What is depreciation? Methods, examples, and tax tips

Published Friday 20 March 2026

Table of contents

• What is depreciation?
• Purpose of depreciation: 3 main functions
• What can be depreciated?
• Methods of calculating depreciation
• Choosing a depreciation schedule
• How depreciation works: a practical example
• Depreciation for small business
• How to set up depreciation in your business
• Simplify depreciation with Xero
• FAQs on depreciation

Key takeaways

• Record depreciation as a business expense on your income statement to accurately calculate your true costs and avoid overstating profits, since assets that wear down eventually need replacement.
• Use depreciation deductions to lower your tax bill by writing off the declining value of qualifying fixed assets like equipment, computers, vehicles, and buildings over their useful life.
• Apply the straight-line depreciation method for simplicity by dividing an asset's purchase price by its expected useful life to determine equal annual depreciation amounts.
• Set up your depreciation tracking in accounting software once to automate calculations and ensure depreciation expenses flow directly to your financial reports and tax returns.

What is depreciation?

Depreciation is the gradual loss of value that business assets experience over time. For tax purposes, business owners use Form 4562 to figure their deduction for depreciation. A work computer, for example, depreciates from its purchase price down to $0 as it ages.

Accounting techniques help you measure and record this declining value in your books. Because depreciation can get complex, many business owners work with an accountant or bookkeeper.

Purpose of depreciation: 3 main functions

Depreciation accounting serves three key purposes for your business. It helps you understand your true costs, potentially reduce your tax bill, and accurately estimate your business value.

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 shows how much value your assets lost during the year. That number appears on your income statement and gets subtracted from revenue when calculating profit.

If you don't account for depreciation, you'll underestimate your costs and overstate your profits.

You can download our free income statement template so that you can work out all of your costs.

2. Depreciation and tax

Depreciation can lower your tax bill by letting you claim the declining value of assets as a deduction; for tax years beginning in 2024, the maximum section 179 expense deduction is $1,220,000. You may be able to gradually write off the entire cost of an asset over its useful life.

The IRS has specific rules about how quickly you can depreciate different assets. These include a special depreciation allowance of 60% for certain qualified property you place in service during 2024. Check with your accountant or tax professional to make sure you're following the right schedule.

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 the fixed asset register. Update this register whenever you calculate depreciation.

Assets also affect your ability to get financing. Lenders often use assets as loan security. As they drop in value, they offer less collateral, which can make it harder to secure funding.

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

What can be depreciated?

Not every business expense can be depreciated. While most expenses are tax-deductible, depreciation works differently.

Consumables like stationery get deducted in the year you buy them. Fixed assets are the items you can depreciate over multiple years.

What are fixed assets?

A fixed asset is something that helps you generate income over more than a year. According to the IRS, to be depreciable, an asset must have a useful life that extends substantially beyond the year you place it in service. Common examples include:

• Tools and machinery: Equipment used in production or service delivery
• Computers and office furniture: Items supporting daily operations
• Vehicles: Cars, trucks, and other transportation used for business. For tax purposes, the IRS sets specific limits, such as a maximum 2024 section 179 deduction for sport utility vehicles of $30,500.
• Buildings: Owned structures used for business purposes

You don't always have to own an asset to depreciate it. Some leased items may qualify too.

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

What can't be depreciated:

Some items don't qualify for depreciation.

• Land: Doesn't lose value over time
• Inventory: Handled separately through inventory accounting

Methods of calculating depreciation

Depreciation methods determine how an asset's value declines over its lifespan. Some assets lose value evenly each year while others depreciate faster early on.

Three methods are most common for small businesses:

Straight-line depreciation

Straight-line depreciation spreads the cost evenly across an asset's useful life. The asset loses the same amount of value each year until it reaches zero.

For example, if you expect an asset to last five years, it would depreciate by one-fifth of its purchase price annually. Learn more in our guide on straight-line depreciation.

Diminishing value depreciation

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

This method works well for assets that lose value quickly, like technology or vehicles.

Units of production depreciation

Units of production depreciation measures an asset's lifespan by the work it does rather than time. You depreciate based on actual usage.

For example, you might depreciate a vehicle based on miles driven or a machine based on units produced. This method works well for assets with measurable output.

Choosing a depreciation schedule

A depreciation schedule determines how long you'll depreciate an asset. A computer might last three years while factory equipment could last 30.

Two main sources provide guidance on asset lifespans:

• GAAP (generally accepted accounting principles): Offers standard depreciation guidance for financial reporting
• IRS rules: Specify depreciation schedules for tax purposes

Many businesses keep two schedules: one for tax purposes using IRS rules, and one for their business books. Financial accounting standards require that you treat a change in depreciation method as a change in accounting estimate.

You can adjust an asset's value to zero at any time if someone loses, steals, or damages it. You can also sell, trade, or combine assets into a new asset.

How depreciation works: a practical example

Here's how depreciation works for a common small business purchase using the straight-line method.

Example: Office computer

Here are the details for this example:

• Purchase price: $3,000
• Useful life: five years
• Annual depreciation: $600 ($3,000 ÷ five years)

Year-by-year breakdown:

Here's how the book value changes each year:

• Year 1: Book value drops from $3,000 to $2,400
• Year 2: Book value drops from $2,400 to $1,800
• Year 3: Book value drops from $1,800 to $1,200
• Year 4: Book value drops from $1,200 to $600
• Year 5: Book value drops from $600 to $0

Each year, you'd record $600 as a depreciation expense on your income statement. This reduces your taxable income by $600 annually, potentially lowering your tax bill.

Depreciation for small business

Depreciation doesn't have to be complex for small businesses. It helps you understand your true costs and may lower your tax bill.

Most businesses adopt the IRS depreciation schedule, which simplifies compliance. Once you set up your assets in accounting software, depreciation calculates automatically and flows straight through to your tax return.

An accountant or bookkeeper can help you get started and provide guidance as your business grows.

How to set up depreciation in your business

1. List your depreciable assets. Create an inventory of all qualifying fixed assets your business owns. For each one, record its purchase price and the date you started using it for your business.
2. Determine the useful life. Estimate how long each asset will be productive for your business. You can consult IRS guidelines or consider industry standards for similar equipment.
3. Choose a depreciation method. Decide which calculation method fits your assets and business needs. The straight-line method is the most common choice for its simplicity.
4. Set up your records. Use accounting software to enter your asset details, select your depreciation method, and let the system handle the calculations for you.
5. Review and update regularly. Check your depreciation records each quarter to keep them current. Remember to add new assets and remove any that have been sold or retired.

Simplify depreciation with Xero

Depreciation helps you understand your true costs, potentially lower your taxes, and accurately value your business. With the right tools, tracking it doesn't have to be complicated.

With Xero's accounting software, your depreciation calculations happen automatically. Set up your assets once, and your depreciation expenses flow directly to your financial reports and tax returns. You can focus on running your business instead of managing spreadsheets.

Get one month free and see how Xero simplifies your financial management.

FAQs on depreciation

Here are answers to a few common questions small business owners have about depreciation.

Is depreciation good or bad?

Depreciation is simply an essential part of accounting. It benefits your business by giving you a clearer picture of your long-term expenses. It also helps you calculate your business's true net income.

What is depreciation on a car?

Car depreciation is the rate at which your vehicle loses value over time. If you use your car for business, you can often deduct this loss in value as a depreciation expense, which can help lower your taxable income.

How is depreciation calculated?

The most common way is the straight-line method, where you divide the asset's cost by its useful life in years. Other methods include diminishing value and units of production, which you use for assets that lose value more quickly or based on usage.