Depreciation is the reduction in value of a business asset over time. If you purchase a laptop today, it will gradually become less useful and less valuable over the next few years.
This loss in value happens for many reasons:
- Regular use
- Aging
- Wear and tear
- New technology making the asset obsolete
Rather than recording the full cost of an asset as an expense in the year you buy it, depreciation allows you to spread the cost over its useful life. This gives a more accurate picture of your profits each year and ensures your accounts reflect the asset’s real value.
The Impact of Depreciation
1. Understanding the True Cost of Doing Business
Every business owner needs to know how much it truly costs to run their business. Depreciation is one of those hidden costs.
As assets age and lose value, they will eventually need replacing. Spreading the cost over several years shows the real cost of using those assets to generate income.
2. Producing Accurate Financial Reports
Depreciation appears on your Profit and Loss Statement, reducing your reported income.
If you do not include it, your profits may look higher than they actually are. This can mislead internal stakeholders, investors or lenders.
3. Valuing Your Business Correctly
Depreciation affects your Balance Sheet. This shows Fixed Assets at their current book value, not the original purchase price. As an asset depreciates, its value decreases.
This adjustment gives a more realistic view of your business’s net worth, which is especially useful when applying for loans or considering a business sale.
Assets You Can Depreciate
Not every purchase qualifies for depreciation.
You will typically use up consumable items, such as paper or cleaning supplies, rather quickly. This means you can claim them as expenses in the year of purchase. However, fixed assets last longer than a year which means you can depreciate them.
These fixed assets include:
- Computers
- Office furniture
- Factory equipment
- Vehicles
- Tools
Land is the exception, as it does not wear out and you cannot use it up. Therefore, you are unable to depreciate it. Similarly, you should handle stock and inventory separately through inventory accounting.
You can also depreciate intangible assets, such as software and trademarks, through a process called Amortisation. However, they are not eligible for Capital Allowances unless they fall under specific rules.
Choosing the Right Depreciation Method
Once you have identified a depreciable asset, you will need to select how its value will decrease over time. The three most common methods are:
1. Straight-Line
This is the most straightforward method. You divide the asset’s cost evenly across its useful life. It is predictable and simple.
If a printer costs £1,000 and you expect it to last four years, you record £250 in depreciation each year.
2. Reducing Balance
This method applies a fixed percentage to the remaining book value each year. It reflects how some assets lose more value early in their life.
With a 20% rate and a £1,000 asset, you would record £200 in depreciation the first year. In the second year, you would take 20% off the remaining £800.
3. Units of Production
Some assets wear down based on how much you use them. It suits machinery or vehicles with predictable usage.
If a van costs £120,000 and you expect it to run for 300,000 miles, each mile equals £0.40 in depreciation.
If you drive 30,000 miles in the first year, you record £12,000 in depreciation.
Recording Depreciation in Your Accounts
Depreciation appears as an expense on your Profit and Loss Statement and reduces the asset’s value on your Balance Sheet.
It also tracks the total depreciation charged over the years in a separate account called Accumulated Depreciation. This allows you to see how much of an asset’s value you have used and how much remains.
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This article is for general informational purposes only and does not constitute legal or financial advice. While we aim to keep our content up to date and accurate, UK tax laws and regulations are subject to change. Please speak to an accountant or tax professional for advice tailored to your individual circumstances. Pi Accountancy accepts no responsibility for any issues arising from reliance on the information provided.