Depreciation

Depreciation Definition

Depreciation is the systematic allocation of an asset's cost over its useful life. Instead of expensing the full purchase price in year one, depreciation spreads the cost across the years the asset will be used. It appears as an expense on your P&L and accumulates as a contra-asset on your balance sheet, reducing the asset's book value over time.

Depreciation in Practice — Example

Your construction company buys a $30,000 truck with an expected 6-year useful life. Using straight-line depreciation, you expense $5,000 per year ($30,000 ÷ 6 years). Each year: debit Depreciation Expense $5,000, credit Accumulated Depreciation - Vehicles $5,000. After 3 years, your balance sheet shows: Truck $30,000, less Accumulated Depreciation $15,000, net book value $15,000. The truck's original cost is preserved while its declining value is reflected.

Why Depreciation Matters for Your Books

Depreciation matches the cost of an asset to the periods it generates revenue — a fundamental accounting principle called matching. Without depreciation, the year you buy equipment looks artificially unprofitable while subsequent years look artificially profitable. Depreciation smooths this distortion.

It also provides a more accurate picture of your business's financial position. Assets lose value through use and obsolescence. Depreciation reflects this reality on your balance sheet, showing net book values instead of outdated purchase prices.

Depreciation creates significant tax benefits. It's a non-cash expense that reduces taxable income — you get tax savings without spending additional money. Section 179 and bonus depreciation allow many small businesses to accelerate these benefits by deducting full asset costs in year one.

How Depreciation Shows Up in QuickBooks

In QBO, set up fixed assets with cost and useful life information. QBO Advanced includes a Fixed Asset Manager that automatically calculates monthly depreciation. For other plans, use recurring journal entries to record monthly depreciation. The expense appears on the Profit and Loss report, while accumulated depreciation shows on the Balance Sheet as a negative amount under fixed assets, reducing their net value.

Common Mistakes

Not recording depreciation at all. Fixed assets don't depreciate themselves. If you're not recording it, your balance sheet overstates asset values and your P&L understates expenses.

Depreciating land. Land doesn't wear out or become obsolete, so it's not depreciated. Only the buildings or improvements on land are depreciated.

Using the wrong useful life. The IRS publishes guidelines (Modified Accelerated Cost Recovery System) for asset depreciation periods. Using incorrect periods can create tax issues.

FAQ

Q: What's the difference between book and tax depreciation? A: Book depreciation is what appears in your financial statements (often straight-line). Tax depreciation follows IRS rules (often accelerated methods like MACRS) and may differ. Many businesses track both.

Q: Can I change depreciation methods? A: Changing methods requires careful consideration and may need IRS approval. It also affects comparability across periods. Generally, pick a method and stick with it unless there's a compelling reason to change.

Related Terms

Amortization

Book Value

Capital Expenditure

Asset

Contra Account

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