What is Depreciation?

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what is depreciation?

What is Depreciation?

Depreciation is the accounting method of spreading the cost of a fixed asset over a certain period of time which is greater than one year. The method of depreciation you adopt should reflect not just how long the asset will last for but also how the asset is used to generate business income.

How to Calculate Depreciation

Step 1: Estimate Useful Life of Your Asset

To calculate depreciation you first need to make an estimate of the useful life of the asset. Useful life in accounting refers to the number of years the asset in question will remain in service to the business and contribute to income generation. For example: if you buy a new laptop you may estimate that you will use the laptop for 3 years before it becomes obsolete and need replacing.  Therefore the useful life of your computer equipment is 3 years.

Step 2: Choose Depreciation Method

Once you have worked out useful life, then in accounting your fixed asset can be written off over useful life in two different ways:

Straight Line Method of Depreciation

The straight line method is the simplest way to depreciate fixed assets where you write off the asset over the useful life in equal amounts.  The calculation is:

Depreciation = Cost of Fixed Asset / Useful Life of Fixed Asset

Example:

You have purchased a laptop for £1,000 with a useful life of 3 years.  Therefore the laptop will be depreciated at £333.33 per year for 3 years (£1,000/3 years).

Reducing Balance Method of Depreciation

The reducing balance method of depreciation is used if an asset depreciates more at the start of its life compared to the end of its life. It is particularly applicable if you have an asset that loses significant value at the beginning of its life, such as a van or lorry.

In the first year you depreciate the asset by a percentage and then in the following years depreciate the asset at the same percentage but based on the remaining value rather than the original cost.

Example:

You have purchased a company pickup truck for £44,000 and estimate it will lose 30% of its value in the first year. Depreciation for the first 5 years would be worked out as follows:

Year  Value Depreciation     (30%) Book Value remaining
1  £44,000.00  £13,200.00  £30,800.00
2  £30,800.00  £9,240.00  £21,560.00
3  £21,560.00  £6,468.00  £15,092.00
4  £15,092.00  £4,527.60  £10,564.40
5  £10,564.40  £3,169.32  £7,395.08

The Effect On Your Financial Statements

Whichever method of depreciation you choose, the amount you depreciate your asset by each year will be shown in your profit and loss account, reducing your profit each financial year as an overhead.  This reflects the use of your asset each year as you generate income.

The reduction in profit therefore means retained profit each year is reduced, hence lowering shareholders funds on your balance sheet.

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