Depreciation expense reflects the gradual loss of value in an asset over time. It’s not just an accounting term—it’s a practical tool for businesses to manage costs and make informed decisions. When a company purchases equipment or machinery, that asset doesn’t last forever. Depreciation helps allocate the asset’s cost over its useful life, matching it with the revenue it helps generate.

Why Do Companies Use Depreciation?

Imagine buying a $500,000 piece of machinery. Without depreciation, the entire amount would show as an expense in the year of purchase, distorting profits and making financial statements less meaningful. Instead, companies spread the cost across the asset’s useful life. This method aligns the expense with the revenue generated during that period, providing a clearer picture of the company’s financial health.

Reporting Depreciation Expense

Depreciation is recorded as an operating expense on the income statement, especially for assets used in production. For example, if a factory machine costs $500,000 and has a five-year useful life with a residual value of $100,000, the company allocates $80,000 per year as depreciation expense.

Common Depreciation Methods

1. Straight-Line Depreciation

The company spreads the asset’s cost evenly over its useful life. It’s simple and widely used.

Formula:

Depreciation Expense=Asset Cost – Residual ValueUseful Life\text{Depreciation Expense} = \frac{\text{Asset Cost – Residual Value}}{\text{Useful Life}}Depreciation Expense=Useful LifeAsset Cost – Residual Value​

Example:

A company buys a building for $50 million, planning to use it for 25 years. Using the straight-line depreciation method, calculate the annual expense by dividing the asset’s cost minus its residual value by its useful life. For example:

$50,000,00025=$2,000,000\frac{\$50,000,000}{25} = \$2,000,00025$50,000,000​=$2,000,000

2. Declining Balance Depreciation

This accelerated method records higher depreciation in the early years of an asset’s life. Companies often use it for assets like vehicles that lose value fast.

Formula:

Depreciation Expense=Beginning Value × Factor ÷ Useful Life\text{Depreciation Expense} = \text{Beginning Value × Factor ÷ Useful Life}Depreciation Expense=Beginning Value × Factor ÷ Useful Life

Example:

The company uses a double-declining factor (2x) for a $100,000 vehicle with a five-year useful life.

• Year 1: $100,000×2÷5=$40,000\$100,000 × 2 ÷ 5 = \$40,000$100,000×2÷5=$40,000
• Year 2: ($100,000−$40,000)×2÷5=$24,000(\$100,000 – \$40,000) × 2 ÷ 5 = \$24,000($100,000−$40,000)×2÷5=$24,00

3. Units-of-Production Depreciation

This method ties depreciation to usage, not time. It’s ideal for machinery or equipment with variable production levels.

Formula:

Unit Depreciation Expense=Asset Cost – Residual ValueTotal Units Expected\text{Unit Depreciation Expense} = \frac{\text{Asset Cost – Residual Value}}{\text{Total Units Expected}}Unit Depreciation Expense=Total Units ExpectedAsset Cost – Residual Value​ Periodic Depreciation Expense=Unit Expense × Units Produced\text{Periodic Depreciation Expense} = \text{Unit Expense × Units Produced}Periodic Depreciation Expense=Unit Expense × Units Produced

Example:

A company owns a $100,000 machine with a $5,000 residual value. If the company plans to produce 95,000 units, it calculates depreciation per unit as follows:

$100,000−$5,00095,000=$1 per unit\frac{\$100,000 – \$5,000}{95,000} = \$1 \text{ per unit}95,000$100,000−$5,000​=$1 per unit

The company calculates the expense based on 10,000 units produced in a year:

10,000×1=$10,00010,000 × 1 = \$10,00010,000×1=$10,000

Accumulated Depreciation vs. Depreciation Expense

The company records depreciation expenses annually and tracks accumulated depreciation as the total amount recorded. It appears on the balance sheet as a contra asset, reducing the asset’s book value.

Choosing the Right Depreciation Method

The choice of method depends on how an asset loses value:

• Consistent Value: Use straight-line depreciation for assets like buildings.
• Rapid Value Loss: Choose a declining balance for vehicles or technology.
• Usage-Based Loss: Use units-of-production for machinery tied to production output.

Each method offers a unique way to reflect the asset’s cost on financial statements accurately.

Practical Examples of Depreciation

Straight-Line Example

A company buys a $480,000 building with a 40-year life and no residual value. Monthly depreciation:

$480,000480 months=$1,000 per month\frac{\$480,000}{480 \text{ months}} = \$1,000 \text{ per month}480 months$480,000​=$1,000 per month

Declining Balance Example

The company uses double-declining to depreciate a $100,000 vehicle over five years:

• Year 1: $100,000×2÷5=$40,000\$100,000 × 2 ÷ 5 = \$40,000$100,000×2÷5=$40,000
• Year 2: ($100,000−$40,000)×2÷5=$24,000(\$100,000 – \$40,000) × 2 ÷ 5 = \$24,000($100,000−$40,000)×2÷5=$24,000

Units-of-Production Example

The company calculates depreciation per unit for a $100,000 machine with a $5,000 residual value and expects it to produce 70,000 units.

$100,000−$5,00070,000=$1.36 per unit\frac{\$100,000 – \$5,000}{70,000} = \$1.36 \text{ per unit}70,000$100,000−$5,000​=$1.36 per unit

Why Depreciation Matters

Depreciation affects more than financial statements. It impacts taxes, cash flow, and profitability. Properly accounting for depreciation ensures businesses can accurately plan budgets and forecast future expenses.

Final Thoughts

Depreciation isn’t just an accounting entry; it’s a way to keep financial records realistic and helpful. Whether managing machinery or planning long-term investments, understanding depreciation methods helps you stay on top of your finances. Always choose the method that best reflects how your assets lose value, keeping your financial reporting clear and consistent.