is ideal for assets such as vehicles or technology, which lose value quickly in their early years, offering tax benefits through higher deductions in the initial periods.

3. Units of production depreciation method

The units of production method calculates depreciation based on the asset’s actual usage or production output, making it ideal for machinery used in manufacturing.

Depreciation Expense = (Cost of Asset – Salvage Value) / Total Units Produced * Units Produced in Period

Example:

Say your company purchases a machine for $150,000 with a residual value of $10,000. You expect the machine to produce 100,000 units in total. If you produce 10,000 units in the first year, the depreciation expense is:

($150,000 – $10,000) / 100,000 * 10,000 = $14,000

This method is best suited for depreciable assets used based on output.

How to choose the right depreciation method

The method you choose depends on the asset’s useful life, how you use it, and its rate of depreciation:

• Straight-line depreciation: Ideal for assets that lose value evenly, like office buildings or furniture
• Declining balance depreciation: Best for assets like vehicles or tech hardware, which lose value more quickly in the early years
• Units of production depreciation: Suitable for production machinery where usage directly correlates with depreciation

Tax implications of depreciation

Depreciation expenses offer significant tax benefits by reducing taxable income. By recording depreciation on assets, your business can lower its net income, which lowers the amount of income subject to income tax. This reduces tax liability in the short term, improving your business’s overall cash flow.

Two common methods that provide immediate tax relief are Section 179 and bonus depreciation:

Section 179

Section 179 of the IRS tax code allows businesses to deduct the entire cost of qualifying assets in the first year they’re placed into service. This method is particularly beneficial for businesses that need to make significant capital expenditures but want to reduce their taxable income right away.

There are limits to the total amount you can deduct under Section 179, so be sure to consult with a tax professional and make sure you qualify and are within the deduction limits.

Here’s an example. Let’s say your company purchases machinery for $200,000 and uses Section 179 to deduct the full purchase price in the first year. This immediately reduces taxable income, significantly lowering your company's tax liability and freeing up cash for other investments.

Bonus depreciation

Bonus depreciation allows businesses to depreciate a larger portion of an asset’s cost in the first year. The rules for bonus depreciation have changed over the years, especially with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017.

In general, bonus depreciation rules allow you to immediately deduct a percentage of the cost of equipment placed into service. It’s a great tool for small businesses or companies investing heavily in tangible assets.

How depreciation improves cash flow

Both Section 179 and bonus depreciation help businesses maximize tax deductions and improve cash flow. Because you can recover the full cost of assets in the first year rather than spreading the deductions over several years, you get a larger immediate tax refund or lower tax payment. You can reinvest this improved cash flow into the business for growth, or use it to cover operating expenses.

Building a depreciation schedule

Depreciation schedules help you track the depreciation expenses of multiple fixed assets over time. It’s a tool for making sure you accurately record depreciation in financial statements, and it also makes tax filings more efficient.

Here’s a step-by-step guide to building a depreciation schedule with Excel or accounting software:

1. Gather asset information

Start by compiling a list of all depreciable assets that your business owns. For each asset, gather the following information:

• Purchase price: Total cost of the asset
• Salvage value: Estimated value at the end of its useful life
• Useful life: Number of years you’ll use the asset
• Depreciation method: Straight-line, declining balance, units of production, etc.

2. Choose the right depreciation method

Select the depreciation method for each asset based on its type and usage. The three most common methods include:

• Straight-line depreciation for assets that lose value evenly over their useful life
• Declining balance method for assets that lose value more quickly in the earlier years of their useful life
• Units of production method for assets used based on output, such as machinery in a factory

3. Create a depreciation table in Excel

In Excel, set up a table to track each asset’s purchase price, annual depreciation expense, and accumulated depreciation. Use the formula for your chosen depreciation method (e.g., straight-line or double declining balance) to calculate the annual depreciation expense for each asset.

For example, let’s say your company buys equipment for $100,000 with a 5-year useful life and a salvage value of $10,000.For straight-line depreciation, the annual depreciation expense is:

($100,000 – $10,000) / 5 = $18,000

In the table, create columns for each year to track how much depreciation accumulates over time.

4. Track accumulated depreciation

Track the amount of accumulated depreciation recorded for each asset each year. Accumulated depreciation grows as the asset is depreciated.

Here’s an example:

• Year 1: $18,000
• Year 2: $18,000 + $18,000 = $36,000 (accumulated depreciation)

5. Monitor net book value

The net book value of each asset is calculated by subtracting the accumulated depreciation from the purchase price. As the asset is depreciated, its value decreases over time.

For example:

• Year 1: $100,000 – $18,000 = $82,000
• Year 2: $100,000 – $36,000 = $64,000

6. Use historical data for predicting future depreciation

As you track multiple assets over time, use historical data to predict future depreciation. This helps you plan for future purchases and understand how depreciation will impact taxable income and cash flow. For example, based on your historical depreciation schedule, you can predict how much future tax deductions you can expect as assets reach the end of their useful life.

Automate depreciation tracking with Ramp

Depreciation expenses are just one piece of your company’s overall accounting puzzle. If you’re looking to streamline your financial processes and improve visibility into all your business expenses, Ramp can help.

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