What is Depreciation, and why Should you Care About it?
By understanding complicated topics such as depreciation in business, your business operations can be arranged in the most efficient structure possible. When it comes to depreciation, if you get it wrong, you might be overpaying on tax. Needless to say, this is wasteful and means you’re likely diverting important resources that could be used elsewhere.
Continue reading below for a complete guide to depreciation.
What is depreciation?
Depreciation is an accounting method that’s used to allocate the expense of an asset over its useful life.
Asset: An asset is any resource that possesses value and is owned or controlled by a business for the purpose of a future benefit. Assets are reported on a company’s balance sheet and can be bought or created. The future benefit of an asset might include increasing cashflow, reducing expenses or improving sales.
Useful life: The term useful life relates to an estimation of the number of years it’s likely that an asset will remain in useful service. The useful life is related to depreciation in terms of the number of years over which an asset’s value can be depreciated. Useful life estimates can be impacted by such things as usage patterns and the age of the asset when it was purchased.
Depreciation then, represents how much of the asset’s value has been ‘used up’. Depreciation allows a company to pay for an asset over a certain amount of time, whilst still earning revenue from them. By not having to account for ownership of an asset in the first year, the immediate cost of ownership can be significantly reduced. If a company were not to account for depreciation, this could have a significant impact on their profits. Assets can be depreciated for both tax and accounting purposes.
Appreciation of depreciation
Assets that a company utilises, such as machinery or factory equipment, can be incredibly expensive. Companies don’t have to realise the entire cost of that asset in the first year though. They can use depreciation to spread out the cost over the asset's useful life, writing off its value over an extended period of time.
Depreciation can also be applied to intangible assets.
Intangible assets: This is an asset that is not physically tangible. Intangible assets can include things like goodwill, brand recognition, and intellectual property (for example trademarks and patents). These assets are in contrast to tangible assets, which is a term that relates to things like land, equipment and vehicles.
The depreciation of intangible assets can sometimes be called amortisation. This is where accounting terminology becomes complex, as amortisation of intangible assets such as a brand is depreciation, however amortisation when applied to a loan, is the repayment schedule of the capital and interest.
Sometimes management are required to make certain assumptions relating to the expensing of depreciation. This might include the method and rate of depreciation, the length of the useful life and the scrap value of the asset.
Depreciation in business
Depreciation in business has three main purposes.
1. The cost of doing business
In order to understand how profitable a business is, there needs to be a clear understanding of all of the costs involved. Depreciation is one of these costs. Assets such as machinery and vehicles used in the business will wear down and will one day need to be replaced.
Depreciation accounting allows a business to calculate how much value of an asset is lost in any accounting period. The depreciation of assets is recorded on the profit and loss statement and is subtracted from the revenue to calculate profit. Failing to account for depreciation properly will result in an understatement of costs, which may result in a company that thinks it’s profitable, when in fact it isn’t.
Depreciating assets lowers the profits of a company. By lowering the profits, you can lower the tax exposure during any given accounting period. By not allocating depreciation correctly, there may be a situation where a company is paying more tax that it would otherwise have to.
There are strict rules relating to the depreciation of assets but over the useful life, the entire asset value can be claimed off of tax.
3. Balance sheet depreciation
The value of some businesses is inextricably linked to the assets they hold. For example, the valuation of a shipping company will be based on the number of ships it operates. The valuation of this company will be greater if the ships are brand new and high-tech. An identical company operating 20 year old ships will receive a lesser valuation.
Assets are listed on the company balance sheet in the fixed asset register. This register should be updated every time depreciation is calculated.
Assets can also be linked to securing capital. For example, by acting as security on bank loans. As these assets are depreciated, so is the value of capital that can be secured against them.
Many business expenses are tax deductible, but they’re not all depreciable. There is an important difference. Only fixed assets can be depreciated over a useful life. Whereas, consumable items that are deductible must be claimed for in the year that they are purchased.
Depreciation in business can seem daunting and the complexity of the language used to describe depreciation in practice doesn’t help. But, getting an understanding of depreciation can help lower costs and taxes, which are both positive things for your business.
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As we have discussed, depreciation decreases the value in company assets over time. There are strict accounting rules that relate to depreciation and these depend on the territory your company is listed in. These rules stipulate the detail, complexity and legality of practices relating to corporate accounting. Generally speaking though, there are several acceptable methods of depreciation that professionals use.
These methods are:
Straight line depreciation is the simplest way to calculate the asset value that’s lost in any given period of time. The calculation is simple:
(Asset cost – Asset Scrap Value) / Useful Life
The straight line method is attractive because it is simple to understand and apply. The calculation is easy to perform and the depreciation value is identical for each accounting period over the useful life of the asset.
This simplicity is also a weakness. The calculation uses the useful life assumption; however, this is susceptible to being rendered incorrect by advancements in technology making the asset obsolete earlier than expected. The accelerated loss in value of assets in the short-term is also missed by straight-line depreciation, as is the expectation of increased servicing costs related to older machinery towards the end of its useful life.
This method should be used for simple assets that can be reasonably expected to have a steadily declining value over time.
Declining value depreciation is an accelerated depreciation system that records larger depreciation expenses during the first years of the asset's useful life. As the asset ages, the depreciation gets smaller.
Declining value depreciation is calculated by:
Current Book Value x Depreciation Rate
The current book value is the asset’s value at the start of the accounting period.
The depreciation rate is defined by the usage of the asset over its useful life. This may be an estimate based on experience with other similar assets.
An asset that’s worth £10,000, with a scrap value of £1,000, might depreciate at 30% of it’s value each year. If the asset has a useful life of 10 years, in year 1 the depreciation expense is £2,700, in year 2 it’s £1,890, and so on.
This method is best suited to assets that lose their value more quickly. This may include technology assets such as computers and other high-tech equipment that are more useful at the start of their lives.
Unit of production depreciation is a way of calculating depreciation when the asset value is linked to the number of units it produces. This is opposed to the value of an asset being linked to it’s useful life in years.
This method can result in different depreciation amounts for periods where use is non-linear. For example, if the asset is heavily used in year 1, but then used less in year 2, the depreciation will be greater in year 1.
To calculate the unit of production depreciation:
((Asset Value – Scrap Value) / Estimated Production Capability) x Units per year
This method is dependent upon the proportion of the asset’s production capacity that is used up in that accounting year. This method allows companies to make larger deductions during years where the asset is heavily used. This may be advantageous if a company wants to offset higher costs that can be associated with greater production.
The depreciation of an asset using this method begins when it produces its first unit and ends when the final unit of its estimated production capability is finished.
In summary, why should you care?
As a business, assets are put to use to grow the business and increase revenues. All businesses that put assets to use need to understand depreciation, by doing so the effects of depreciation timing and calculation methods can be used efficiently.
Assets increase the valuation of a company. Performing depreciation allows a company to reflect the true value of it’s assets as time passes by. This might lower the valuation of the company as a whole, which seems counterproductive, but this is important as the reported figures in accounts need to match up to the reality of the operation. By not depreciating accurately there may be an undetected discrepancy between a company that appears profitable on paper, and a company that when assets are considered, is loss making.
The accountancy rules surrounding depreciation require expertise to navigate. As with many aspects of accounting and tax, there are nuances, risks and opportunities when it comes to depreciation. Engaging with professional advisors is a great way to mitigate the risks while maximising the opportunities. Finding the right advisors to partner with can sometimes be difficult, but if you know where to look, there are market-leading experts out there that can level up your financial reporting and allow your business to grow.
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