What Is Depreciation on a Balance Sheet?

Depreciation is an accounting technique that allocates the cost of a tangible asset over its useful life. Businesses acquire assets like machinery, vehicles, or buildings that provide economic benefits for many years. Instead of expensing the entire cost in the year of purchase, depreciation systematically spreads this cost across the periods when the asset generates revenue. This aligns expenses with the revenues they help produce and is a fundamental principle in accrual accounting.

Core Concepts of Depreciation

Depreciation systematically reduces the recorded cost of a tangible asset over its useful life. This process recognizes that physical assets, such as equipment or property, gradually lose their ability to contribute to revenue generation as they are used or become obsolete. Unlike a decline in market value, depreciation allocates cost, rather than valuing the asset at its current selling price. Its purpose is to match the expense of using an asset with the revenues it helps create during an accounting period.

Several key terms are essential for understanding depreciation. The “cost basis” is the original amount paid for an asset, including its purchase price and any costs to get it ready for its intended use, such as shipping or installation fees. This initial cost is the starting point for all depreciation calculations. The “useful life” is the estimated period, often expressed in years or units of activity, over which a business expects to benefit from the asset. This estimate considers factors like wear and tear, technological obsolescence, and legal limitations.

“Salvage value” is the estimated residual value of an asset at the end of its useful life. This is the amount a business expects to receive from disposing of the asset. If an asset is expected to have no value, its salvage value is zero. The “depreciable base” is the amount of an asset’s cost that will be depreciated over its useful life. This is calculated by subtracting the salvage value from the cost basis. Only the depreciable base is allocated as an expense.

Methods for Calculating Depreciation

Businesses use various methods to calculate annual depreciation expense, each distributing the asset’s cost differently over its useful life. The choice of method depends on the asset’s nature and how its economic benefits are expected to be consumed.

The straight-line method is the simplest and most common. It allocates an equal amount of depreciation expense to each period over an asset’s useful life. This is calculated by dividing the depreciable base (cost basis minus salvage value) by the asset’s estimated useful life in years. For instance, an asset costing $10,000 with a $1,000 salvage value and a 5-year useful life would incur $1,800 in depreciation expense each year ($9,000 depreciable base / 5 years). This method provides a consistent expense recognition pattern, making it suitable for assets that provide steady economic benefits over time.

The declining balance method is an accelerated depreciation method. It records a higher depreciation expense in earlier years and a lower expense in later years. The double-declining balance method, a common variation, applies twice the straight-line depreciation rate to the asset’s book value each year, without initially subtracting salvage value. For example, if the straight-line rate is 20% (1/5 years), the double-declining rate is 40%. This 40% is applied to the remaining book value each year, stopping when the book value reaches the salvage value. This method is favored for assets that lose significant value or productivity early in their life, such as certain technology or vehicles.

The units of production method ties depreciation directly to an asset’s actual usage or output. This method calculates a depreciation rate per unit of activity, such as per hour of operation or per unit produced. The total depreciable base is divided by the estimated total units the asset will produce over its useful life to determine the per-unit rate. Each year’s depreciation expense is then calculated by multiplying this rate by the actual number of units produced or hours operated during that period. This method is appropriate for assets whose wear and tear relate directly to their activity level, like manufacturing machinery or delivery vehicles.

Presentation on the Balance Sheet

Depreciation impacts the balance sheet through accumulated depreciation, a contra-asset account. This account reduces the value of a related asset account on the balance sheet. It does not represent a pool of cash for asset replacement.

On the balance sheet, long-term assets like property, plant, and equipment are listed at their original cost. Accumulated depreciation for that asset or class of assets is presented immediately below or alongside the original cost. The difference between the asset’s original cost and its accumulated depreciation is its “net book value” or “carrying value.” This is the amount at which the asset is reported.

For example, machinery purchased for $100,000 might have accumulated depreciation of $30,000. On the balance sheet, it would be presented as “Machinery: $100,000” and “Less: Accumulated Depreciation: $30,000,” resulting in a “Net Book Value: $70,000.” This shows the original investment and the portion of its cost allocated as an expense to date.

The impact of accumulated depreciation on asset value is continuous. As a business records depreciation expense, the accumulated depreciation balance grows. This progressively lowers the asset’s net book value. This reduction reflects the ongoing consumption of the asset’s economic benefits and its diminishing capacity to generate future revenues. The net book value decreases until it reaches the asset’s salvage value or until the asset is fully depreciated.