Depreciation and amortisation in accounting
In this post:
- What is depreciation
- What is a useful life?
- Why do assets lose their value?
- Why is depreciation important to record in books
- How does depreciation work in practice?
- Depreciation Methods
- How to record depreciation
- Impact on financial statements
- Conclusion
If you are studying bookkeeping or running a business, you will often come across the depreciation term. It may sound complicated at first, but in this article, you will find what depreciation is, why it matters and how to use it in practice with simple UK-based examples.
What is a Depreciation
Assets that the business owns—such as equipment, vehicles, buildings, and computers—do not last forever. As they are used, they wear out, become outdated, or lose value.
Depreciation is the periodic allocation of a certain amount as a loss in the asset’s value. If you bought a car today, every year it will lose its original value until the worth of the car is residual, or very small. That loss in value is calculated through the entire useful life of an asset.
What is a useful life?
It is a period you believe this asset would make the most of. As an example, the laptop may have 5 years of useful life, while a car may have 10 years.
Some business assets have only a limited number of years to use, like laptops, cars, and manufacturing equipment. As it gets used and old, its value diminishes.
Other business assets have an indefinite number of years to use, and these do not lose value. Examples are investment property, building or equipment in construction, stock or inventory.
Why do assets lose their value?
There could be many reasons for the asset to lose its value:
- Physical wear and tear of equipment, resulting in reduced performance
- Shift in the market pricing results in a lower value of the items than it was originally bought for
- With time, the item becomes obsolete or unusable, or unsafe to use.
So, we need to reflect the loss of value in our accounts.
Before we move into depreciation methods, let’s remember the asset classes: tangible and intangible. Tangible assets that a business owns can be physically seen or touched, and intangible assets that are also owned by a business cannot be physically seen.
Tangible assets examples:
- Machinery & manufacturing equipment
- Vehicles used in business
- Buildings (offices and warehouses)
- Technology devices
Intangible assets examples:
- Copyright and patents
- Franchise and licensing agreements
- Trademarks and trade names
- Copyright for plays, books and photography
- Client’s database, customers’ contracts
The tangible assets depreciate, and intangible assets amortise, but only for a limited useful life, like trademarks. Some intangible assets are not amortised and instead reviewed annually.
The process of reviewing intangible assets and how valuable they are according to the balance sheet is called impairment.
By now, we have established which assets are depreciated and amortised.
Why is depreciation important to record in books
- Provides a reliable value of an asset
- Shows the actual profit for a year
- Important in making an investment decision to replace assets
- Better transparency and accuracy
We know an asset loses its value over time, which we need to reflect in our accounting books.
Businesses need to allocate the original purchased value in the period the asset was used to generate the revenue. Thus, complying with the matching accounting principle – recognising expenses in the accounting period- helped to generate revenue.
Costs that match revenue, these help to produce an accurate and reliable view of profitability.
How does depreciation work in practice?
- Buy an asset and record it in the accounting system
- Decide on the useful life
- Choose a depreciation method and stick to it
- Calculate and journal depreciation yearly
Depreciation methods
Straight line
A straight line method calculated the depreciation equally over the useful life of an asset after deduction of its residual (final) value. Price paid – £1,000, and we expect this asset to last for 5 years and be valued at zero. This means we divide £1,000 over 5 years = £200 per year is our depreciation amount.
If you expect the asset to be worth something in 5 years, say £100. We then need to deduct this first from our initial amount £1,000-£100= £900 and then divide by 5 years = £180 per year.
That value we expect to find at the end of useful life is called a residual value. Residual value is an estimate of the future cost less any expenses related to the disposal of this item. It is more often used for a large asset, like a factory.
Reduced balance
The reduced balance or written down value method is based on a fixed percentage, which is used to reduce the balance each year.
Using the earlier example, the business has paid £1,000 in year 1, and we have chosen a fixed rate of 20%. For this year 1, we calculate depreciation as follows: £1,000 x 20% = £200. This leaves a balance of £800.
In year 2, we multiply our balance, not the original amount, by 20% and get £160. Then at the end of year 2, £800-£160, our balance will be £640.
The same process applies till the balance is NIL.
How to record depreciation
There are two accounts for depreciation: depreciation charge – an increase in expense for profit and loss, and accumulated depreciation for the relevant type of asset (computer, vehicle) for the balance sheet.
Manual journal for depreciation:
DR depreciation charge
CR accumulated depreciation
Impact on financial statements
The depreciation has an impact on various financial statements.
On the balance sheet statement, we reflect the original cost of an asset less the accumulated depreciation over the years. This shows a realistic value of an asset. Investors can rely on this data to make decisions in capital expenditure and replacement of assets, which is a vital part of the budget and planning.
On the profit and loss statement, a yearly depreciation cost is deducted. This expense reduces accounting profit. For tax purposes, depreciation is adjusted and replaced with capital allowances. This deduction allows effective assessment of the cash flow and ability of a business to pay for its expenses, loans, and dividends to shareholders.
Conclusion
Depreciation is an important item in accounting if you have assets in your company or a self-employment business. By now, you have learned the basics and understand not only what depreciation is, but also about methods and practical use.
Next step, why not download the asset register to keep your assets and depreciation overview organised?
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