What are depreciation expenses?

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Almost every business needs some sort of equipment to operate. Assets like vehicles, machinery, and servers are expensive but necessary costs. Unfortunately, many of these major purchases tend not to hold their value over the long term.

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That’s where the concept of depreciation comes in. Depreciation is a critical tool in accounting for the gradual loss of value of a tangible asset over a number of years. This concept acknowledges that most physical assets don't retain their original value indefinitely.

In this post, we’ll explain what depreciation expenses are (with examples), describe the different methods for calculating depreciation, and offer some advice on which depreciation expense method to use for your business.

What is depreciation?

Depreciation is an accounting practice that spreads out the cost of a physical asset over the course of its useful life. Depreciation accounts for the fact that assets like cars and machinery not only help generate revenue over a long period of time, but also don’t retain their original value as you continue to use them.

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For those reasons, depreciation plays a pivotal role in accurately reflecting the value of your business’s assets. It allows your business to earn income from an asset, simultaneously accounting for a part of its cost annually as an expense on your income statement. This strategy guarantees that your income statement accurately represents the decreasing worth of your assets, offering a more accurate picture of your company's financial status.

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The implications of depreciation extend beyond accounting; it can impact your company's financial strategy and tax planning. Because depreciation is recognized as an expense, it reduces your company's reported net income and, as a result, decreases your taxable income. It's important to note that depreciation is solely a bookkeeping transaction and does not entail any real cash outflow from the company.

Depreciation expenses vs. accumulated depreciation

A depreciation expense refers to the portion of an asset’s cost that you expense each year, reflecting the asset's usage and wear over a given period (typically one fiscal year). This annual depreciation charge is recorded on the income statement, directly reducing your net income.

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Accumulated depreciation represents the entire sum of depreciation expenses you’ve recorded for an asset since you first began using it. This cumulative figure reflects the total depreciation charged over the asset's operational history, providing a holistic view of its value reduction.

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Examples of depreciable assets

Depreciable assets are used for longer than a year and are integral to a business's operations. This distinguishes them from short-term assets or investment holdings like stocks. Depreciable assets are generally tangible, fixed assets—that is, physical, long-term assets. By their nature, intangible assets don’t depreciate.

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Examples of depreciable assets include:

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• Industrial machinery: In sectors like manufacturing, heavy machinery such as lathes, CNC machines, and robotics represent key depreciable assets
• Company vehicles: Vehicles used for business purposes, including delivery vans, company cars, and heavy-duty trucks, are classic examples of depreciable assets
• Office buildings and facilities: Real estate assets like office complexes, retail stores, and manufacturing facilities are subject to depreciation. Notably, while the structures themselves depreciate, the land they’re on typically doesn't.
• Technology assets: Items like servers, computers, and scanners are rapidly depreciating assets
• Office furnishings: Everyday office items like desks, chairs, and filing cabinets
• Leasehold enhancements: Modifications or improvements made to a rented space, such as custom-built fixtures or structural changes, depreciate over the lease term or the improvement's useful life, whichever is shorter

How to account for depreciation expenses

Depreciating property is a systematic process that involves spreading the cost of an asset over its estimated useful life. This accounting practice reflects the diminishing value of an asset as it ages and is used in business operations. The process involves several key steps and adheres to specific timeframes depending on the type of property you’re depreciating.

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Key steps include:

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• Identifying the asset's total acquisition cost: This calculation goes beyond the basic purchase price, encompassing all related expenses essential for making the asset operational. These expenses might include costs for installation, delivery, and setup.
• Assessing the useful life of the asset: This varies depending on the asset type. For example, the typical economic lifespan for office machinery ranges between 5 to 7 years, while vehicles are often depreciated across 5 years. In contrast, the lifespan of buildings for depreciation purposes extends considerably longer, from 27.5 to 39 years.
• Choosing an appropriate depreciation technique: While the straight-line depreciation method is widely used for its simplicity—evenly distributing the asset's cost across its useful life—alternative approaches may be more fitting in certain circumstances
• Calculating the annual depreciation expense: Using your chosen method, calculate the annual depreciation expense
• Recording depreciation in your financial statements: At the end of each accounting period, you record the total amount of depreciation expenses in your financial statements. It's shown as an expense on the income statement and also reduces the book value of the asset on the balance sheet.

Methods of calculating depreciation expenses

There are a few different methods for calculating depreciation, each tailored to accommodate distinct asset categories. The most common depreciation methods include straight-line depreciation, accelerated depreciation methods, the units-of-production method, and the Section 179 deduction.

Straight-line depreciation method

Straight-line depreciation is the simplest and most commonly used method of calculating depreciation expenses. In straight-line depreciation, the cost of the asset is divided evenly over its estimated useful life. The formula is straightforward:

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(Cost of the asset - Salvage value) / Useful life = Depreciation

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This method assumes the asset will provide equal value each year until it reaches its salvage value or the end of its useful life. Salvage value is the asset’s estimated value at the end of its useful life.

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For example, let’s say your business purchases a truck for $50,000. You estimate its useful life to be 10 years, and its residual value will be around $1,000 when you sell it for scrap. Using the straight-line method, here’s how you’d calculate the truck’s annual depreciation expenses:

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($50,000 - $1,000) / 10 years = $4,900 per year

Accelerated depreciation methods

These methods allow for larger depreciation expenses in the earlier years of the asset's life. The double-declining balance depreciation method and sum-of-the-years' digits (SYD) method both fall into this category.

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The rationale behind accelerated depreciation is that some assets are more productive in their first years or may become obsolete more quickly due to technological advancements. These methods of depreciation can be useful if you want to defer your income tax liabilities, especially if you have low income when you purchase your assets.

Units-of-production depreciation method

The units-of-production method calculates depreciation based on the number of units you can produce with the asset over its useful life. As such, your depreciation expenses for the asset will be greater when production is high to match the equipment’s usage. This is a popular depreciation method for production machinery like printers and CNC machines since it directly correlates value with expected output.

Section 179 deduction

Section 179 of the Internal Revenue Code (IRC) allows businesses to deduct the full purchase price of qualifying assets purchased or financed over the tax year. The Section 179 deduction expedites the depreciation schedule, offering your business immediate tax advantages.

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The IRS requires you to follow specific criteria and limitations to benefit from this deduction. For example, beginning in the 2023 tax year, the maximum Section 179 deduction your business can claim is $1,160,000.

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How to record a depreciation journal entry

When you record a depreciation expense, it involves a debit to the Depreciation Expense account and a corresponding credit to the Accumulated Depreciation account. The Depreciation Expense account appears on your income statement and reduces your company's net income for the period, reflecting the cost of using the asset. Because it reduces your income without affecting your cash balance, it’s considered a non-cash expense.

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On the other side, the credit entry to the Accumulated Depreciation account reflects the total depreciation that has been accumulated on the asset since its acquisition. This account is shown on your balance sheet and offsets the asset's original cost. Over time, as more depreciation accumulates, the book value of the asset (its original cost minus accumulated depreciation) decreases on the balance sheet.

Is it better to depreciate or expense an asset?

In general, it’s usually better to expense smaller, short-lived items and depreciate larger, long-term assets. Expensing an item immediately provides a larger tax deduction in the current year, which can be beneficial for smaller purchases or assets with a short useful life.

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However, for larger, more costly assets you plan to use over several years, depreciation is typically the better approach because it spreads the cost over the asset's useful life, matching the expense with the revenue the asset helps generate.

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Expensing assets immediately can benefit small enterprises or businesses in their developmental phase since it offers more immediate tax deductions. This financial relief can be crucial for improving cash flow.

What is a good depreciation expense ratio?

The depreciation expense ratio plays a crucial role in asset management. To calculate your depreciation expense ratio, divide your company’s yearly depreciation expenses by your total revenue. This metric sheds light on the portion of your company's revenue that you’ve allocated to cover the depreciation of your assets.

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What constitutes a good depreciation expense ratio can vary across different industries and ultimately hinges on your company's unique investment approach. Industries that are heavily reliant on capital, like manufacturing or transportation, typically exhibit a higher ratio, reflecting their substantial investment in assets subject to depreciation.

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A good depreciation expense ratio reflects the efficient use of assets in generating revenue and aligns with your industry standards and financial goals.

Streamline your expense management with Ramp

Depreciation expenses are just one piece of your company’s expense management 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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Ramp’s all-in-one expense management platform tracks all your business spending and automatically categorizes expenses, helping you identify trends and make more informed financial decisions. We integrate with leading account software like QuickBooks, NetSuite, Xero, and Sage Intacct, making budgeting, reporting, and planning easier and more accurate.

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