What is depreciation in accounting?

4 min read

Depreciation accounting is an essential metric. It will impact the way you value your business, balance your books, report on your tax return and how you treat the purchasing and useful life of your fixed assets. So, what is depreciation?

While slightly complex, understanding the principles and practice of depreciation in your small business accounting is an area you should become very familiar with.

Let’s take a quick look at the purpose of depreciation, methods of calculating depreciation and how it’s deployed.

What is depreciation?

What exactly is (and what is the purpose of) depreciation? Put simply, depreciation is an accounting term referring to the gradual devaluing of a business-related asset over its useful life.

Business assets age and deteriorate. You’re able to use this lowering value of the asset to balance your books and accurately portray asset value, profits, and loss. 

What are capital assets and expenditure?

In the UK, such depreciating assets are known as ‘capital assets’. A capital asset is a piece of equipment used for business purposes, such as a digital device, vehicle, or office furniture, which will be useful for at least a year of operation.

If you spend money on capital assets, the HMRC refers to this as ‘capital expenditure’.

Capital assets are distinct to ‘revenue expenditure’, which refers to the regular running costs of your business.

Depreciation and tax

As you may be aware, in the UK you’re not allowed to claim depreciation directly for tax purposes. 

‘Capital allowances’ will be used instead to potentially lower your taxes by writing off capital assets.

UK capital allowances rules

In the UK, depreciation is calculated and framed under ‘capital allowance’ rules.

Again, you can’t directly gain tax breaks from the depreciation of an asset. 

This doesn’t mean you don’t get a direct tax benefit. Instead, the HMRC grants ‘capital allowances’ which gives the ability for allowable business assets to be deducted from your profits to lower your taxes.

So, if you’ve depreciated an asset on your balance sheet for accounting purposes, you need to add this back in to accurately portray profits.

Small business depreciation 

For the most part, putting depreciation to work in your small business is deftly managed by enlisting the assistance of an accountant or bookkeeper. 

By combining this professional consultation with the automating prowess of a cloud accounting solution, you’ll be all over this necessity of business accounting.

Depreciation and profit

When you approach your business’s profits and losses for the year, you need to account for depreciation. By not doing so, you’ll get a skewed idea of your assets and their value and thus the value of your business. 

For accurate accounting and a full understanding of the financial standing of your business, knowledge and deployment of depreciation must be fostered.

Different methods of calculating depreciation

In the UK, there are two primary methods of calculating depreciation. The more straightforward method is known as ‘straight line depreciation’. The slightly more complex method is known as ‘reducing-balance depreciation’. 

Straight line depreciation

Straight line depreciation (or simplified depreciation) is a very simple fraction-based method that’s easily understood. 

For each year of the useful life of the asset being depreciated, you simply divide the original purchase price by the number of years.

For example, if a piece of furniture will be useful to the business for a period of three years and cost you £1,200, you divide the price by the number of years and get a yearly depreciation of £400.

This is the most basic and easily deployed form of depreciation.

Reducing-balance depreciation

Reducing balance depreciation, also known as declining balance depreciation, is a more complex method. It’s suitable if the fixed asset needs to be depreciated more in its early years as it will realistically drop in value more quickly than other assets.

This method suits most machines, IT equipment and cars. These assets don’t hold value evenly over their lifetimes.

Firstly, you’ll need the following information:

  • original asset cost 
  • salvage value (end of life value)
  • depreciation factor (determined by market)

Then, for each year you which to determine depreciation for accounting purposes:

Depreciation per annum = (net book value – residual value) x depreciation factor (rate %)

As you can see, there are a lot of complexities in this method and there are also a few ways of going about it and several possible formulas. 

As such, when approaching depreciation accounting and pondering ‘what is depreciation and what does it mean for my business?’, your most fruitful avenue is to consult with a tax professional and remove any possibility of error.