How Depreciation Works: Straight-Line, Declining Balance, and Why It Matters
Buying a machine is not an expense — it is an investment. Depreciation is how you account for that investment wearing out over time, and it has real tax consequences.
Depreciation is one of those accounting concepts that sounds intimidating but is actually just a way of answering a simple question: how much of this asset did I use up this year?
When your business buys a piece of equipment, a vehicle, or a machine, that cost does not disappear on day one. The asset will help generate revenue for several years. Depreciation matches that cost to the periods that benefit from it — giving you a truer picture of profit and a legitimate tax deduction along the way.
Why depreciation matters
There are two practical reasons to care about depreciation.
Tax deductions. Most tax authorities allow businesses to deduct the depreciation of qualifying assets each year. Instead of deducting the full purchase price in year one (unless a special immediate-expensing rule applies), you spread the deduction across the asset's useful life. This reduces taxable income every year the asset is in service.
Accurate profit reporting. If you ran a bakery and expensed a commercial oven in full the month you bought it, that month would look terrible and every subsequent month would look artificially profitable. Spreading the cost gives a more honest read of how the business is performing.
The straight-line method
Straight-line is the simplest approach. You divide the depreciable cost equally across the asset's useful life.
Formula:
Annual depreciation = (Cost − Salvage value) ÷ Useful life in years
Worked example:
You buy a piece of machinery for 10,000, expect it to last 5 years, and estimate a salvage value of 0.
Annual depreciation = (10,000 − 0) ÷ 5 = 2,000 per year
| Year | Opening book value | Depreciation | Closing book value |
|---|---|---|---|
| 1 | 10,000 | 2,000 | 8,000 |
| 2 | 8,000 | 2,000 | 6,000 |
| 3 | 6,000 | 2,000 | 4,000 |
| 4 | 4,000 | 2,000 | 2,000 |
| 5 | 2,000 | 2,000 | 0 |
The deduction is identical every year — predictable, easy to plan around, and easy to audit.
Use the depreciation calculator to run these numbers instantly for any asset.
The declining-balance method (double-declining)
Declining balance accelerates depreciation — you write off more in the early years when the asset is newest and loses value fastest (think of a car losing the most value the moment you drive it off the lot).
The double-declining balance (DDB) rate is simply twice the straight-line rate.
Formula:
DDB rate = (1 ÷ Useful life) × 2 Annual depreciation = Opening book value × DDB rate
Using the same 10,000 machine over 5 years:
DDB rate = (1 ÷ 5) × 2 = 40%
| Year | Opening book value | Depreciation (40%) | Closing book value |
|---|---|---|---|
| 1 | 10,000 | 4,000 | 6,000 |
| 2 | 6,000 | 2,400 | 3,600 |
| 3 | 3,600 | 1,440 | 2,160 |
| 4 | 2,160 | 864 | 1,296 |
| 5 | 1,296 | 1,296* | 0 |
In the final year, most accountants switch to straight-line to fully depreciate the remaining book value down to salvage value.
Notice that DDB gives you a 4,000 deduction in year 1 versus 2,000 under straight-line. That earlier deduction has real value — money you do not pay in tax today is money you keep earning interest on.
Units-of-production method
A third approach ties depreciation to actual usage rather than time. If you buy a machine rated for 100,000 units of output, you depreciate it proportionally to how many units you actually produce each year. This is ideal for manufacturing businesses where equipment use varies dramatically season to season.
Which method should you use?
| Situation | Recommended method |
|---|---|
| Predictable, even usage | Straight-line |
| Asset loses value quickly early on | Declining balance / DDB |
| Usage varies year to year | Units of production |
| You want maximum early tax relief | Double-declining balance |
There is often a tax-law dimension too — some jurisdictions prescribe specific methods or useful lives for categories of assets. Check with an accountant or use your tax authority's published asset-life tables.
Impact on financial statements
Depreciation shows up in two places on your financials:
- Income statement: as an operating expense, reducing gross profit and taxable income.
- Balance sheet: as accumulated depreciation, which reduces the asset's carrying (book) value.
Getting depreciation right feeds directly into your break-even analysis. If you are wondering how asset costs affect the point at which your business covers all expenses, the break-even calculator is a natural next step — and our guide what is break-even explains the concept from scratch.
Key takeaways
- Depreciation spreads an asset's cost across its useful life, matching the expense to the periods that benefit from it.
- Straight-line gives equal annual deductions; double-declining balance front-loads them for greater early tax relief.
- Depreciation is a non-cash expense — it reduces taxable profit without any additional money leaving your business.
These examples are for illustration. Tax treatment and accounting rules vary by jurisdiction — consult an accountant for advice specific to your business.
Frequently asked questions
Does depreciation affect cash flow?+
No — depreciation is a non-cash expense. The cash left when you bought the asset. Depreciation simply spreads that cost across accounting periods, reducing reported profit (and therefore tax) without any further cash leaving your account.
Can I depreciate land?+
No. Land is not depreciated because it does not wear out or become obsolete. Only the building or improvements on the land can be depreciated.
What is salvage value?+
Salvage value (also called residual value) is the estimated worth of an asset at the end of its useful life. You subtract it from the purchase cost before calculating depreciation, since you are only writing off the portion of value the asset actually loses.
Which depreciation method is best for taxes?+
Accelerated methods like declining balance produce larger deductions in early years, which reduces taxable income sooner — a real cash-flow benefit. However, tax rules in your jurisdiction may dictate which methods are allowed. Always confirm with an accountant.
What happens if I sell an asset before it is fully depreciated?+
You compare the sale price to the asset's book value (cost minus accumulated depreciation). If you sell for more than the book value, you may owe tax on the gain. If you sell for less, you may be able to claim a loss. Tax treatment varies by jurisdiction.
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Keep reading
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- Markup vs Margin: The Difference Every Seller Should Know
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- How to Start Investing With Little Money
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Elena writes about taxes and the money side of running a small business. She’s on a mission to make VAT, margins, and break-even points feel a lot less scary.