Depreciation – What Is It?

Depreciation is a term that is often used in accounting but usually without any explanation.  In a nutshell it is the amount by which a business asset, such as a machine or van, reduces in value over it’s lifetime.  The cost of anything that is used in the business can be offset against tax over  a number of years as it is a cost of doing business.

The period over which some items are depreciated is controlled but, unless an asset falls into that category there are two main methods by which depreciation is calculated – reducing balance or straight line.

Reducing Balance Depreciation

Using this method the depreciation on an item is higher at the beginning of it’s life span.  If you chose to use this method and you chose to depreciate the asset over 5 years at 20% per year, you would take the new value each year and calculate 20 % of that  figure. As an example if you chose to depreciate a new machine that cost £2,000 over 5 years the first years depreciation would be £400, (2000 x 20%), the second year would be £320 (1600 x 20%), the third year £256 (1280 x 20%).

Straight Line Depreciation

Straight line depreciation is a little easier to calculate.  You simply divide the cost of the aset by the number of years you expect it to be useful and reduce it’s value by that amount each year.  Using the previous example, each year the value of the asset would reduce by £400 each year.

Why Is Depreciation Important

Depreciation is important for three main reasons:-

1:- It is an expense of doing business, assets only have a limited life span and then have to be renewed so the reduction in value of assets has to be factored in when calculating your cost of production.

2:- Depreciation affects the amount of tax you pay.  It is a cost of doing business and so can be offset against  your profits, allowing you to put money aside to renew equipment as and when necessary.

3:- Depreciation affects the value of  your business.  New equipment has a higher value so is worth more to your business, older equipment has less value so as it ages the value of your business assets becomes less.

There are many fine details on how depreciation can be applied and how it affects different business items – fixed assets depreciate using different methods and there are special rules for certain classes of asset.  However neglecting to take proper account of it will affect your profitability and the value of  your business.  For detailed advice, consult your Bookkeeper who will be able to give you accurate information and make sure that the correct methods and amounts are applied to your accounts.  

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