Depreciation
Spreading the cost of a physical asset, such as equipment or a vehicle, over the years it is expected to be used.
In short
- It matches the cost of an asset to the periods that benefit from it.
- Straight-line spreads the cost evenly; declining balance expenses more in the early years.
- For Canadian tax, capital cost allowance (CCA) replaces book depreciation, using rates set by asset class.
Straight-line depreciation per year = (Cost − Residual value) ÷ Useful life in years
Useful life and residual value are estimates. Review them periodically and adjust future depreciation if they change.
Depreciation is the gradual expensing of a tangible long-lived asset. When a business buys a truck, a machine or computers, it records them as assets on the balance sheet. Each period, part of their cost is moved to the income statement as depreciation expense, until the asset reaches its estimated residual value.
Common methods
- Straight-line: the same amount every year. A $50,000 machine with a $5,000 residual value and a nine-year life is depreciated $5,000 a year.
- Declining balance: a fixed percentage of the remaining book value each year, so the expense is highest early on. It suits assets like vehicles and computers that lose value quickly.
- Units of production: based on use, such as machine hours or kilometres.
Depreciation and tax in Canada
Book depreciation is not deductible for income tax. Instead, businesses claim capital cost allowance, with each type of asset assigned to a class and a maximum rate, for example 20% declining balance for most general equipment, 30% for vehicles and 55% for computer hardware. Special first-year rules apply. The tax deduction and the book expense usually differ, which creates deferred tax balances in the financial statements.
Depreciation is a non-cash expense: the cash left when the asset was bought. That is why it is added back when calculating cash flow from operations.
Worked example
A delivery van
A florist buys a van for $48,000, expects to use it for six years and to sell it for $12,000 at the end. Straight-line depreciation is ($48,000 − $12,000) ÷ 6 = $6,000 a year, or $500 a month. After two years, the van's book value is $36,000.