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What Is Depreciation?

What Is Depreciation?

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What Is Depreciation?

What Is Depreciation?

As a small business owner, it’s important to record your company asset values accurately. Items such as machinery, office equipment, or vehicles need to reflect their declining value over time. Recording this decline in value can also reduce your annual tax charge.

Depreciation is an accountancy method of doing exactly this for you.

It adjusts the value of an asset over a specified period, reflecting its useful life span, with reference to its original value and its end of useful life value. It’s often the case that the value will be nil at the end of its useful life. 

The original value is the purchase price,  plus any additional costs, such as delivery or installation fees. To get from the original value to zero value, an amount is deducted each year until the value hits zero.

The annual amount that is deducted is the ‘depreciation charge’. This appears in the profit and loss account as a non-cash expense of the business.

For all fixed assets in your business, you need to apply a method to reduce the value over an appropriate estimate of the useful life of the asset.

For example, a car used in a business would generally be considered to have a useful life of 5 years. On the other hand, a piece of machinery that is guaranteed to work well for 10 or 15 years may well have a longer ‘depreciation period’ applied to it. 

Therefore, the overall aim of depreciation is to help with matching the revenues and expenses of a business during a period.

What assets can you depreciate?

There are many assets in a business that help you to generate revenues. Fixed assets are a particular type of asset.

Examples of fixed assets include tools, machinery, computers, office furniture, vehicles, and buildings. All of these are assets that will help you to run your business to generate revenues and are expected to have a useful life span of more than one year.

It’s important to note that only fixed assets that lose value can be depreciated. That may seem an odd thing to highlight, but not everything loses value over time. 

For example, land does not generally lose value, in fact, it will most likely increase in value. Therefore, land is not a fixed asset that can be depreciated.

Why depreciate?

There are 3 main reasons for depreciating an asset in your business:

Depreciation is a way of identifying depreciation expenses as the ‘cost of doing business’

Depreciation is essentially an expense of the business – not one that you physically pay out for, but one that you need to be aware of as it impacts how profitable your business is at the end of each year.

By calculating how much value your fixed asset has lost during a year, you are able to include this element as a cost of the business. 

If it was excluded, you would have underestimated costs and therefore be under the misconception that you have made more money than you think.

Depreciation and Taxes

As depreciation is a cost of the business, it’s included in the calculation of profits at the end of the year. This is then used to determine your corporation tax charge.

If depreciation was not charged, your profits would be higher, and you would be required to pay more tax than if you did not depreciate your assets.

Valuing your business more accurately

It’s important to include your assets in your accounts at an amount that accurately reflects the value of them at the end of each year.

If we didn’t charge depreciation, the assets would be overvalued and not reflect what they are worth to the business at the end of each year.

What are the different methods of calculating depreciation?

There are several methods that can be adopted to calculate depreciation. Once you have decided on the method that you want to use, you need to stick with it and apply it consistently.

Here are the main methods that are generally used to calculate depreciation:

Straight-line depreciation method

The straight-line method is the most straightforward of methods.

It simply depreciates the same amount each year, taking the asset value from the original value on day 1, right down to zero value at the end of useful life.

To calculate, the cost of the asset is determined and then the estimated salvage value of the asset is subtracted from the cost of the asset to get the total depreciable amount.  

For example, an asset being depreciated over 5 years to zero value, you would simply calculate a depreciation charge of one-fifth of the original value each year.

Double-declining balance depreciation method

This is a way of depreciating an asset more quickly, by doubling up on the annual charge and effectively having more depreciation of the asset in the early years of ownership.

The main advantage of this is that tax liabilities are pushed back until the later years of ownership of the asset.

Sum of the year’s digit depreciation method

Here’s another method that accelerates the depreciation in the earlier years of ownership. It’s most appropriate to use on assets that have a greater production capacity in the earlier years, rather than the later years of ownership.

For example, computers may become obsolete quicker due to changes in technology. This means that depreciating more quickly at the start, based on lifespan and any end of use value, is more appropriate.

Unit of production depreciation method

With this method, it’s more relevant and appropriate to measure the life span of the asset by reference to the work that the asset is doing, rather than by reference to the time of ownership.

A good example of this would be a packaging machine that works on an ad hoc basis, rather than in continuous production. In this instance, it may be more appropriate to count the number of items packaged and calculate depreciation based on usage, rather than by age or period of ownership.

Modified accelerated cost recovery system method (MACRS)

The MACRS is another way to depreciate the cost of business assets in the United States. It’s the system that calculates the depreciation over the life span of the asset, allowing for larger charges in the early years and lower charges towards the end of the useful life of the asset.

There are specific depreciation methods and rates that have been set by the IRS, split by asset category.

In summary, all methods should be considered when reviewing the fixed assets in your business, to ensure accurate valuations and that company tax charges can be reduced.

Resources: IRS Publication – How to Depreciate Property

What Is Depreciation?

What Is Depreciation?

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