How does depreciation work

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Introduction 

How does depreciation work, and what is depreciation meaning? This is primarily an accounting function and the depreciation definition in accounting can be described as a method by which to reduce the value of business assets for a given period which is usually a year. There is both straight-line depreciation and reducing balance depreciation. Let us now take a look into this.

If you are a UK limited company contractor small business owner and run your own company, you can buy various business assets for your company. These are computer equipment, office equipment, plant and machinery, or motor vehicles. The business assets are known as `Fixed Assets’ in a company’s set of accounts. What’s more, a company’s assets do lose value over time.

Tangible assets are types of assets that are usually transacted for a monetary value. These include property, plant and machinery, equipment, motor vehicles, and investments. In contrast, intangible assets include goodwill, and intellectual property, such as patents, trademarks, and copyrights.

Depreciation applies to tangible assets (physical assets), while amortisation applies to intangible assets. Therefore, depreciation is the accounting function that we use to reduce the value of any tangible assets in the business `books.’

The definition of depreciation 

When we consider the depreciation meaning in accounting, the method of this is the permanent and continual decrease in the quality, quantity, or value of an asset.

Furthermore, the definition of depreciation is the measure of the wearing out of a fixed asset. All types of fixed assets are less efficient as time goes by, as your business continues to use them. Therefore, depreciation of assets is applied in company accounts and this is the reduction in value of company fixed assets.

We calculate the fixed asset depreciation charge in company accounts as the estimate of the measure of wear. We record the depreciation cost in the Profit & Loss report, either on a monthly or an annual basis. The cost of the asset (which is the purchase price less any VAT that you reclaim), less the total depreciation, will give you the asset’s Net Book Value. The Net Book Value will show on your company’s Balance Sheet.

How does depreciation work -the types of depreciation 

When we account for the depreciation value, how we calculate this will depend on the type of asset. In general, there are two ways to depreciate assets, and these are:

  • Straight-line depreciation.
  • Reducing balance depreciation. 

Straight line method

For short-life assets, it is sensible to opt for straight-line depreciation. This method of accounting depreciation will see the asset written off over a relatively short period of time.

As a UK contractor, you will likely buy a computer for your business. Notably, computer equipment may only last for three years or so due to the pace of technology. In this example, when we use the straight-line method, we may choose to use a computer equipment depreciation rate of 33.3% when we calculate straight-line computer equipment depreciation. This means that when we work out the depreciation of computer equipment, one-third of the cost of this equipment is depreciated each year. Therefore, after three years, the computer equipment will have a book value of zero.

Reducing balance method

For longer-term life assets, it is sensible to use a reducing balance method in terms of accounting depreciation. For example, plant and machinery or motor vehicles. These assets will lose more value in the earlier years and then less in the future.

How does car depreciation work? As cars will last a long time in most cases, we apply reducing balance depreciation. Typically, this will be 25% reducing balance -please see the next example.

Net book value meaning

The net book value (NBV) is the actual value of an asset in the company’s Balance Sheet, after the reduction due to depreciation charges.

How does depreciation work -a look at depreciation with example

In this depreciation example, we will use reducing balance depreciation. As part of this, we use a 25% reducing balance rate, which means that the rate of depreciation is 25% of the original cost in the first year.

In year 2 in this depreciation example, 25% of the net book value brought forward at the end of year one is depreciated.

When we get to year three, 25% of the net book value brought forward at the end of year two is depreciated.

Therefore, if the asset (motor vehicle) costs £10K, the Balance Sheet depreciation cost in year one is £2.5K (25% of £10K).

The net book value of the motor vehicle which we carry forward at the end of year one is £7.5K, and the Balance Sheet depreciation charge in year two is £1,875 (25% of £7.5K).

Furthermore, the net book value of the motor vehicle which we carry forward at the end of year two is £5,625, and the depreciation cost in year three is £1,406 (25% of £5,625).

How does depreciation work -why do we use it? 

The idea of depreciation is to spread the cost of the capital asset over its useful life. When a business calculates depreciation, it will write off the asset’s cost over several years. Therefore, in the company accounts, the total depreciation value for a particular asset is the depreciation for the number of years in which the business has owned the asset.

When we claim depreciation in the company accounts, this is a journal entry. Therefore, each business asset’s depreciation amount is a charge to the Profit and Loss account over several years.

How and why do assets depreciate?  

When we look at depreciation, the assets you buy will depreciate for two main reasons. These are as follows:

  • Wear and tear. A car will decrease in value because of the mileage that you do. It will also reduce due to the wear of the tyres. Other factors relate to the use of the vehicle, which will also cause the value to decrease.
  • In the future, they will be obsolete. Assets will decrease in value over time as newer models come out. Last year’s car model is not worth as much this year as a more modern model is now available.

Assets and expenses 

It is key to see the difference between assets and expenses. Notably, it is the case that we treat a purchase as an asset (rather than an expense) when the item has ongoing use from year to year. Items which you treat as Fixed Assets are `capitalised.’ Please note that this is a term which we use in accounting and the assets will show on the company’s Balance Sheet. In contrast, expenses will go against business profit.

A valid business expense claim is deductible against tax. However, the depreciation charge is not -please see below.

How does depreciation work -Capital Allowances (CA) 

What are they? 

In a business’ tax workings, we claim for `Capital allowances.’ These allowances are tax deductible and are set in the government Budgets each year. They also vary for each type of asset.

In the accounts

In the business accounts, you include the depreciation charge as an expense. However, you add the depreciation expense onto the profit in the business tax workings. For tax purposes, you then deduct CA to reduce the taxable profit.

First Year Allowances

The First Year Allowance and Annual Investment Allowance are available and they have been so for several recent years. As a result, most contractors and small business owners can claim 100% CA against the computer and office-type equipment in the year they buy these.

Super Deduction

There is now a new allowance available from 1 April 2021 until 31 March 2023. Notably, the Super Deduction is a 130% first-year allowance and we claim this in the year of asset purchase. In addition, this will only apply to new assets, second-hand assets do not qualify.

Company cars

Capital allowances on company cars are a little more complex, and the rates which we can use are as follows:

  • 100% First Year Allowance for electric cars if the car has zero CO2 emissions.
  • 18% Writing down allowance for cars if the CO2 emissions are below 50g per km.
  • 6% Writing down allowance for cars if the CO2 emissions exceed 50g per km.

Final thoughts 

Finally, when we look at how depreciation works, much of the above is accounts/tax terminology. However, this is how these functions work. They are a key part of how you treat business assets in company accounts.

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Published On: August 1st, 2022 / Categories: Accounting /

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