Annual Depreciation Formula and Examples

When your business purchases equipment, vehicles, or software, these assets tend to lose value over time. Depreciation is the method used to record the decrease in value of an asset each year, helping you accurately reflect the cost of using those assets to generate income. Understanding your annual depreciation formula ensures you’re not under- or over-deducting expenses and that your financial records stay compliant and reliable.

Use this blog to understand your annual depreciation formula along with real-world examples. 

Key Highlights

• Annual depreciation spreads the cost of a business asset over its useful life.

• The straight-line depreciation formula is the simplest and most common method.

• Proper calculation helps reduce taxable income and maintain accurate financial statements.

• Forgetting salvage value or using unrealistic useful lives are common mistakes in depreciation.

• Maintaining a depreciation schedule helps with audits, budgeting, and tax planning.

• Professional small business bookkeeping services can help automate and manage depreciation tracking.

What Is Annual Depreciation?

Annual depreciation is the process of allocating the cost of a tangible asset, like machinery, vehicles, or computers, over its expected useful life. Instead of expensing the full cost in the year of purchase, you spread it out evenly (or in another pattern, depending on the method) to reflect gradual wear and tear.

This process impacts:

• Profit and loss statements, by reducing net income each year.

• Tax deductions, since depreciation is a deductible expense.

• Cash flow planning as it affects taxable income, but not cash outflows.

• Book value tracking, ensuring accurate asset valuation over time.

There are multiple methods of depreciation, but here we’ll focus on calculating the annual figure.

Key Terms You Need to Know

Cost (or Purchase Price) of the Asset

The cost includes not only the purchase price but also the expenses necessary to prepare the asset for use, such as delivery, installation, and setup fees. Always use the correct cost basis when calculating depreciation.

Salvage Value (Residual Value)

The salvage value is the estimated worth of an asset at the end of its useful life. Subtracting this from the total cost ensures you’re not depreciating more than the asset’s true expense.

Useful Life

Useful life refers to the period during which your business expects to utilize the asset. For tax purposes, the government provides standard “class lives” for different types of property in IRS Publication 946.

Depreciable Base

The depreciable base equals the cost minus salvage value. This is the total amount that will be expensed over the asset’s life.

Annual Depreciation Expense

This is the amount you record each year to represent the asset’s decline in value. In the straight line method, this amount remains consistent annually. 

The Straight-Line Method: Annual Depreciation Formula

The Formula

The straight-line depreciation formula is:

Annual Depreciation Expense = (Cost of Asset – Salvage Value) ÷ Useful Life

This method divides the depreciable base evenly across each year. It’s the simplest and most common way to compute annual depreciation.

Step-by-Step Calculation

1. Determine the cost of the asset, including any setup costs.

2. Estimate the salvage value based on resale or scrap estimates.

3. Define the useful life based on the expected years of use or guidance from the IRS.

4. Subtract salvage value from cost, then divide by useful life.

The depreciation expense calculation will yield your annual expense for the books. Businesses use this calculation method because it’s simple and common.

Example for Service Business

Learn how to calculate depreciation expense with this annual depreciation example for small businesses. A tree service company buys a wood chipper for $40,000. They estimate a salvage value of $5,000 and a useful life of 8 years.

Annual Depreciation = ($40,000 – $5,000) ÷ 8 = $4,375

Each year, the business records a depreciation expense of $4,375 until the asset’s book value equals its salvage value.

Journal Entry and Financial Statement Impact

Depreciation is a non-cash expense, which is particularly helpful for cash-flow-aware business owners.

• Journal Entry:

  • Debit: Depreciation Expense – $4,375

  • Credit: Accumulated Depreciation – $4,375

• Impact:

  • On the Income Statement, net income decreases by $4,375.

  • On the Balance Sheet, the asset’s book value declines over time.

  • Depreciation is a non-cash expense, meaning it does not directly affect cash flow but does reduce taxable income.

Other Methods of Calculating Annual Depreciation (and When to Use Them)

Double-Declining Balance (DDB)

DDB is an accelerated depreciation method that records higher expenses in early years and lower amounts later on.

Formula: Depreciation = 2 × Straight-Line Rate × Book Value at Beginning of Year.

This method suits assets like vehicles or tech equipment that lose value quickly.

Units-of-Production Method

This depreciation method is based on asset usage rather than time.

Formula: (Cost – Salvage) ÷ Total Estimated Units × Units Used.

Suitable for machinery with fluctuating usage, such as a delivery truck or a manufacturing press.

Sum-of-the-Years’ Digits (SYD)

Another accelerated approach, SYD, emphasizes faster expense recognition upfront. It benefits tax strategy but adds complexity.

Which Method Should My Small Business Use?

For simplicity and consistency, many small businesses prefer straight-line depreciation. However, if your goal is tax optimization or aligning expenses with usage, consider alternative options. IRS rules may guide your choice.

Consulting with your dedicated 1-800Accountant tax advisor ensures compliance and maximized deductions.

Common Mistakes and How to Avoid Them

Review these common mistakes small business owners make with depreciation and how to avoid them. 

1. Forgetting to subtract salvage value.

2. Choosing unrealistic useful lives.

3. Mixing depreciation methods without documentation.

4. Failing to align with IRS depreciation conventions (like half-year rules).

Prevention Tips:

• Keep an up-to-date fixed asset register.

• Review assumptions annually.

• Use reliable small business bookkeeping services to automate schedules and ensure accuracy.

Preparing a Simple Annual Depreciation Schedule

View this depreciation schedule for business assets example to help determine your business asset depreciation annual amount.

What Should a Schedule Include?

How to Use the Schedule in Your Business

• Budgeting: Predict future expenses.

• Tax Planning: Prepare for deductions and audit readiness.

• Asset Management: Determine replacement timing for aging equipment.

For a full explanation of how assets fit into your books, see Assets, Liabilities & Equity: A Complete Guide.

Real-Life Example: Service Business Use Case

A landscaping company buys a truck for $50,000. The estimated salvage value is $10,000, with a useful life of five years.

This example shows how depreciation affects your books year over year and informs when to plan asset replacements.

FAQs About Annual Depreciation for Small Business

Can I change the useful life of an asset after I’ve started depreciating it?

Yes, you can change the useful life of an asset if there’s a justifiable reason, such as unexpected wear or upgrades; however, update your depreciation schedule accordingly.

What happens if I sell the asset before the end of its useful life?

If you sell an asset before the end of its useful life, you’ll recognize a gain or loss depending on the selling price versus book value.

Do intangible assets depreciate the same way?

No, intangible assets don't depreciate the same way. They’re amortized, not depreciated.

Does depreciation reduce cash taxes?

Depreciation doesn’t change cash flow immediately, but it reduces taxable income, which lowers your overall tax liability.

What happens if I dispose of the asset for more than its book value?

If you sell an asset for more than its book value, you recognize a gain on disposal, which increases your income and may have tax implications. This includes the potential for being subject to capital gains tax.

Takeaways and Action Steps for Your Business

This article should help you ensure you’re not under- or over-deducting expenses and that your financial records stay compliant and reliable, which depends on the depreciation formula you select. Make sure you: 

• Know your annual depreciation formula.

• Choose the right depreciation method for your assets.

• Keep an updated asset register.

• Review depreciation schedules yearly.

• Consult a professional to ensure compliance and maximize deductions.

If you’d rather delegate this task, the bookkeeping and tax experts at 1-800Accountant, America's leading virtual accounting firm, can track your assets, calculate depreciation, and ensure your books are audit-ready and tax-optimized.

Schedule a free 30-minute consultation to get started.