Depreciation is the way accounts spread the cost of a long-term asset, such as a van, machine or computer, over the years it is used. Instead of showing the full cost as an expense in the year you buy it, a share of the cost is charged each year.
It gives a fairer picture of profit, because the cost of the asset is matched with the years in which it helps earn income. It does not involve any cash leaving the business, and it is not deductible for tax.
Why it matters
Imagine you buy a £30,000 machine that will last five years. If the whole £30,000 hit your profit and loss account in year one, that year would look poor and the next four would look better than they really were. Depreciation evens this out, charging part of the cost in each year.
On the balance sheet, the asset is shown at its cost less the depreciation charged so far. This is its net book value. It is an accounting figure, not a valuation, and may be quite different from what you could sell the asset for.
Straight line method
The straight line method charges the same amount each year. You take the cost, deduct any expected value at the end of the asset's life, and divide by the number of years you expect to use it.
For example, a van costs £24,000. You expect to keep it for four years and sell it for £4,000. The annual depreciation is £24,000 less £4,000, divided by four, which is £5,000 a year.
Reducing balance method
The reducing balance method charges a fixed percentage of the remaining net book value each year. The charge is higher in the early years and falls over time, which suits assets such as vehicles that lose more value when new.
Using 25 percent on the same £24,000 van:
- Year one: £6,000, leaving £18,000
- Year two: £4,500, leaving £13,500
- Year three: £3,375, leaving £10,125
Whichever method you choose, it should reflect how the asset is used up, and be applied consistently from year to year.
Depreciation and tax
Depreciation is not deductible for tax. When we prepare your tax computation, the depreciation charge is added back to profit and replaced with capital allowances, which are set by law.
For most equipment and vans, capital allowances give relief for the full cost in the year of purchase, through the Annual Investment Allowance or, for companies, full expensing. So the tax relief often comes much faster than the depreciation in your accounts. Cars are relieved more slowly.
This is why your taxable profit and your accounting profit are usually different numbers.
Selling an asset
When you sell an asset, the sale price is compared with its net book value. If you get more, there is a profit on disposal in the accounts. If you get less, there is a loss. A large profit or loss on disposal is a sign the depreciation rate may not have been right.
For tax, the sale is dealt with through capital allowances. If you have already had full relief, the sale proceeds are usually taxable.
Why it still matters to you
Although depreciation does not affect cash or tax, it does affect the profit figures that others rely on. Lenders look at profit when assessing borrowing. Buyers look at it when valuing a business. And a company can only pay dividends out of accumulated realised profits, which are reduced by depreciation.
If you track profit in management accounts each month, include a monthly depreciation charge so the figures are not overstated.
What to do
- Keep a fixed asset register showing each asset, its cost, date of purchase and depreciation.
- Review useful lives and rates if you regularly make large profits or losses when selling assets.
- Include depreciation in your monthly management accounts.
- Remember that tax relief comes from capital allowances, not depreciation.
If you would like help understanding the numbers in your accounts, book a free call.
