To begin to understand depreciation from an accounting point of view, let’s use the example of a company van. Unless you’re unlucky, very rarely is it in perfect working condition one day, and fit for the scrapyard the next. From day one, your vehicle – like the majority of your business assets (e.g. computers and machinery) – will shed its value over time, and succumb gradually to wear and tear until it eventually outlives its usefulness: this is depreciation.
To grasp how depreciation can actually help your business, it’s important to understand the specific ways in which accountants use the term. It’s not so much concerned with the ‘market value’ of the asset, but rather with spreading the cost of your ownership of that asset – and writing off that cost against your profits over a period of several years.
Why is depreciation important for a small business?
Depreciation involves reducing the stated value of a particular asset on your balance sheet. The term ‘net book value’ refers to the cost of the asset less any calculated depreciation, as stated on your balance sheet. There are several ways of calculating depreciation on an asset, and we’ll come to those shortly.
At this stage, however, you may be wondering why it’s necessary to go through this process. Is it pointless tax admin, or is there a good reason for it? In fact, there are a couple:
- It means small businesses can use their balance sheets to state their financial position more accurately over a longer period. Let’s say you have a piece of machinery that will give you a few years’ useful service before being fit for scrap. If the stated value of that asset were to remain unchanged on your balance sheet from one year to the next, before suddenly being removed altogether, this will give a distorted picture of its value.
- Depreciation can make sense for tax reasons, too. This may not seem obvious at first glance, because when you file your tax return as a sole trader or company, the tax man requires you to add back depreciation expenses. However, a system of capital allowances exists to enable you to claim the cost of some assets against taxable income.
Ways of calculating depreciation: tangible assets
For small businesses especially, depreciation is most relevant in the context of tangible assets (e.g. machinery, vehicles, and office equipment). There are two standard methods of calculation:
Straight line method
This involves depreciating the net book value of the asset at equal amounts and fixed, identical amounts throughout the estimated useful lifespan of the item.
Here’s an example:
- You buy a piece of video production equipment at a cost of £5,500. It is expected to have a useful lifespan within your business of 5 years.
- You also estimate its scrap value (‘salvage value’) at the end of its working life. Here, we’ve assumed it is £500.
- You enter the item in your list of assets on the balance sheet.
- We’ll assume that you generate a profit and loss account (P&L) each month for record keeping and planning purposes. Remember that depreciation is logged as an expense and will, therefore, need to be entered on your P&L account. You are depreciating the asset over its 5-year useful lifespan in equal, fixed amounts (£1,000 per year). Each month, you will, therefore, reduce the net book value of the asset on your balance sheet by £83.33 and simultaneously record this amount an expense on your P&L account. By the fifth anniversary of the purchase, the net book value will be reduced to zero.
The straight line method is appropriate where you know the likely shelf life of the item in question. Tech is a good example. A wedding photographer, for instance, may estimate the need to replace essential kit at regular intervals of every few years. This is just to keep up with what your competitors are offering. The same is true when wear and tear can be forecasted: a landscaper can predict from experience that certain tools will need to be replaced after three years, for example.
Reducing balance depreciation
For some assets, you know that the bulk of their value will be lost in the first few years, but you cannot predict the useful lifespan of the item with any certainty – a company van being an example. Here, the reducing balance method is likely to be useful:
- You buy a Transit van for £11,000.
- The van is expected to give you service of at least 5 years, and you estimate a salvage value of £1,000.
- You apply a depreciation rate of 25% to each year’s balance. For the first year, £2,500 is depreciated to leave a balance of £7,500. In year 2, that’s reduced by £1875 to £5625. In year 3, it’s reduced by £1406.25 to £4218.75, and so on.
This method is particularly useful should you have to take out repair work, as the reducing balance method causes you to make smaller and smaller charges to your P&L account every year over the asset’s life. This is not the case with the straight-line method, in which you pay the same amount every year. Therefore a considerable sum may be taken out should the van need repair when it’s nearing the end of its lifespan. Using the reducing balance method, however, will mean a smaller sum will have to be taken out. This is because you will be paying less at this point in time.
Intangible assets and amortisation
Non-physical assets, such as goodwill and intellectual property, need to be depreciated in those cases where they have limited useful economic lives. Examples include expiry of patents or legal rights to trade exclusively in a specific geographical area. The process of depreciation here is referred to as amortisation, and it usually involves a straight line method of depreciation. Certain specialist accounting standards apply here – making it an area that’s best referred to an accountant.
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