How does depreciation work

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Introduction 

How does depreciation work when you run your own UK contractor company or small business? Also, what’s the business depreciation meaning? 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 by which 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’s two main methods of calculating depreciation (UK) when we compute this. What’s more, 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 known as `Fixed Assets’ in a company’s set of accounts. You may ask do I need to depreciate a computer or other equipment? To sum up, the meaning of depreciation is a company’s assets lose value over time, therefore we make a charge for company depreciation in business to account for this.

Initial thoughts on how does depreciation work

What to think about first

When we think about depreciation, tangible assets are types of assets that 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 the term 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.’

What we’ll look into

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’s the depreciation meaning in business.

What’s more, we’ll look into 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

As a UK contractor or business owner, you may have some questions around depreciation. What’s more, you may also wonder how 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 also 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 look at how to calculate depreciation in business. What’s more, we’ll research how to work this out in your accounts. Further still, we’ll look at what you need to consider here as a UK business owner.

UK depreciation of assets and the types of depreciation 

How does depreciation work -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 the quality, quantity, or value of an asset. What’s more, 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 (UK) is applied in company accounts for each accounting period. When we prepare the accounts, a business will calculate the annual depreciation and charge this as an expense to the business. Indeed, the charge in the accounts results in the loss of value of the company’s fixed assets.

When we’re depreciating 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 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 actual net book value of company assets will show on your company’s Balance Sheet in the company’s accounts.

How does depreciation work -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. When we apply this to an asset, it’ll reduce it to its net book value in your company’s accounts. Indeed, there’s 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. What is more, this method of accounting depreciation will see you write the asset off over a relatively short period of time.

As a UK contractor, you’ll more than likely buy a computer for your contracting business. Therefore, what method and rate should we use for the depreciation of computer equipment (UK)? Computer equipment may only last for three years or so due to the pace of technology. Therefore, in this example, when we calculate straight line depreciation, we could choose to use a computer equipment depreciation rate (UK) of 33.33%.

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

Reducing balance method

For longer-term life assets, it’s best to select a reducing balance method, in terms of accounting depreciation. 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 asset in question in the accounts each year.

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

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

How does car depreciation work? As cars will last a long time in most cases, we apply the reducing balance method. Indeed, this’ll be 25% reducing balance -please see the example later on.

The 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. Basically, this is the original cost of the asset after a reduction to cost, due to the depreciation charges so far. What’s more, it’s the net book value which’ll show as a balance in your company’s Balance Sheet. In this page in the accounts, the NBV will show along with the balances of all the other assets and liabilities.

How does depreciation work -a look at this in more detail 

An example of how to calculate depreciation 

In this depreciation example we’ll take a small business company motor car. What’s more, we’ll use the reducing balance method. As part of this, we’ll use a motor vehicle depreciation rate of 25%. With the rate of depreciation of 25%, this 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 in this depreciation example, we use the small business motor car depreciation rate of 25%. 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 get to 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, the 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 which we carry forward at the end of 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 net book value or depreciated cost of the motor vehicle 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 which is carried forward at the end of year 3 is £4,219.

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 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 a number of years. Therefore, in the company accounts, the accumulated depreciation (or 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 known as a `journal entry’. Therefore, each business asset that you buy has a charge to the Profit and Loss account over a number of 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. 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 that you do when you drive it. What’s more, it’ll also reduce due to the wear of the tyres. Other factors will relate to the use of the vehicle, which’ll also cause the value to decrease.
  • In the future, assets will become obsolete. Indeed, assets will decrease in value over time as newer models come out. 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 basic factors with regard to how assets lose value over time. Hence, this is why we use this as an accounting function.

Assets and expenses 

It’s key to see the difference between assets and expenses in your business accounts. Basically, we treat a purchase as an asset as a Balance Sheet item when the item has ongoing use from year to year. Indeed, items which you treat as Fixed Assets are `capitalised’ in your business accounts. What’s more, 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 in the Profit and Loss account.

A valid business expense claim saves tax. On the other hand, the depreciation charge isn’t -please see below.

How does depreciation work -Capital Allowances (CA) 

How CA works? 

In a business’ tax workings, we’ll claim for Capital Allowances. These claims reduce tax and are set in the Budgets each year. The rates and types of CA will also 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 back onto the profit in the business tax workings. For tax reasons, you’ll then deduct CA from the profit 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

There was a new allowance from 1 April 2021 until 31 March 2023. Basically, the Super Deduction was a 130% first-year allowance and you could claim this in the year of asset purchase. What’s more, 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 that it buys against company profit. Indeed, this offers 100% first-year relief to companies on qualifying new main rate plant and machinery investments (this’ll include a computer) from 1 April 2023 until 31 March 2026. However, to qualify for the new allowance the equipment needs to be new and unused. What’s more, it doesn’t include cars and it’s only available for companies. Therefore, if you buy a second-hand computer, you can claim the AIA instead.

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.

Disposals of company assets

In the final year of ownership of an asset it may either be sold or scrapped if it has become worthless. In the company accounts, the cost of the asset and depreciation to date for this will be disposed of. Therefore, the total cost and depreciation to date for the type of asset will reduce 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, this is how these functions operate for company depreciation in business when you’ve your own UK company. As a final note, these accounting terms and functions are a key part of how you treat business assets in company accounts.

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Published On: January 4th, 2024 / Categories: Accounting /

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