What is Depreciation in Business

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what is depreciation?

Depreciation in business is an accounting term.  When a business buys a fixed assets it will use it for a number of years.  Therefore, in accounting, there is a way to reflect this cost apportionment. These rules apply whether the fixed asset is paid for in full or on finance.

What is a Business Fixed Asset

fixed asset is an item which a business purchases and uses to generate its income.

Unlike an asset like stock which you may buy to sell onto customers, a fixed asset is an overhead which you buy to run your business.  A fixed asset however is not classified as an overhead because it will last for more than one year.

An example of a fixed asset is a:

  • Laptop
  • Printer
  • Vehicle
  • Building

What is Depreciation in Business

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 adopted by a business reflects:

  • The length of time the asset will last for and;
  • How it’s used to generate business income.

How to Calculate Depreciation in Business

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 means the number of years the asset will remain in use by the business and contribute to income generation.

For example: if you buy a new laptop and expect to keep it for 3 years before it needs replacing. The useful life of the computer is 3 years.

Step 2: Choose Depreciation Method

The cost of a fixed asset can be written off against profits 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 of Straight Line Depreciation:

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 based on the remaining value rather than the original cost.

Example:

You have purchased a company pickup truck for £44,000. You estimate it will lose 30% of its value in the first year. Depreciation for the first 5 years is:

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 of Business Depreciation On Your Financial Statements

Whichever method of depreciation used, depreciation every year is shown in the profit and loss account. This reduces business profit each financial year as an overhead.  It is a reflections of the use of an asset each year as you generate income.

The reduction in profit therefore lowers retained profit each year. Hence lowering shareholders funds on your balance sheet.

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