How does depreciation work?
As a business owner, running your own company, you may buy various assets for your company. These could be computer equipment, office equipment, plant, and machinery or motor vehicles. What’s more, all of these assets will lose value over time.
Depreciation is the accounting function that you use to reduce the value of any assets in the business’ `books.’
Methods and how it works
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.
You calculate the fixed asset depreciation charge as the estimate of the measure of wear. You 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.
Why is it used?
The idea of depreciation is to spread the cost of the capital asset. You will write off the cost of this throughout its useful life to your business.
How 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 profit.
A valid business expense claim will be deductible against tax however the depreciation charge will not be -please see below
Capital Allowances (CA)
In a business tax workings, we will claim for `Capital allowances.’ The CA are set in the government Budget each year. They also vary for each type of asset.
In the business accounts, you include the depreciation charge as an expense. However, in the business tax workings, you add this back on to the profit. You then deduct CA here to reduce the taxable profit.
In recent years, there have been the First Year allowance and Annual Investment Allowance. These have resulted in most contractors being able to claim 100% CA against computer and office type equipment in the year that they buy these.
Capital allowances on company cars are a bit more complex, and the rates that we can use are as follows:
- 100% First Year Allowance for electric cars if the CO2 emissions are 50g per km or lower. From April 2021, the 100% first year allowance will only apply to zero emission cars.
- 18% Writing down allowance for cars if the CO2 emissions exceed 50g per km but they do not exceed 130g per km
- 6% Writing down allowance for cars if the CO2 emissions exceed 110g per km
As a final thought when we look at how does depreciation work, a lot of the above is accounts/tax speak, but this does set out how these functions work. They are a key part of how you treat assets in company accounts.
You may also be one who likes to know your stuff, and if you do, the above may have been a helpful read to you!
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