How does depreciation work

Introduction

How does depreciation work and what is this? Depreciation is a method that is used to reduce the value of business assets. There is both straight line depreciation and reducing balance depreciation. Let us take a look.

As a small business owner, running your own company, you may buy various business assets for your company. These could be computer equipment, office equipment, plant, and machinery or motor vehicles. These business assets are called `Fixed Assets’ in a company’s set of accounts. What’s more, a company’s assets will lose value over time.

Tangible assets are types of assets that can usually be transacted for a monetary value. These include property, plant and machinery including equipment, motor vehicles and investments.

In contrast, Intangible assets include goodwill, intellectual property, such as patents, trademarks, and copyrights.

Depreciation applies to tangible assets (physical assets) whilst 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.’

How does depreciation work

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

Furthermore, depreciation is the measure of wearing out of a fixed asset. All types of fixed assets are likely to be less efficient as time goes on, as your business carries on using them.

We calculate the fixed asset depreciation charge in company accounts, as the estimate of the measure of wear. We record it in the Profit & Loss report, either on a monthly or an annual basis. The cost of the asset less the total depreciation will give you the Net Book Value of the asset. In turn, the Net Book Value will show in your company’s Balance Sheet.

The types of depreciation

When accounting for depreciation, the method of calculating depreciation will depend on the type of asset. There are two methods that are generally used for depreciating assets and these are:

  • Straight line depreciation
  • Reducing balance depreciation

Straight line method

For short life assets, it would be sensible to opt for straight line depreciation. For example, computer equipment may only last for three years due to the pace of technology. In this example, when we use the straight line method of depreciation, we may choose to use a percentage rate of 33.3% and this means that one third of the cost of the computer equipment will be depreciated each year. Therefore, after three years the computer equipment would have a book value of zero.

Reducing balance method

For longer term life assets, it would be sensible to use reducing balance depreciation. For example, plant, machinery or motor vehicles. These assets will lose more value in the early years and then less in the future.

Example

In this example, for reducing balance depreciation, we may use 25% reducing balance and this means that the rate of depreciation is 25% of the original cost in the first year.

In year 2, 25% of the accumulated depreciation balance brought forward at the end of year 1 would be depreciated.

When we get to year 3, 25% of the accumulated depreciation balance brought forward at the end of year 2 would be depreciated.

Therefore, if the asset cost £10K, the depreciation in year 1 would be £2.5K (25% of £10K).

The net book value carried forward at the end of year 1 would be £7.5K and the depreciation in year 2 would be £1,875 (25% of £7.5K).

Furthermore, the net book value carried forward at the end of year 2 would be £5,625 and the depreciation in year 3 would be £1,406 (25% of £5,625).

Why is depreciation used? 

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 cost of the asset over a number of years.

Therefore, the amount of depreciation of each business asset is charged to the Profit and Loss account, over a number of years.

How and why do assets depreciate? 

When we take a look at, how does depreciation work, assets that 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 decrease due to the wear of the tyres. Other factors relate to the use of the vehicle, which will also cause the value to decrease.
  • They become 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 there is now a more modern model out there.

Assets and expenses 

It is key to see the difference between assets and expenses. It tends to be that to treat a purchase as an asset (rather than an expense), the item has an ongoing use from year to year. Items that you treat as Fixed Assets are `capitalised.’ Indeed, this is a term used in accounting. The assets show in the company’s Balance Sheet. In contrast, expenses go against business profit.

A valid business expense claim will be deductible against tax, however the depreciation charge will not be -please see below.

Capital Allowances (CA)

What are they

In a business’ tax workings, we will claim for `Capital allowances.’ These allowances 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, in the business tax workings, you add the depreciation expense back on to the profit. For tax purposes, you then deduct CA to reduce the taxable profit.

First Year Allowances

In recent years, there have been the allowances available called First Year Allowance and Annual Investment Allowance. These have resulted in most contractors and small business owners being able to claim 100% CA against computer and office type equipment in the year that they buy these.

Company cars

Capital allowances on company cars are a little more complex, and the rates that 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   

As a final thought, when we look at how does depreciation work, a lot of the above is accounts/tax speak, however this is how these functions work. They are a key part of how you treat assets in company accounts.

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Published On: March 15th, 2021 / Categories: Accounting /

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