Introduction
How does depreciation work for UK contractors and UK businesses and what is the depreciation meaning? This is primarily an accounting function and the depreciation definition in accounting is used to reduce the value of company assets. Please note, the purpose of depreciation 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 are two main methods of calculating depreciation when we work this out. These methods are straight-line and reducing balance. Once we calculate this, the reduction in value is the annual depreciation cost or charge.
What is depreciation in accounting? 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 could be 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 therefore we make a charge in the accounts to account for this.
Initial thoughts
Tangible assets are types of assets that are usually transacted for a monetary value. Please note, 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, the definition of depreciation is the accounting function that we use to reduce the value of any tangible assets in the business `books.’
How does depreciation work -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 depreciation definition 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 and tear. 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 in the company’s accounts.
How does depreciation work -the types of depreciation
Besides the definition of depreciation, when we account for the depreciation value, how we calculate this will depend on the type of the asset. In general, there are two ways to depreciate assets, and these are:
- A straight-line method.
- A reducing balance method.
The straight line method
For short-life assets, it is best to opt for the straight-line method. Please note, this method of accounting depreciation will see the asset written off over a relatively short period of time.
As a UK contractor, you will be likely to 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 calculate straight line depreciation, we may choose to use a computer equipment depreciation rate of 33.33%. This means that when we work out the depreciation of computer equipment, one-third of the cost of this equipment is depreciated each year. As a result, the computer equipment depreciation will appear as a cost in the company accounts. Therefore, when we use this straight-line depreciation formula, after three years the computer equipment will then have a book value of zero.
The 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 the reducing balance method. 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 the charge for reduction in value.
How does depreciation work -a look at depreciation with example
In this depreciation example, we will use reducing balance method. As part of this, we use a rate of depreciation of 25%, which means that the charge 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 put through as the asset depreciation cost. 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 (a motor vehicle) costs £10K, the Balance Sheet depreciation cost in year one is £2.5K (25% of the £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 the £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 accounting depreciation cost in year three is £1,406 (25% of the £5,625).
Therefore, in terms of asset depreciation the sum of the years is:
| Year 1 | 2,500.00 |
| Year 2 | 1,875.00 |
| Year 3 | 1,406.00 |
| Sum of the years | 5,781.00 |
Therefore, after year 3 the position in the accounts is:
| Cost | 10,000.00 |
| Depreciation to date | – 5,781.00 |
| Net Book Value | 4,219.00 |
How does depreciation work -why do we use it?
The idea of this is to spread the cost of the capital asset over its useful life. When a business calculates this, it will write off the asset’s cost over a number of years. Therefore, in the company accounts, the total depreciation value for a particular asset is the depreciation on Balance Sheet for the number of years in which the business has owned the asset.
When we make a charge in the company accounts, this is a journal entry. Therefore, each business asset has a charge to the Profit and Loss account over several years.
How does depreciation work -why do assets lose value?
When we look into this further, the assets you buy will lose value for two main reasons. Please note, these are as follows:
- Wear and tear. Key to note, a car will decrease in value because of the mileage that you do. What’s more, it will also reduce due to the wear of the tyres. Other factors will 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
Please note, it is key to see the difference between assets and expenses. Key to note, 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 will claim for `Capital allowances.’ These allowances are tax deductible and are set in the government Budgets each year. They will also vary for each type of asset.
In the accounts
In your contractor limited company accounts, you include the accounting depreciation charge as an expense. However, you will add the expense onto the profit in the business tax workings. For tax purposes, you will 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 limited company contractors and small business owners can claim 100% CA against the computer and office-type equipment in the year they buy these.
Super Deduction
Please note, 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. What’s more, 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 the depreciation definition, depreciation meaning and how accounting depreciation works, much of the above is accounts/tax terminology. However, this is how these functions work. Key to note, they are a key part of how you treat business assets in company accounts.
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