Written byDepreciation is the fall in an asset's value over time, spread across the years the asset is used so the cost can be claimed as a tax deduction.
Also known as: decline in value, capital allowance, depreciation deduction
Key points
- The ATO allows two methods: prime cost (the same amount each year) and diminishing value (more in the early years).
- The claim is based on the asset's effective life, which you can take from the ATO's published determinations or self-assess.
- Whoever owns the asset claims it: the borrower under a chattel mortgage or hire purchase, the lessor under a lease.
- Small businesses may be able to deduct the whole cost in one year under the instant asset write-off, subject to the current threshold.
How depreciation works
Instead of deducting the full cost of a ute, machine or computer in the year you buy it, you deduct a portion each year over its effective life. For tax, the ATO calls this the decline in value of a depreciating asset and the deduction a capital allowance. In your accounts, depreciation reduces the asset's carrying value on the balance sheet and appears as an expense in the profit and loss.
The two figures can differ: accounting depreciation follows your accounting policy, while tax depreciation follows the ATO's rules on methods, effective life and thresholds.
Prime cost vs diminishing value
Prime cost (also called straight-line) spreads the cost evenly: the annual deduction is the cost multiplied by the days held over 365, multiplied by 100% divided by the effective life. Diminishing value front-loads the deduction: each year's claim is the asset's remaining base value multiplied by the days held over 365, multiplied by 200% divided by the effective life.
Diminishing value gives a bigger deduction early and a smaller one later; prime cost is simpler and steadier. Once you choose a method for an asset you generally stay with it.
Depreciation on financed assets
Ownership decides who claims. Under a chattel mortgage or hire purchase you are treated as the owner and claim depreciation plus the interest. Under a finance or operating lease the lessor owns the asset and claims the depreciation, while you claim the lease rentals instead. For cars, the amount you can depreciate is capped at the ATO car limit for the year.
Keep a record of the purchase date, cost, method, effective life and business-use percentage for each asset, usually in an asset register or depreciation schedule.
Example
A business buys a $60,000 excavator with an effective life of ten years. Under prime cost it deducts $6,000 a year for ten years. Under diminishing value it deducts $12,000 in the first full year (20% of $60,000), then 20% of the remaining $48,000, and so on, so the deductions start higher and taper off. Diminishing value leaves a small balance at the end of the ten years, which is squared up when you sell or scrap the asset.
Not to be confused with
- Amortisation
- amortisation spreads the cost of an intangible asset, or the repayment of a loan, over time; depreciation applies to physical assets
- Written-down value (WDV)
- the written-down value is what is left of the asset's cost after the depreciation claimed so far
Frequently asked questions
What is depreciation in simple terms?
It is the way the cost of something that wears out over time, like a vehicle or machine, is spread across the years you use it. Instead of one big deduction when you buy it, you claim a slice each year that reflects how much value the asset has lost.
How do you calculate depreciation?
Pick a method and an effective life. Prime cost: cost, times days held over 365, times 100% divided by the effective life. Diminishing value: remaining base value, times days held over 365, times 200% divided by the effective life. The ATO's depreciation and capital allowances tool does the arithmetic for you.
What is the difference between prime cost and diminishing value?
Prime cost gives the same deduction every year. Diminishing value gives a larger deduction in the early years and smaller ones later, because each year's claim is worked out on what is left of the asset's value. Diminishing value leaves a balance at the end of the effective life, so the totals only square up once you sell or scrap the asset and the balancing adjustment picks it up.
Can I claim depreciation on a financed asset?
Yes, if you own it for tax purposes. That is the case under a chattel mortgage or hire purchase, where you claim depreciation and the interest on the finance. Under a lease the financier owns the asset and claims the depreciation, and you claim the rentals instead.
What is a depreciation schedule?
A record of each depreciating asset showing its cost, purchase date, method, effective life, the deduction claimed each year and its written-down value. Businesses keep one for their plant and equipment, and property investors have one prepared by a quantity surveyor for building fixtures.
Related terms
Narrower terms: Accelerated depreciation, Depreciation schedule, Reducing balance depreciation, Straight-line depreciation
Straight-line depreciation
Straight-line depreciation is a method that spreads an asset's cost, less its expected salvage value, evenly over its useful life so the same amount is deducted each year.
Read definitionReducing balance depreciation
Reducing balance depreciation is a depreciation method that charges a fixed percentage of an asset's written-down value each year, so the deduction starts high and falls over time.
Read definitionAccelerated depreciation
Accelerated depreciation is any depreciation method that front-loads deductions, so a business claims more of an asset's cost in the early years of its life and less later.
Read definitionCapital allowances
Capital allowances are the tax deductions you can claim for the decline in value of depreciating assets, such as plant and equipment, that you hold to produce assessable income.
Read definitionInstant asset write-off
The instant asset write-off is a tax concession that lets eligible businesses deduct the full cost of a depreciating asset in the year of first use, up to a threshold.
Read definitionWritten-down value (WDV)
Written-down value (WDV) is a depreciating asset's cost less the depreciation claimed so far, and the base for future deductions and for gains or losses on disposal.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.