Many small business owners compile the business accounts without including depreciation. In some cases, they may include depreciation but with a low knowledge of the principles, making the figure stated no more than an educated (I'm being nice) guess.
For those business owners that use accountants to complete their financials, depreciation is something that can be left to the professionals. For the rest of us, it can be beneficial to have some understanding in this area even if it is the very basics.
This article will teach you the basics of depreciation helping you to make your accounts (balance sheet and profit and loss) more accurate for giving you a realistic financial position. Further, it can help you determine when an asset should be replaced, and what prices to charge for your products/service with respect to the profits lost each year by depreciation.
Finally, and most importantly. There is an undoubted link between lack of financial knowledge and business failure. Acquainting yourself with the basics of business accounting will almost certainly pay more dividends than learning about any other business discipline.
What is Depreciation?
An asset, say, a car or a machine, will never have the same value throughout its lifetime. As time passes, the asset loses value known as DEPRECIATION. There are many factors that cause depreciation of an asset:
Introduction of a newer, perhaps, more efficient asset (obsolescence)
Deterioration
Time (aging of the asset)
Level of maintenance
The Accounts and Depreciation
On the balance sheet, depreciation will be evidenced by the BOOK VALUE of the asset: original value less depreciation. For example, a machine is worth £1000 during one year, but depreciates by £300 in the next. On the balance sheet, this figure (£700) is what will be recorded within the assets section in the following year.
On the profit and loss, depreciation is listed under EXPENSES: recorded as the total amount of depreciation. In time, the accumulated depreciation will have covered the original (or close to) value of the asset. This occurrence is known as WRITING OFF.
Calculating Depreciation
Depreciation can be calculated in several different ways, but to avoid confusing you with many figures and formulas, we will look at the two most common methods used. As you will see, depreciation is not 100% accurate as some of the figures used for calculation are estimates: this is always the case for everyone.
1. Straight-line Method
This is the most commonly used method of depreciation and is relatively straightforward to understand. The theory behind it assumes that an asset should be depreciated in EQUAL amounts each year until it reaches its residual value (or scrap value). The residual value is the value that the business expects it to be worth when the asset has no use anymore. This value can often be nil but realistically, it usually has some value even if it is, say £10 worth of scrap metal.
Further, you must predict the expected life of the asset, i.e. the number of years that you believe the asset will be of use to the business.
To calculate each years depreciation using the straight-line method, the formula is:
Depreciation = Original Value (less) Residual Value / Expected Life
For example, a car is purchased at £16,000 and the business expects to use the vehicle for four years. The residual value is estimated at £4000.
Therefore,
Depreciation = £16,000 less £4,000 divided by 4 years = £3,000 per year
This figure will then be deducted from the previous years asset value giving the new Net Book Value (see table below). In addition, this figure will be added to the total expenses each year on the profit and loss account.
Year
Depreciation
Net Book Value
0
0
£16,000
1
£3000
£13,000
2
£3000
£10,000
3
£3000
£7000
4
£3000
£4000
Article Index 1. Introduction and Straight Line Method
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