Depreciation is the process of spreading the cost of a long-lived tangible asset, such as a machine, vehicle or building, over the years in which it is used. Each year part of the cost is charged as an expense in the income statement, and the asset's carrying amount on the balance sheet falls by the same amount. The charge reflects wear and tear, ageing and the fact that newer technology makes older equipment less valuable.
Depreciation applies to physical assets; the equivalent for an intangible asset such as a licence is amortization, and for natural resources it is depletion. The word has two other uses that should not be confused with the accounting one. In national accounts, economists record the using-up of a country's capital stock as consumption of fixed capital. In foreign exchange, a currency depreciates when it loses value against other currencies in the market, which differs from a deliberate devaluation under a fixed regime.
Depreciation in plain terms
A delivery company buys a van it expects to use for five years. Counting the full price as a cost in the first year would make that year look terrible and the next four look unrealistically good, even though the van was working hard the whole time. Depreciation spreads the cost evenly, a slice each year, so profits reflect how much of the van was actually used up.
It is a bit like paying for a season ticket. The money leaves the bank account on day one, but it makes sense to think of each match as costing a share of it. Depreciation does not move any cash; it is an accounting way of matching costs with the years that benefit.
Methods and worked examples
The most common method is straight-line depreciation:
- is the depreciation charge per year.
- is the asset's cost, including delivery and installation.
- is the expected residual (salvage) value at the end of its life.
- is the useful life in years.
Worked example: a machine costs $60,000, is expected to be sold for $10,000 after five years, and is depreciated straight-line. The annual charge is dollars. After two years its book value is dollars.
Accelerated methods charge more in the early years, when assets often lose value fastest. Under the declining-balance method a fixed rate is applied to the remaining book value. With a 40% rate, the same machine would be charged $24,000 in year one (40% of $60,000) and $14,400 in year two (40% of $36,000). The units-of-production method links the charge to actual use, such as hours run or miles driven. Under IAS 16 and US GAAP, a company should choose the method that best reflects how the asset's benefits are consumed and review useful lives regularly. Land is normally not depreciated.
Depreciation, profit and tax
Because depreciation is a non-cash expense, it reduces reported profit without reducing cash in that year, which is why analysts add it back when estimating cash flow and why EBITDA excludes it. Heavy depreciation can therefore make a capital-intensive company look less profitable than its cash generation suggests, while unusually long assumed lives can flatter earnings.
Tax systems have their own rules. In the United States, the Modified Accelerated Cost Recovery System (MACRS) sets recovery periods by asset class, and the One Big Beautiful Bill Act of 2025 made 100% bonus depreciation permanent for qualifying property acquired after 19 January 2025, letting businesses deduct the full cost in the first year. The United Kingdom ignores accounting depreciation for tax and gives capital allowances instead, with full expensing for companies' main-rate plant and machinery made permanent in November 2023. Faster tax write-offs lower the effective cost of investment and are used as a policy tool to encourage spending on capital goods, though critics question how much extra investment they produce and how much revenue they cost.
Depreciation in national accounts
Economists measure the wear and obsolescence of a whole economy's buildings, machinery, software and infrastructure as consumption of fixed capital. Subtracting it from gross domestic product gives net domestic product, and subtracting it from gross national income gives net national income. Gross investment, recorded as gross fixed capital formation, must exceed this amount for the capital stock to grow. Because software and computers become obsolete quickly, a shift toward these assets raises measured depreciation, which is one reason some economists prefer net measures when judging living standards.
Currency depreciation
A currency depreciates when its exchange rate falls in the market, so each unit buys less foreign currency. Under a floating exchange rate this happens through supply and demand, often after interest rate cuts, higher inflation, a widening current account deficit or capital flight. Depreciation makes exports cheaper and imports dearer, which may improve the trade balance after a delay described by the J-curve, but it also raises import prices and the burden of foreign currency debt.