In business, depreciation’s meaning is twofold. The simplest definition is the way a company’s assets lose their value over time. In accounting terms, depreciation refers to the value of an asset over its useful life.
Accounting for depreciation helps to improve a company’s understanding of its asset turnover and quantify how much the value of the asset justifies its cost.
Depreciation occurs in all kinds of physical or tangible assets, from vehicles and computer hardware to machinery and plant. Failing to account for asset depreciation can have a profound impact on your company’s profits.
What is the purpose of depreciation?
Accounting for depreciation helps companies to better understand the true cost of doing business and estimate the value of the company. The wear and tear of assets over time is classed as a business expense, and as such it has tax implications.
The main reasons companies track depreciation are:
- to quantify depreciation as a loss
- to determine how much of the asset’s value can be declared as a loss for tax purposes
- to gauge the accurate value of the company overall. A company with depreciated assets will be worth less than a company with the exact same turnover but newer assets
Example of depreciation
Businesses often invest in capital expenditures like machinery and equipment to improve their business operations. Depreciation allows companies to spread out an asset’s cost and generate value throughout the life of the asset. The depreciation rate will depend on how long your business uses the asset for.
For instance, let’s say your company buys a piece of machinery for £20,000. You can expect this machine to function for around 10 years. This is its useful life. Rather than claiming for the asset in one financial year, businesses will instead use depreciation to move the asset’s cost from its balance sheet to its income statement.
At the end of its useful life, the machine is sold for a scrap value of £5,000. The depreciation expense is calculated as the difference between the asset’s cost and its scrap value, divided the asset’s useful life.
20,000 - 5,000 ÷ 10 equals £1,500 per year in depreciation expenses.
Thus, the company can gradually write off the value of the asset over time and thereby boost its net income.
Different types of depreciation
Different assets depreciate in value at different rates. The tracking of asset depreciation over time is known as a depreciation schedule. There are numerous types of depreciation that can be applied to a schedule.
This is where an equal depreciation expense is reported for each year of the asset’s useful lifetime. The formula for calculating this is (cost – salvage value) / useful life.
Example of straight-line depreciation
If a restaurant buys a new tablet for its front-of-house team and uses it for 10 years, it is likely to depreciate in value fairly consistently over time. As such, when the company sells the tablet it will use the straight-line depreciation method to gauge the van’s value over its useful life.
Here, as assets depreciate, the depreciation expense declines each year. The asset depreciates at its straight-line depreciation percentage multiplied by its remaining depreciable amount with every passing year of its useful life.
Example of declining balance
Machinery and plant will often be good examples of declining balance. With each passing year, not only is the machinery subject to greater wear as the company grows and it experiences more usage, other machinery is developed with greater capabilities as time goes by.
Units of production
The units of production method is often used to describe depreciation of manufacturing assets. here, depreciation expense is calculated each year based on an estimation of units produced. This helps to gauge its production efficiency.
Example of units of production
A company buys a PET bottle-making machine in 2020. In its first year of production, it is able to make 1,500 bottles per hour on average . By 2023, it is capable of making 1,000 bottles per hour due to increased idle time from repairs and maintenance.
Sum-of-the year’s-digits (SYD)
Also known as sum-of-the-year’s-depreciation. Here the depreciation rate is calculated by combining each digit of the asset’s expected useful life. This is another form of accelerated depreciation that can make it easier to reconcile asset expenses with other overhead costs over time.
Example of SYD
SYD is often used to calculate the lifetime value of vehicles as they lose most of their value within the first few years of use. As long as the vehicle is well maintained, its depreciation will plateau after its initial drop in market value.
If a removals company keeps a van for 5 years, the sum of the years’ digits would be calculated by adding: 5 + 4 + 3 + 2 + 1 to get a total of 15. As such, its depreciation schedule might look something like this:
- year 1: 5/15 = 33%
- year 2: 4/15 = 27%
- year 3: 3/15 = 20%
- year 4: 2/15 = 13%
- year 5: 1/15 = 7%
Frequently asked questions about depreciation
How does asset Depreciation work for tax purposes?
Businesses accountants often create depreciation schedules in line with tax benefits under HMRC’s guidelines. Rates vary depending on the asset, but businesses can typically expense around 15% - 20% of the overall value of an asset over each year.
What is accumulated Depreciation?
Accumulated depreciation refers to all of the depreciation that has been recorded on an asset up to a specified date (e.g. the end of its useful life). Accumulated depreciation is recorded as a credit on the company’s balance sheet.
What is an asset’s carrying value?
The carrying value of an asset represents its historical cost minus the accumulated depreciation over time. An asset will have a higher carrying value in earlier years, and this will decline as the asset nears the end of its useful life. After all depreciation has been deducted, the asset’s carrying value is referred to as its scrap value or salvage value.
What is a depreciation schedule?
A depreciation schedule shows how much an asset will depreciate in value over the course of its useful life.
It typically includes:
- a description of the asset
- purchase date and price
- expected useful life
- salvage value
- depreciation method used
- depreciation deductible for the current year
- cumulative depreciation
- the asset’s net value (price paid-cumulative depreciation)
Is depreciation classed as a fixed cost?
Most methods treat depreciation as a fixed cost as the amount is set each year and is not impacted by company activities.
There are, however, some exceptions to this such as the units of production method. Under this method, the costs are variable as the more the asset is used, the higher its depreciation expense will be.