Depreciation is an accounting method in which the cost of a fixed company asset is offset over a period of several years, rather than charged all at once.
Businesses make use of depreciation for several reasons, ranging from accounting benefits to the tax advantages it offers. There are several different methods used by businesses in order to calculate depreciation for different assets.
The tax benefits of depreciation can vary from one country to another (in the US, there are more benefits to depreciating assets than in the UK). Despite this, it’s still important to understand the basics of depreciation if you’re an investor or business owner in any country.
Below, we’ve explained what depreciation is, how it works and why it’s important for any investor or business owner. We’ve also included examples of how depreciation can be applied to assets, ranging from office equipment such as computers to company vehicles.
What is Depreciation?
Depreciation is an accounting method in which your business writes off the cost of a fixed asset over the period in which it’s used.
When you purchase equipment for your company, it’s fair to assume that its value will decrease over time as it’s used. Depreciation allows a company to write off the cost of the asset during its useful life to more accurately account for its value in your company accounts.
How Depreciation Works
Depreciation is a process by which your business can transfer the cost of a company asset from its balance sheet to its profit and loss account as an expense. In simple terms, it’s a method that you can use to record how much of a fixed asset’s value your business has used.
Most businesses calculate depression once per year. It’s usually a fairly simple calculation that’s based on your usage of an asset, its useful life and its value at sale.
For example, pretend that you own a graphic design business and need to purchase a powerful computer workstation for rendering images. The cost of the computer is £5,000 and you believe it will last for five years before becoming outdated.
The opening book value of the computer is £5,000 -- the amount that you paid to purchase it. If your business uses a straight line depreciation method, you can subtract £1,000 from the value of the computer for every year of use, resulting in a £1,000 annual depreciation expense.
This method allows you to write off the cost of the computer workstation over five years, rather than treating the purchase as an expense.
Depreciation can apply to vehicles and machinery. For example, if your business purchases a delivery van for £25,000 and uses it for five years before selling it for £10,000, these costs can be treated as depreciation.
Depreciation can be used to claim capital allowances, potentially affecting the total amount of corporation tax a business is required to pay.
Methods Used to Calculate Depreciation
There are several different methods used to calculate depreciation. These range from the fairly simple straight-line depreciation method, which is mainly used by small businesses, to a range of more complicated methods. Common depreciation methods include:
Straight line depreciation. Using this method, the expense amount of a fixed asset is the same throughout the entire useful life of the asset. Each year, a specific amount is deducted from the asset’s book value until it’s sold or no longer used.
Units of production depreciation. Using this method, the book value of a fixed asset is depreciated for each unit produced. This method is also commonly used with vehicles or other equipment, with miles travelled or hours used in place of units produced.
Double declining balance depreciation. Using this method, the bulk of the value of a fixed asset is depreciated in the first two to three years of ownership. This is commonly referred to as a form of “accelerated depreciation”.
Sum of the years depreciation. This is another method used to calculate accelerated depreciation. It uses a unique depression factor for each year in which an asset is used by the business. This method is often used for assets that become obsolete quickly.
As with many other accounting methods, there’s no “best” method of calculating depreciation for every business. In some cases, simple methods such as straight line depreciation may offer the best results for your business; in others, a more complicated method might be required.
Like many other accounting concepts, depreciation can be difficult to wrap your head around at first. However, as one of the most important parts of maintaining reliable accounting records, it’s something that every business owner or investor should take time to learn.
By using depreciation, you’ll find it easier to accurately record the cost of purchasing and using company assets, helping you stay more aware of your business’s overall financial condition.