The decline in the value of assets over time is like the passage of time itself: it is inevitable.
Over the years, many assets lose value – and your fancy new office equipment, state-of-the-art computers, and state-of-the-art office buildings are no exception. It’s called depreciation (DEPN).
DEPN is also an accounting practice that allows your company to keep track of wear and tear on its assets.
This can reduce your taxable income and provide a more accurate picture of your company’s financial performance.
In this article, we will cover the meaning of DEPN and why it is important. We will also discuss different forms of DEPN and the commonly used formulas to calculate DEPN costs.
What is depreciation?
DEPN is the process by which physical (or investment) assets lose value over time, resulting in their final value being less than their purchase value. It indicates how much value assets have lost over a certain period of time.
DEPN can occur in two ways:
- Direct DEPN arise from the continued use of an asset, for example through wear and tear, whereas indirect DEPN can arise from the introduction of a product upgrade or even inflation.
Almost all physical assets lose value, with the exception of real estate, which appreciates (or increases in value) over time.
- Intangible assets also lose value, but this is known as amortization. This refers to intangible assets such as intellectual property, which includes copyrights, patents and trademarks.
Why is depreciation important?
As a small business owner, DEPN is important for tax and accounting reasons.
The main tax benefit is that DEPN allows your business to deduct the cost of acquiring assets from its taxable income not just over one year, but potentially over several years — reducing your taxable income and therefore your tax liability.
Essentially, if you don’t allow DEPN, your business could potentially end up paying more taxes than it should.
And when it comes to accounting, DEPN enables your business to produce better financial reports.
DEPN gives you a clear indication of how much value your assets have lost over time. If you don’t factor this into your revenue, you may be underestimating your costs.
By spreading the cost of an asset evenly over its lifespan, you don’t run the risk of overinflating your profits when you purchase the asset or understating your profits in subsequent years.
DEPN is also important in other situations, such as when you are valuing your business or applying for a business loan, in both cases taking into account the current value of your assets.
Depreciation terminology
To determine DEPN, you must first familiarize yourself with some important accounting terms.
One term is useful life, which refers to the period of time an asset is productive. After this time, further use is no longer economical.
Another reason is residual value (or salvage value), which is the reduced value of an asset after its useful life – sometimes referred to as “scrap value.” This may be based on a prior professional estimate or a percentage estimate of an asset’s value at the end of its useful life.
The penultimate term you should know is the cost of an asset. This is the original purchase price of an asset including taxes and any setup or delivery costs.
And the last term is book value, which is the value of an asset recorded on the balance sheet. It is calculated by subtracting DEPN from the cost of an asset.
How to calculate depreciation
There are three main methods to calculate your annual DEPN expenses.
1. Straight DEPN
Linear DEPN is the simplest and most popular method for calculating DEPN.
It is often used for devices that lose value at the same rate every year until it reaches zero. For example, if your asset has a useful life of 20 years, its value would decrease by 5% each year.
The formula is:
Cost of Asset – Residual Value of Asset / Useful Life of Asset = DEPN Expense
Let’s say your company buys a top-of-the-line computer for £5,000 that has a useful life of 5 years and a residual value of £1,000.
Here is the calculation:
1. Depreciation basis = Cost of asset: £5,000 – Residual value: £1,000 = £4,000
2. Annual DEPN costs = Depreciation basis: £4,000 / Useful life of asset: 5 years = £800 per year
The advantage of linear DEPN is that costs are spread evenly across each billing cycle, making them completely predictable.
A potential disadvantage is that it is not easy to accurately calculate the useful life of an asset. It’s usually a matter of making an educated guess, and if you’re wrong, the asset could be overvalued in the years to come.
2. Decrease in balance DEPN
Reducing Balance DEPN is an accelerated form of DEPN used when dealing with an asset such as a car or van that loses more of its value in the early stages of its useful life.
The formula is:
Book value x (1/useful life) = DEPN expense
Suppose the top computer you purchased costs £5,000 with a useful life of 3 years and a DEPN rate of 40%.
Here is the calculation:
Year 1
Book value: £5,000
DEPN: Facility Cost: £5,000 x DEPN Rate: 40% = £2,000
Book value at the end of the year: Book value: £5,000 – DEPN: £2,000 = £3,000
Year 2
Book value: £3,000
DEPN: Book value: £3,000 x DEPN rate: 40% = £1,200
Book value at the end of the year: Book value: £3,000 – DEPN: £1,200 = £1,800
Year 3
Book value: £1,800
DEPN: Book value: £1,800 x DEPN rate: 40% = £720
Book value at the end of the year: Book value: £1,800 – DEPN: £720 = £1,080
An advantage of reducing equilibrium DEPN is the higher accuracy compared to straight-line DEPN. At the beginning of an asset’s useful life, when it reaches peak productivity, you receive larger tax write-offs.
One disadvantage is that this DEPN calculation can be a little more complicated than other methods. Typically, this involves creating a DEPN schedule that shows the DEPN costs for each year of an asset’s useful life.
3. Production units DEPN
In certain circumstances, it is more logical to determine DEPN by measuring how much work the asset does, rather than how long it lasts.
The production units method commonly used in manufacturing focuses on how many units a device can produce before it is no longer useful. It assigns an equal DEPN rate to each unit of production.
The formula is:
(Number of Units Produced / Total Number of Estimated Units) x (Cost of Asset – Residual Value of Asset) = DEPN Expenses
Imagine our top computer costs a staggering £50,000 and has a residual value of £5,000. The total number of estimated units is 100,000 and the units produced during this period are 10,000.
Here is the calculation:
1. Depreciation basis = Cost of asset: £50,000 – Residual value: £5,000 = £45,000
2. DEPN per unit = Depreciation basis: £45,000 / Estimated total number of units: 100,000 = £0.45 per unit
3. DEPN for the period = Units produced during the period: 10,000 x DEPN per unit: £0.45 = £4,500
An advantage of this method is that the DEPN calculation is more accurate because it is related to the number of units a device produces.
However, since the number of items produced by the facility is likely to fluctuate from month to month, you must keep accurate records. Unlike linear DEPN, these numbers cannot be automated.
If you are unsure which DEPN method to use, your accountant can advise you based on the assets you have in mind.
Final thoughts
DEPN provides you with the ability to establish a correlation between the cost of a physical asset and its utility or ability to generate income from one year to the next.
Instead of recording the entire cost of an asset at the time of purchase, DEPN allows you to spread the cost over its useful life, which is beneficial from a tax and accounting perspective.
DEPN can not only help you reduce your tax bill and provide a clearer picture of your company’s financial health, but also help you plan for future capital expenditures, ensuring your assets are replaced or upgraded in a timely manner.
Keeping all of these potentially business-boosting benefits in mind will give you a new appreciation for DEPN.
