How does depreciation work

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Introduction 

How does depreciation work when you run your own UK contractor company? Also, what does depreciation mean in business? This is an accounting function, and the depreciation definition in accounting is used to reduce the value of company assets. Indeed, the purpose of depreciation (UK) can be described as an accounting depreciation method to reduce the value of business assets for a given period, which is usually a year. As a UK contractor, it’s key to note there are two main methods of calculating depreciation (UK) when we compute this. Moreover, these two asset depreciation methods are straight-line and reducing balance depreciation. When we consider how depreciation works, under each method, we apply levels of depreciation rates (UK). To sum up, once we calculate depreciation, the reduction in value is the annual depreciation cost or charge.

What is depreciation in accounting? If you’re a UK limited company contractor or small business owner and run your own company, you can buy various business assets for your company. These could be computer and office equipment, plant and machinery, or motor vehicles. The business assets are `Fixed Assets’ in a company’s accounts. You may ask if I need to depreciate a computer or other equipment. To sum up, the meaning of depreciation is when a company’s assets lose value over time. Therefore, we charge company depreciation in business to account for this.

Initial thoughts –how does depreciation work? 

First thoughts

When considering depreciation, tangible assets are usually transacted for a monetary value. Indeed, 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 in business applies to tangible assets (physical assets), while amortisation applies to intangible assets. Therefore, the definition of depreciation is the accounting function we use to reduce the value of any tangible assets in the business `books.’

What we’ll investigate

In this guide, as part of the depreciation business definition, we’ll look at:

  • What depreciation means.
  • The definition of depreciation in accounting.
  • The meaning of depreciation in accounting.
  • What does depreciation mean in business?
  • What is the business depreciation meaning?

What’s more, we’ll investigate the UK depreciation rates (fixed assets) for a UK business, and this includes:

  • Computer depreciation rate (UK).
  • Office equipment depreciation rate (UK).
  • UK car depreciation and motor vehicle depreciation rate (UK).

Common questions on how does depreciation work?

You may have questions about depreciation as a UK contractor or business owner. What’s more, you may wonder how to compute this. Therefore, such questions could include:

  • What is the purpose of depreciation?
  • What is the definition of depreciation?
  • How does asset depreciation work?
  • How to calculate depreciation?
  • What does depreciate mean?
  • What does depreciation mean in accounting?
  • How to work out depreciation?

Some further questions around depreciation may include:

  • Why do we charge depreciation?
  • Is depreciation tax-deductible (UK)?
  • What is depreciation in business?
  • How to calculate net book value?
  • What is the meaning of depreciation in accounting?
  • How does depreciation work on equipment?
  • How much does a car depreciate per year (UK)?

In this guide, we’ll examine how to calculate depreciation in business, research how to work this out in your accounts and consider what you must consider as a UK business owner.

UK depreciation of assets & the types of depreciation 

How does depreciation work -what is the definition of depreciation? 

Let’s now turn to the depreciation accounting definition and research the depreciation meaning in accounting. In company accounts, the purpose of depreciation is to reduce the value of an asset to its current market value estimate. Indeed, when we do this, it’s due to the permanent and continued decrease in an asset’s quality, quantity, or value. What’s more, the depreciation definition measures the wearing out of a fixed asset. All fixed assets are less efficient as time goes by as your business continues to use them. Therefore, the depreciation of assets (UK) is applied to company accounts for each accounting period. When we prepare the accounts, a business will calculate the annual depreciation and charge this as an expense for the company. Indeed, the charge in the accounts results in the loss of value of the company’s fixed assets.

When we depreciate assets, we work out the fixed asset depreciation charge in company accounts as the estimate of the measure of wear and tear. We record the company depreciation cost in the Profit & Loss report, either monthly or annually. The asset’s cost (purchase price minus any VAT you reclaim), less the total depreciation, will give you the asset’s net book value. The net book value of company assets will show on your company’s Balance Sheet in the company’s accounts. 

How does depreciation work -what are the two main methods? 

Besides the function of depreciation, when we account for the depreciation value, how we calculate this depends on the type of the asset. Applying this to an asset will reduce its net book value in your company’s accounts. Indeed, there are two ways to depreciate assets, and these are:

  • The straight-line method.
  • The reducing balance method. 

Straight line method

For short-life assets, it’s best to choose the straight-line depreciation method. This method of accounting depreciation allows you to write the asset off over a relatively short period.

As a UK contractor, you’ll likely buy a computer for your business. Therefore, what method and rate should we use for the depreciation of computer equipment (UK)? Due to the pace of technology, computer equipment may only last three years or so. Therefore, we could use a computer equipment depreciation rate (UK) of 33.33% when calculating straight line depreciation.

The above means that when we calculate depreciation on computer equipment, one-third of the cost of this equipment is the cost write-off each year. This depreciation rate for computer equipment is an excellent example of how long new equipment keeps its value -three years at best. As a result, the depreciation of computer equipment will appear as a cost in the company accounts. Moreover, when we use this straight-line depreciation formula for computer depreciation, the computer equipment will have a book value of zero after three years.

Reducing balance method

Selecting a reducing balance method for accounting depreciation is best for longer-term life assets. For example, we use this method for plant and machinery, office equipment, and company vehicle depreciation. Indeed, under the reducing balance depreciation method, the assets will lose more value in the earlier years and then less in the future. As a result, there’s a declining company depreciation charge for the assets in question in the accounts each year.

As a UK contractor, you may decide to purchase office equipment. This could include a desk, chair, and perhaps other furniture for your home office. Therefore, what method and rate should we use for the depreciation of office equipment? Indeed, office-type furniture usually lasts for many years. Therefore, in this example, when we use the reducing balance method, we may use a depreciation rate of 15% on office equipment.

Therefore, a depreciation rate of perhaps 15% under the reducing balance method for office equipment would be prudent.

How does car depreciation work? Since cars usually last a long time, we apply the reducing balance method. Indeed, this will be a 25% reduction in balance -please see the example later.

Net book value meaning

The net book value definition or net book value (NBV) meaning is the actual value of an asset(s) in the company’s Balance Sheet. It’s the asset’s original cost after a reduction in cost due to the depreciation charges. Moreover, the net book value will be one of the balances in your company’s Balance Sheet. On this page in the accounts, the NBV will show along with the balances of all the other assets and liabilities.

A detailed look at how depreciation works 

An example of how to calculate depreciation 

In this depreciation example, we’ll take a small company’s motor car and use the reducing balance method. As part of this, we’ll use a motor vehicle depreciation rate of 25%. The rate of depreciation of 25% means that when we’re accounting for depreciation, the business car depreciation charge is 25% of the original cost in year 1.

In year 2, we use the small business motor car depreciation rate of 25% in this depreciation example. We apply it against the net book value brought forward at the end of year 1. As a result, this charge is put through the accounts as the asset depreciation cost for year 2.

When we reach year 3, we use the 25% rate again. Therefore, we’ll apply the rate against the net book value brought forward at the end of year 2. As a result, this amount is the small business vehicle depreciation cost for year 3. 

Depreciation with example

Therefore, if the asset (a motor vehicle) costs £10K, depreciation is charged on the £10K in year 1. As a result, the Balance Sheet depreciation cost in year 1 is £2.5K (25% of the £10K). To sum up, the net book value of the motor vehicle that we carry forward from year 1 is £7.5K.

We then carry the £7.5K net book value or depreciated cost from year 1 into year 2. Next, in year 2, the Balance Sheet depreciation charge is £1,875 (25% of the £7.5K). As a result, the motor vehicle’s net book value or depreciated cost, which we carry forward at the end of year 2, is £5,625.

The £5,625 net book value from year 2 is then carried forward to year 3. Next, in year 3, the accounting depreciation cost is £1,406 (25% of the £5,625). As a result, the net book value carried forward at the end of year 3 is £4,219.

What’s more, 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
The sum of the years 5,781.00

Therefore, after year 3, the position in the company accounts is:

Cost 10,000.00
Depreciation to date –   5,781.00
Net Book Value 4,219.00

Other thoughts

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 this, it’ll write off the asset’s cost over several years. Therefore, in the company accounts, the accumulated depreciation (or total depreciation value) for a particular asset is the depreciation on the 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 known as a `journal entry.’ Therefore, each business asset you buy has a charge to the Profit and Loss account over several years.

How does depreciation work & why do assets lose value? 

When we research this further, the assets you buy will lose value for two reasons. Indeed, these reasons are as follows:

  • Wear and tear of the asset. Indeed, in the case of a car, it’ll decrease in value because of the mileage you do when you drive it. Moreover, it’ll reduce due to the wear on the tyres. Other factors related to vehicle use will cause the value to decrease.
  • In the future, assets become obsolete. Indeed, assets will decrease in value over time as newer models emerge. What’s more, last year’s car model isn’t worth as much this year as a more modern model is now available.

These are both essential factors in how assets lose value over time. Hence, it’s why we use this as an accounting function.

Assets & expenses 

It’s vital to see the difference between assets and expenses in your business accounts. We treat an asset purchase as a Balance Sheet item when the item is used continuously from year to year. Indeed, items that you treat as Fixed Assets are `capitalised’ in your business accounts. Additionally, depreciation is a term we use in accounting, and assets will show on the company’s Balance Sheet. In contrast, expenses will go against business profit in the Profit and Loss account.

A valid business expense claim saves tax. The depreciation charge doesn’t -please see below.

How does depreciation work -Capital Allowances (CA) 

How do Capital Allowances work? 

In a business’ tax workings, we’ll claim for Capital Allowances. These claims reduce tax and are set in the Budgets each year. What’s more, the rates and types of CA vary for each type of asset.

In the accounts

In your contractor limited company accounts, you include the accounting depreciation charge on an asset as an expense. However, you’ll add any depreciation expenses to the profit in the business tax workings. Next, you’ll deduct CA from the profit for tax reasons to arrive at the taxable profit amount.

First Year Allowances

The First Year Allowance and Annual Investment Allowance are available to businesses, and they’ve 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

A new allowance was introduced from 1 April 2021 until 31 March 2023. The Super Deduction was a 130% first-year allowance, and you could claim it in the year of asset purchase. Moreover, this only applied to new assets, as second-hand assets didn’t qualify.

Full Expensing 

From 2023/24 onwards, there’s now `Full Expensing,’ which allows a business to claim the cost of assets it buys against company profit. Indeed, this offers 100% first-year relief to companies on qualifying new main rate plant and machinery investments (including a computer) from 1 April 2023 until 31 March 2026. 1 April 2026. Similar rules apply to integral features and long-life assets at a rate of 50%. The government has announced both allowances will now be made permanent.

The equipment must be new and unused to qualify for the new allowance. Moreover, it doesn’t include cars and is only available for companies. Therefore, you can claim the AIA instead if you buy a second-hand computer.

Company cars

Capital allowances on company cars are a little more complex. Indeed, 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.

What happens when you dispose of company assets?

In the final year of ownership of an asset, it may either be sold or scrapped if it has become worthless. The asset’s cost and cumulative depreciation are disposed of in the company accounts. Therefore, the total cost and depreciation to date for the type of asset will be reduced accordingly. If the asset is sold for a monetary value, there’ll be a profit or loss on disposal in the accounts. However, from a tax point of view, the business will claim a Balancing Allowance or pay a Balancing Charge in the company tax computations.

Final thoughts 

When we look at the depreciation definition, depreciation meaning and how accounting depreciation functions, much of the above is accounts/tax terms; therefore, when we consider the depreciation of assets definition, it’s how these functions operate for company depreciation in business when you’ve your own UK company. Finally, these accounting terms and functions are a key part of how we treat business assets in company accounts.

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Published On: April 6th, 2024 / Categories: Accounting /

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