What is depreciation and why it matters for your business
When you buy equipment, vehicles, or tools for your business, they don’t hold their value forever. Over time, these assets wear out, become outdated, or lose value — and that’s where depreciation comes in.
Depreciation is an accounting method that spreads the cost of a business asset over its useful life. Rather than claiming the full amount as an expense in the year you buy it, you deduct a portion each year to reflect how the asset is used.
It’s not just a tax tool, depreciation helps give a more accurate picture of your profits, supports better cash flow planning, and prepares you for future upgrades. In this article, we’ll break down what depreciation is, why it matters, and how to make the most of it in your business.
What is depreciation in simple words?
Depreciation is how we show that something you buy for your business — like tools, machinery or vehicles — loses value over time. Instead of claiming the full cost in one go as a tax deduction, you claim a bit each year to reflect the wear and tear as you use it. It’s a way to spread the cost of an asset over its useful life. Essentially it's recognising the wear and tear that naturally happens to tools, machinery, and vehicles as these business assets age. Depreciable assets are generally classed as either fixed assets or capital assets.
What is depreciation in accounting used for?
1. Tax benefits
You can claim depreciation as a tax deduction. That means lower taxable income and a lower tax bill. In businesses where equipment and vehicles are essential, this can add up to significant savings.
2. Accurate financial reporting
Depreciation ensures your profit and loss statement reflects the real cost of using fixed assets over time. Without it, your books may look overly profitable in the year you buy the asset, and inaccurate in the years that follow.
Let’s say you buy a $50,000 excavator. If you claimed the full $50,000 as an expense in the year you bought it, your profits for that year would look a lot lower than they really are (profit = revenue - expenses. The $50,000 excavator would be counted as an expense, reducing profit by the full amount). But the excavator is going to be used for several years, not just one.
By spreading the cost over its useful life through depreciation, you’re matching the expense to the years you're actually using the equipment. That way, each year shows a fair picture of your business’s true operating costs and profit. Without depreciation, your financial reports could be misleading — too low in the year you buy an asset, and too high in the years after. This has a flow on effect for cash flow; your income tax liability would be much lower in the first year, and then significantly higher in the following years where you're using the same piece of equipment (if all other variables remain stable).
3. Better budgeting and planning
Knowing how long your equipment will last (and how its value is dropping over time) can help you plan ahead. Depreciation gives you a clearer picture of when key assets like vehicles, machinery, or tools are nearing the end of their useful life. This helps you avoid surprises and budget for replacements before things break down or become unreliable.
A depreciation schedule acts like a roadmap, showing how much value each asset is losing each year. It’s a useful tool for planning future upgrades, managing cash flow, and making sure your business isn’t caught off guard by big expenses down the track.
How depreciation works
There are three main methods for calculating depreciation in Australia:
1. Diminishing value depreciation method
You claim a larger deduction in the earlier years of the asset’s life with this depreciation method. This is popular for items that lose value quickly, like vehicles or tools.
Australian Taxation Office (ATO) formula:
Depreciation = Base value × (days held ÷ 365) × (200% ÷ asset’s effective life)
Example:
You buy a work vehicle for a purchase price of $40,000, and it has an effective life of 8 years.
Using the formula:
$40,000 × (365 ÷ 365) × (200% ÷ 8)
= $40,000 × 1 × 0.25
= $10,000 depreciation in the first year.
In the second year, the base value becomes the adjustable value (original cost minus depreciation claimed).
So:
New base value = $40,000 – $10,000 = $30,000
(the $30,000 represents the depreciated value).
Year 2 depreciation:
$30,000 × 1 × 0.25 = $7,500
Each year, the base value gets smaller, and so does the depreciation amount, reflecting how the asset loses value more quickly at the start of its life.
2. Prime cost method (straight line depreciation)
You claim the same deduction each year over the asset’s expected useful life. Good for predictable, long-term business assets like office fittings or buildings.
ATO formula:
Depreciation = Asset cost × (days held ÷ 365) × (100% ÷ asset’s effective life)
Example:
You buy an office fit-out for $20,000, and it has an effective life of 10 years.
Using the formula:
$20,000 × (365 ÷ 365) × (100% ÷ 10)
= $20,000 × 1 × 0.10
= $2,000 annual depreciation expense.
Unlike the diminishing value method, this stays consistent, so you know exactly what your asset depreciation expense will be each year for budgeting and reporting.
3. Units of production depreciation method
This method links depreciation to how much the asset is actually used. Instead of basing depreciation on time, it’s based on output, like the number of hours a machine runs, or the number of jobs completed.
For example, if you have a machine that’s expected to produce 100,000 units over its lifetime, and it produces 10,000 units this year, you’d depreciate 10% of its cost this year.
This approach can make a lot of sense where equipment wear and tear is closely tied to usage rather than just age. It can give you a more accurate view of an asset’s value and align better with how your business operates day to day.
Working with a trusted business accountant ensures you choose the right method and rate for your depreciating assets based on ATO guidelines.
What about residual value?
Residual value (or salvage value) is the estimated amount an asset will be worth at the end of its useful life; what you might sell it for or trade it in.
While the tax office ignores residual value when calculating depreciation for tax purposes, it’s still worth considering in your internal reports. If you plan to sell or upgrade an asset, knowing its estimated end value helps you better manage cash flow and set aside the right amount for future purchases.
Simplified depreciation for small business
If your business has a turnover under $10 million, you may be eligible for the ATO’s simplified depreciation rules. These are designed to make things easier and help you claim deductions sooner.
- Instant Asset Write-Off: You can immediately deduct the full cost of eligible assets under a certain threshold (currently $20,000). Great for tools, equipment, and vehicles.
- Small Business Pool: Assets over the threshold go into a pool and are depreciated at:
- 15% in the year you buy them
- 30% each year after
This approach can reduce admin and improve cash flow by front-loading deductions when the cost hits hardest.
Temporary full expensing and instant asset write-off
In recent years, the government introduced measures like temporary full expensing and the instant asset write-off. These let eligible businesses claim the full cost of certain tangible assets upfront instead of depreciating them over time. These rules have offered a big tax advantage to businesses that invest in equipment.
Always check the current thresholds and eligibility with your accountant before relying on these rules.
A note on asset registers
It’s good practice to keep an up-to-date asset register. This is a list of your business’s assets, their purchase dates, costs, depreciation to date, and remaining book value. It helps track what your business owns and how much it’s really worth.
We're here to help you make the most of depreciation
Depreciation isn’t just an accounting rule, it’s a powerful tool that impacts your bottom line, tax bill, and business planning. If you’re buying or upgrading equipment, talk to your accountant to make sure you’re getting the most out of it.
Want help reviewing your current asset depreciation strategy or preparing for tax time? Get in touch.
