What is Depreciation?
Your business is made up of all sorts of assets. Some are current and short-term, while other assets are fixed and with you for the long term. These fixed assets usually decrease in value over a given time period. This decline in value is known as depreciation.
In accounting terms, however, the definition of depreciation is more specific. Here, 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.
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 by the asset’s useful life.
20,000 - 5,000 ÷ 10 = £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
This is where an equal depreciation expense is reported for each year of the asset’s useful lifetime.
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.
Units of production
Depreciation expense is calculated each year based on an estimation of units produced.
Sum-of-the-year’s digits (SYD)
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.
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 (such as 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.
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