Why depreciation exists.
When a business buys a long-lived asset (truck, computer, machinery, building improvement), the asset will generate value over many years. The matching principle in accounting says you should match expenses against the revenue they help produce. If a USD 80,000 truck will haul freight for 8 years, expensing the full 80,000 in year one and zero in years 2-8 distorts every year. Depreciation spreads the cost: USD 10,000 per year for 8 years, matching the truck contribution to revenue each year.
Depreciation is a non-cash expense. The cash already left the business when you bought the truck. The depreciation entry each year reduces book profit and reduces the asset book value, but no cash moves. This matters for cash flow analysis: net income on the P&L includes depreciation, but cash from operations adds depreciation back. The truck is a Day-1 cash outflow that becomes an 8-year expense recognition.
Straight-line depreciation, the default.
Straight-line spreads the cost evenly over the useful life. Formula: (cost - salvage value) / useful life. A Toronto delivery company buys a Sprinter van for CAD 72,000 with a useful life of 6 years and an estimated salvage value of CAD 12,000. Annual depreciation = (72,000 - 12,000) / 6 = CAD 10,000 per year. Monthly = 833.33. The van starts at 72,000 book value and depreciates 833.33 each month until it reaches 12,000 at month 72.
The journal entry each month: DR Depreciation Expense 833.33 / CR Accumulated Depreciation 833.33. Accumulated depreciation is a contra-asset that sits on the balance sheet against the asset cost. After 24 months, the van shows on the balance sheet as: Vehicles 72,000 less Accumulated Depreciation 20,000 = Net Book Value 52,000. Straight-line is the simplest method and works for most assets where wear is roughly even over time.
Declining balance: front-loaded depreciation.
Declining balance applies a fixed percentage to the remaining book value each year, producing higher depreciation in early years. The most common variant is double-declining balance: rate = 2 / useful life years. For the same van (6 years), rate = 2/6 = 33.3 percent per year. Year 1: 72,000 * 33.3% = CAD 24,000. Book value end of year 1: 48,000. Year 2: 48,000 * 33.3% = 16,000. Book value end of year 2: 32,000. And so on, never going below salvage value.
Declining balance reflects assets that lose value fast in early years (cars, computers, phones). It also defers tax. Most US and Canadian businesses use MACRS (US) or CCA (Canada) which are declining-balance variants for tax purposes. The book financials can use straight-line for management reporting; the tax return uses MACRS or CCA. The two depreciation tracks (book vs tax) create a deferred tax liability on the balance sheet that reverses over the asset life.
Units-of-production: for usage-based wear.
Some assets wear out based on usage, not time. A printing press rated for 10 million pages over its life should depreciate based on pages printed, not years elapsed. Formula: (cost - salvage) / total expected units * units in this period. A printing press costs USD 120,000, salvage USD 20,000, total expected pages 10 million. Cost per page = (120,000 - 20,000) / 10,000,000 = USD 0.01. If the press prints 800,000 pages in 2026, depreciation for the year is 800,000 * 0.01 = USD 8,000.
Units-of-production matches expense to actual use. In a year of heavy production, depreciation is high. In a slow year, depreciation is low. This produces a more accurate gross margin because the cost of the asset is matched to the output it produced. The downside is that you must track units consumed each period, which requires meter readings, hour counters, or production logs. Most businesses use straight-line for simplicity unless usage is genuinely variable.
- Straight-line: even spread over useful life. Default for most assets.
- Declining balance: front-loaded. Cars, computers, electronics.
- Units-of-production: usage-based. Machinery, presses, equipment.
- Sum-of-years-digits: another front-loaded method. Less common.
Useful life and salvage value: where judgment lives.
Useful life is your estimate of how long the asset will produce value. Tax authorities publish default useful lives by asset category (US IRS Publication 946, UK HMRC CA21100). A computer is typically 3-5 years. A vehicle 5-7 years. Office furniture 5-10 years. Buildings 25-50 years. You can use shorter useful lives if you can justify them, but auditors and tax authorities push back on aggressively short lives that accelerate depreciation.
Salvage value is the estimated value at the end of the useful life. For most assets, this is zero or a small percentage of original cost. A vehicle worth USD 80,000 new might have USD 15,000 salvage after 7 years (auction value). Some assets have meaningful salvage (real estate improvements). Most do not. Setting salvage too low overstates depreciation; too high understates it. Pick a reasonable number, document the basis, and stick with it.
Tax treatment by jurisdiction.
United States: MACRS (Modified Accelerated Cost Recovery System) for most assets, plus Section 179 bonus depreciation that can immediately expense up to USD 1.16 million of qualifying property in year one. UK: capital allowances under the Annual Investment Allowance (AIA) up to GBP 1 million immediate write-off, then writing-down allowance at 18 percent or 6 percent per year. Pakistan: depreciation rates under the Third Schedule of the Income Tax Ordinance, ranging from 10 percent (buildings) to 30 percent (computers) declining balance, with first-year bonus depreciation for specific sectors.
The book vs tax difference is a permanent feature of the financial statements. Track both in your accounting system. Use book depreciation (your chosen method) for management reporting and statutory financials. Use tax depreciation (MACRS, AIA, or Pakistan Third Schedule) for the annual tax return. The deferred tax balance on the balance sheet reconciles the two over time. Nonari maintains both schedules per asset automatically.
The fixed asset register: not optional.
Every business with assets over a small threshold must maintain a fixed asset register listing each asset: description, date acquired, cost, useful life, depreciation method, accumulated depreciation, current book value. The register must reconcile to the balance sheet fixed asset accounts at every period end. Without the register, you cannot prove depreciation calculations, you cannot identify disposed or stolen assets, and you fail any tax audit on capital allowances.
For a small business with 20-50 assets, a spreadsheet is barely enough. For a multi-branch operation with hundreds of items across locations, you need software-managed asset tracking with QR codes or barcodes. Nonari tracks fixed assets per branch, runs depreciation monthly, posts the journal entries automatically, and flags assets that have not been physically verified in over 12 months. The register reconciles to the balance sheet by construction.