The concept of depreciation may seem daunting at first, but once understood, it can have numerous beneficial applications to your business. Put simply, depreciation is losing value of a business asset over time. Depreciation can be quite complex, so it is a good idea to consult a professional when first approaching it.
Applications of depreciation
Depreciation, as stated earlier, is the loss of value of a business asset. When an asset depreciates, it must be replaced; this gradual replacement of assets contributes to the costs of a business. Depreciation accounting, or the yearly figuring of how much value was lost from business assets, provides a value that needs to be removed from revenue when determining profit. When depreciation is ignored, your business will underestimate its costs and miscalculate yearly profit.
Assets lose value, and because the value of your business is directly related to these assets, your business can lose value too. A fixed asset register – where your assets are listed on your balance sheet – must be updated regularly to accommodate for depreciation. It’s important to remember that assets are often used to get finance, so as your assets drop in value, so does your security, and it may be more difficult to secure loans.
The specifics of depreciation
A lot of business expenses are tax-deductible, but that does not necessarily mean they are depreciable. For most businesses, only fixed assets are depreciable. Fixed assets are those that continue to contribute to the generation of profit over a period of multiple years. These depreciable assets can be owned, such as tools, machinery, and computers, or can be leased by the business. Physical assets are not the only depreciable assets; intangible assets, namely patents and copyrights, are highly subject to depreciation as they reach their expiry date.
Scheduling and calculation of Depreciation
Depreciation scheduling involves the estimation of an asset’s lifespan, which is dependent on the type and usage of the asset (see the HMRC depreciation schedules for specific assets). Changes to the depreciation schedule can occur when an asset’s value is set to 0 if the asset is lost, stolen, or damaged, or if the asset is combined with other assets if it is bought, sold, or traded.
“Straight-line depreciation assumes that an asset depreciates consistently and by the same amount each year.”
Calculation of depreciation tends to follow a few main pathways. Straight-line depreciation assumes that an asset depreciates consistently and by the same amount each year. The diminishing value of depreciation calculation assumes that an asset depreciates more in the first few years and that percentage of value loss slows over time. Unit of production depreciation uses the assumption that depreciation is more directly tied to the work contributed by an asset rather than the length of time the asset serves.
In order to have the best and most beneficial experience with depreciation, be sure to seek a financial advising professional!