Computers, office furniture, or even a company vehicle. Those are all examples of company assets with a limited life span. As they’re used, their value diminishes. Depreciation is the accounting term that represents the cost of using assets like these over a period of time while they’re useful to your business.
We’ll unpack the meaning of depreciation, explore where it applies and why it should matter to you as a business owner in the UK.
And if you don't want to deal with it yourself, you can always turn to our accounting services for help.
What are depreciable assets?
The concept of depreciation applies to fixed assets that either diminish in value, naturally deteriorate or become obsolete over time. It’s a broad range and they’re generally grouped into categories for balance sheet reporting. Here are some examples:
We can’t apply the term ‘depreciation’ to intangible assets. However to reflect the change in their value you still make additional entries. For intangible assets, it’s called amortization.
Why do you need Depreciation?
Consider a printer as an example. A really good one (yes, that means a really expensive one) that your company buys to use over a long period of time. If you were to write it down in the books as a once-off in January when you bought it, it would skew up the expenses in your books. But this printer is a valuable asset that makes you money over its useful life period by helping you with your operations and can be resold. The reality is that it’s not an asset that has once-off use-value in just one month. In fact, you’ll be able to use it for months, even years after you bought it. Therefore, depreciation will help you derecognize the asset from the balance sheet while recognizing the use of the printer over its useful life as expenses at regular intervals.
You do not want your books to distort the real picture. That’s where depreciation comes in. It’s a way of spreading out the cost of that fancy printer by reporting small “parts” of its overall price as expenses over the amount of time you know it’ll be useful to you.
How does depreciation apply in accounting?
Depreciation is a non-cash expense. It can be broken down as two aspects of the same concept, represented in your:
- Income Statement: The actual decrease in an asset’s value is treated as an expense (e.g wear and tear year-on-year for a printer);
- Balance Sheet: the same as in the income statement. Depreciation reduces the value of your assets on the books.
How to calculate depreciation?
There are different ways to categorize depreciation. You can either rely on the time for which the asset is in use or on the performance of the asset itself.
Straight-line method. Asset value is distributed evenly over the period that it’s useful — i.e at a consistent rate, year on year.
Cost of the asset at purchase/number of years expected to be useful = value
Desk chair costing £100 was purchased at the start of 2019. With daily use, it’s expected to last 2 years. Divide cost of £100 by those 2 years to get depreciation of £50 per year.
Declining Balance method or Reducing Balance method. The depreciation value of an asset gradually declines over its useful lifespan.
Cost of an asset at purchase multiplied by reducing balance percentage / applied over the projected lifespan in years
At the start of 2019, you bought a swanky office computer for £600. Given its specs, you project it’ll be useful to your business for 3 full years. You set a fixed depreciation rate of 15%. You multiply its cost ( £600) by 15%, which gives you £90. When you start the depreciation calculation the following year, it’ll be the original cost of £600 minus £90. So year on year, the computer loses 15% of its original value.
Unit of production method: Based on the actual usage capacity of an asset (and therefore its gradual loss of value). Equal rate expenses are assigned to each unit produced.
(Cost – residual/salvage value) x (Number of units produced / Life in number of units)
Your company vehicle cost £30,000, it’s maximum expected mileage is 200,000km and it has a residual value of £1,000.
= (£30,000 - £1,000) x 1 / 200,000
= £0.145 per km *This is your unit of production rate
You can then work out your total depreciation expense by how many units (in this case, kms) it produces for you during a set period.
= £0.145 x 20,000km per annum
- Depreciation is an accounting term that means “a fixed asset gets worn down and loses its value over time because it is used in business operations”.
- The most common methods of depreciation are straight-line, declining/reducing balance and unit of production.
- The depreciation rate of an asset is usually dependent on the type of asset, its cost at the time of purchase and its estimated useful life.
- Generally Accepted Accounting practices recommend bookkeepers and accountants to record depreciation in certain ways.