Think you’re getting the most out of your business assets?
If you’re not using depreciation, you could be leaving money on the table—and the tax office certainly won’t send it back!
Depreciation is a powerful tool that reduces your business’s taxable income and boosts its bottom line.
What is depreciation, and how can it help you save on taxes?
Key Takeaway BoxWhat is depreciation? Depreciation is the gradual decrease in the value of your business assets over time. You can claim a portion of that decline as a tax deduction each year, lowering your taxable income and reducing the tax you pay. What is the depreciation rate? The depreciation rate is the percentage used to calculate how much of an asset’s cost can be deducted each year based on its useful life, reflecting how quickly an asset loses value over time. |
Depreciation Explained
When you buy a business asset, you can gradually deduct a portion of its cost from your taxable income each year over its expected useful life.
This depreciation reduces your taxable income, meaning you pay less tax and keep more money in your business.
Any tangible asset that helps you run your business for an extended period can depreciate in value.
- Company cars, trucks, and delivery vans
- Tools, machinery, and manufacturing equipment
- Computers, laptops, and printers
- Office desks, chairs, and shelving units
Depreciation Methods
Straight-Line Depreciation
Straight-line depreciation is the easiest and most commonly used depreciation method.
It provides a consistent annual deduction, making it easy to plan for your taxes.
The asset’s cost is spread evenly across its useful life, so you deduct the same amount as depreciation each year.
The straight-line depreciation formula is:
(Asset Cost – Residual Value) / Useful Life = Annual Depreciation Expense
- Asset Cost: What you paid for the asset.
- Residual Value: The asset’s estimated value at the end of its useful life.
- Useful Life: How long you expect to use the asset before it needs replacement.
Example: Your business buys a computer for $2,000. You estimate it will be useful for four years and expect it to be worth $200 by the end of that time.
($2,000 – $200) / 4 = $450. You can claim $450 as a depreciation deduction each year for four years.
Diminishing Value Depreciation
Diminishing value depreciation lets you claim higher depreciation deductions in the early years of an asset’s life.
You apply a fixed depreciation rate (set by the ATO) to the remaining book value (the asset’s value after previous depreciation) each year.
The depreciation amount decreases each year as the remaining book value decreases.
This depreciation method is ideal for assets that depreciate quickly or have higher initial usage.
Claiming larger deductions in the early years of an asset’s life reduces your taxable income quicker and helps improve cash flow.
The diminishing value depreciation formula is:
Remaining Book Value × Depreciation Rate = Annual Depreciation Expense
Example: You buy equipment for $10,000 with a depreciation rate of 30%.
| Year | Remaining Book Value | Annual Depreciation Expense (30%) |
| 1 | $10,000 | $3,000 |
| 2 | $7,000 | $2,100 |
| 3 | $4,900 | $1,470 |
In this example, depreciation could continue for 10-12 years, depending on your policy for writing off low-value assets.
Units of Production Depreciation
The units of production depreciation method calculates depreciation based on how much an asset is used rather than the passage of time.
This approach works best for frequently used assets, such as machinery that produces goods or vehicles driven over long distances.
In years when the asset is used heavily, depreciation expenses are higher. Conversely, when usage is lower, the deduction decreases.
The depreciation aligns closely with how much the asset contributes to your business.
The formula for calculating depreciation using this method is:
(Asset Cost – Residual Value) / Total Estimated Units Produced × Units Produced in the Year = Annual Depreciation Expense
Units Produced: Actual units produced, hours operated, or kilometres driven.
Example: A machine costs $50,000 and has a residual value of $5,000, with an estimated output of 100,000 units over its life.
($50,000 – $5,000) / 100,000 units = $0.45 per unit.
If the machine produces 20,000 units in the first year, the depreciation for that year is:
20,000 units × $0.45 per unit = $9,000.
Calculating Depreciation
Regardless of the depreciation method, you must understand the following three factors to accurately calculate depreciation for your business assets.
1. An Asset’s Effective Life
An asset’s effective (or useful) life is the period over which it’s expected to generate value for your business.
The ATO provides guidelines on the effective life of various assets based on research and industry standards.
Using these guidelines is straightforward and guarantees compliance and consistency.
Alternatively, you can self-assess the effective life of your assets based on how you plan to use them in your business.
This method is suitable if an asset will experience more or less wear and tear than the ATO’s standard estimate.
It’s flexible but requires you to justify your assessment.
2. Depreciation Rates
Depreciation rates are calculated based on an asset’s useful life and the depreciation method you use.
- Straight-line: A fixed annual deduction.
- Diminishing value: A fixed percentage applied to the remaining book value each year.
- Units of production: Determined by the asset’s actual usage.
3. Residual Value
The residual (or salvage) value is the estimated amount you expect to receive when you dispose of the asset at the end of its useful life.
Example: If you think a piece of equipment you bought for $10,000 will be worth $1,000 after five years, the residual value is $1,000.
Instead of depreciating the asset’s full purchase price, you only depreciate the difference between its cost and residual value.
This prevents you from depreciating more than the asset’s expected loss in value.
Depreciation vs. Amortisation
Depreciation and amortisation both let you gradually deduct the cost of an asset from your taxable income over its useful life.
How do these tax deduction methods differ?
Depreciation is used for tangible business assets that wear out over time, like vehicles, machinery, and office equipment, while amortisation applies to intangible business assets, such as patents, trademarks, and software licenses.
One key difference is that depreciation often considers a residual value, the estimated amount you can recover when the asset is no longer useful.
Amortisation typically assumes the intangible asset will have no residual value at the end of its useful life.
Depreciation and Your Business Taxes
If your business relies on expensive assets, depreciation will lower your taxable income each year, minimising your tax liability and improving cash flow.
Spreading out an asset’s deduction reflects how it loses value over time. By reflecting the true value of assets on your balance sheet, you’ll have a clearer picture of your business’s financial health.
This picture will help you make informed decisions and potentially secure loans or investments.
To make the most of depreciation benefits, keep detailed records of asset purchases, depreciation methods, and annual depreciation calculations.
Accurate records ensure you claim the correct deductions, comply with tax requirements, and have reliable financial information for planning and reporting.
For more complex situations, it’s best to consult a tax accountant.
They can navigate depreciation rules and maximise your deductions.
Understand Depreciation Like A Pro with Pherrus
What is depreciation?
It’s a way to turn the gradual decline of your business assets into gradual savings on your taxes.
But understanding depreciation—and making it work for your business—isn’t always straightforward.
Let Pherrus’ accountants unlock every tax-saving opportunity and keep more money where it belongs: in your business!
For expert business taxation planning and compliance services, contact us today by filling out this online form or calling (02) 9099 9109 to book an appointment at our Bella Vista office in Sydney, NSW.
FAQs About “What Is Depreciation?”
What Is the Main Purpose of Depreciation?
Depreciation spreads the cost of tangible assets over their useful lives, helping match expenses to the income those assets generate.
What Is the Simple Explanation of a Depreciation Expense?
A depreciation expense is the portion of an asset’s cost you deduct annually to account for its use and wear over time.
Why Is Depreciation Necessary?
Depreciation ensures that financial statements accurately reflect asset values and expenses.
This practice provides a realistic view of a company’s financial health and offers tax benefits by allowing deductions for asset wear and tear.
