Mechanic pumping up a car tyre | Depreciation: What it means and how to calculate it

Depreciation: What it means and how to calculate it

April 20, 2023
Accounting for expenses is an essential part of being a business owner, and while it’s easy to write off smaller expenses, capital assets, such as vehicles or machinery, can be harder to do so.To understand the value of an asset over the years, you’ll need to get to grips with depreciation. Not only does asset depreciation affect the bottom line of your income statement, but you tax bill and business, too.Read on to learn more about how depreciation works, why it matters and how the different methods of depreciation can be calculated.

What is depreciation?

Depreciation is the process of an asset losing value over time until it becomes either zero or negligible. This can affect almost any type of fixed asset, from office equipment and technology, to machinery and buildings.However, one type of fixed asset that’s exempt from depreciation is land, which gains in value or appreciates over time. This is dealt with separately under inventory accounting.Intangible assets — that is, non-physical items, such as patents and copyrights — can also be depreciated or amortised. These are highly valuable to your business and their value will gradually reduce as they near their expiry.Various accounting techniques exist for depreciation calculations to measure the decreasing value of assets and how to show their book value in your accounts. As this area of accounting can be complex, it’s recommended to always consult with an accounting professional.

Functions of depreciation

As wear and tear counts as an expense, depreciation accounting is essential for understanding the overall cost of running your business and its valuation.There are three main depreciation methods that you need to be aware of before you start your depreciation calculations. We’ll outline these later, but first there are some important terms you need familiarise yourself with.
    The useful life of the asset describes the length of time that an asset is to be considered to be productive. Once an asset reaches the end of its useful life, it’s no longer cost-effective to continue to use it.The salvage value defines the value of the asset when sold at a reduced rate at the end of its useful life.The cost of the asset describes the total cost of an asset, including set up expenses, taxes and shipping.
Typically, new assets have a greater value than older ones. Depreciation measures the value that an asset loses over time – both from wear and tear from ongoing usage, as well as indirectly from the introduction of new products and factors such as inflation.The 3 main functions of depreciation are as follows:

Depreciation expenses (cost of doing business)

In order to understand how profitable your business is, you need to have a clear idea of your costs. Depreciation should be considered as one of these, as assets wear out over time and need to be replaced.Depreciation accounting is you can work out the amount of depreciation that’s taken place across the year. You’ll need to list your accumulated depreciation on certain financial statements, such as your profit and loss statement, and can be subtracted from your revenue when working out your profit.By not accounting for depreciation, you’ll be underestimating the total amount of business costs — and therefore, the amount of money your business is actually making.

Depreciation and tax

Accounting for depreciation is also essential from a tax perspective, too. By knowing what your annual depreciation looks like, you could be due for tax deductions — and over enough time, you could claim the entire value of an asset off of your tax bill.
However, it’s important to be aware that strict rules exist around how quickly you can depreciate certain assets for tax purposes. For this, it's always recommended to get in touch with an accountant.

Depreciation on your balance sheet and valuing your business

As assets age and lose their value, your business can too. All your assets need to be listed on your balance sheet on what is known as the fixed asset register. The register needs to be updated whenever you work out your depreciation calculation.It’s also important to know that assets are often taken into consideration when you apply for a business loan. As assets decrease in value, they offer less security and it may be more difficult for you to secure finance.

What is a depreciation schedule?

To work out the amount a purchase has depreciated, you’ll first need to calculate its lifespan. While a piece of production machinery could last 15 or 20 years, a work van may only last 4 or 5.A depreciation schedule is a table that shows how much different types of assets will depreciate over the years.Information in a depreciation schedule includes:
    A description of the assetDate of purchasePurchase priceExpected useful lifeDepreciation method usedSalvage valueDepreciation amount deductible in the current yearCumulative depreciation amountResulting net book value of the asset (purchase price minus cumulative depreciation)

How to calculate depreciation

Straight-line depreciation method

The most common way to work out the depreciation of a fixed asset is by applying the straight-line method.If opting to use the straight-line method, the asset depreciates by the same value every year until its value reaches 0.For instance, if you had a vehicle that is expected to last 5 years, it would depreciate by 1/5 of its ticket price every year.You calculate straight-line depreciation using the following formula:
Straight-line depreciation = (Asset Cost – Residual Value/Useful Life)

Unit of production depreciation method

Another method of depreciation involves calculating depreciation by measuring the work of an asset, rather than the length of time it serves.With the unit of production method, equal expense rates are assigned to each unit of production. This means that depreciation will be based on output capacity instead of the number of years.The calculate this form of depreciation, you'll first need to work out the per-unit depreciation using this formula:
Per-Unit Depreciation = (Asset Cost – Residual Value)/Useful Life in Units of Production
Next, you need to calculate the total depreciation based on the units that have been produced:
Total Depreciation = Per-Unit Depreciation x Units Produced

Double-declining balance depreciation method

The double-declining balance method describes an accelerated form of depression, where a higher percentage of value is lost in the early years of an asset’s useful life.This type of depreciation method is useful when assets are consumed more quickly during their first years.The formula is as follows:
Depreciation = 2 x Straight-Line Depreciation Rate x Book Value at the Beginning of the Year

Why does depreciation matter for small businesses?

Depreciation accounting will help you to gain a fuller understanding of the real costs of doing business. You’ll also have a more accurate view of how profitable your business is, as you’ll need to replace your assets after a certain amount of time.
Depreciation and tax go hand in hand, as lower profits equal lower taxes. If you don’t account for depreciation, you could end up paying more tax. By claiming these as capital allowances, you may be able to claim up to the entire value of a fixed asset off your taxes.

It’s also worth noting that depreciation is important for valuing your business, as the declining value of its assets could mean your business is declining in value, too.