When purchasing a tangible (physical) asset, you can’t expect that asset to hold its value for as long as you own it.
As time goes on, and you use the asset more and more and cause wear and tear, its value will decrease.
So how do you register this loss in value on your profit and loss and balance sheet?
In this article we’ll go through:
- What depreciation is
- The two main methods of calculating it
- And, which one is best to use
What is depreciation?
Depreciation is a way that businesses spread the expense caused by a loss of value over time. Depreciation is applied to fixed, tangible assets over the course of their useful lives.
Some examples of fixed assets are:
- Office equipment (desks, computers etc.
Why depreciate an asset?
Businesses depreciate assets to show the reduction in value over the course of their useful life. Recognising this ‘loss’ shows a true picture of the declining worth of the business’ assets – an important factor for the Balance Sheet, as well as the Profit & Loss.
An asset that you depreciate is generally one that is bought for a large sum of money – you wouldn’t depreciate paper for your printer but you would depreciate a new car or computer.
You might think that buying an asset in the first place would be reflected as an expense in your financial reports.
If I buy a car for £10,000, haven’t I lost £10,000?
Whilst this is true – that cash has left the business. However, you have also gained something of equal value during this transaction – a car worth £10,000!
This is why the asset is recorded in the balance sheet.
You may have spent a large amount, but you’ve also gained an asset of equal value.
This asset isn’t going to be worth the price you bought it for all of its life though. This is because as you use the asset it will start losing value.
This value is calculated through one of the depreciation methods (which we’ll talk about further down) that gives you a value to reduce the asset’s value by for each month/year.
What is an asset’s ‘useful life’ and how long is it?
An asset’s ‘useful life’ is an educated estimate of how long the asset will be worthwhile keeping for or how long the asset will be usable for.
It’s worth having a look to see what the common assumptions around the useful life of an asset are in your country and industry. For example, in the US, the IRS has set out guidelines for the useful life of many assets.
This “useful life” is the amount of time over which the asset is depreciated on the P&L.
We’ll demonstrate this in an example in the next section.
How do you calculate depreciation?
There are several ways that you can calculate depreciation. We’ll take a close look at the two most common methods.
Straight line depreciation
Arguably the most common method of calculating depreciation, because it’s easy to calculate and can be applied to all fixed assets.
Straight line depreciation works by simply dividing the cost of the asset (less any expected sell/scrap value) by the length of its expected useful life.
This spreads the cost evenly over each year that you depreciate.
Here’s the formula:
It’s known as the straight line method because if you were to plot this on a graph, the line would go down in a straight line, see below:
One of the main issues with the straight line is its accuracy.
It’s simple to calculate and understand that’s for sure, but it doesn’t always accurately reflect an asset’s value over the course of its useful life.
Take computers for example.
Computers often depreciate far quicker early on in their lives due to rapid improvements in technology, meaning they lose a lot of value quickly.
Straight line depreciation example
Let’s wrap all the bits of information we’ve just talked about into one example:
You own a factory and need to buy a new piece of machinery.
The cost of this machinery is £1 million.
You depreciate the machinery using the straight line method.
You expect the useful life to be 10 years, with a scrap/sell value of £100,000 at the end of these years.
This brings the total cost of your machinery to £900,000 (1M – 100,000 sell/scrap value)
Therefore each year your asset depreciates at £90,000 (900,000 / 10 years)
This means each month your asset will depreciate at £7,500.
This £7,500 is what hits your P&L each month, under depreciation.
This method (aka the declining balance method) places greater reductions in value earlier on in the asset’s life.
This is to represent assets that will quickly decline in value in the first months or years of their useful lives, such as cars or computers.
Although the amount and how quickly they depreciate will vary based on what the asset is.
This method is slightly more complex to calculate than the straight line method – here’s how you do it:
Like the straight line method, you’ll need to know:
Your asset purchase price, its estimated scrap/sell value & how long its useful life is.
Next you need to work out a percentage that you want to depreciate by. This can also be expressed as a factor: For example, a depreciation factor of 1 is 100% whereas 0.2 is 20%.
With this knowledge you can start calculating.
Take your purchase price, minus any sell/scrap value then times that by your depreciation percentage.
This gives you an amount to depreciate by each year.
The formula looks like this:
The trick is in the name when it comes to the difference between the two methods. In this method the depreciation rate is applied to a reducing balance – this leads to a high level of depreciation initially which then reduce over time.
By this I mean that whilst the depreciation percentage doesn’t change, the amount you are depreciating by does.
For example, you buy a car for 11,000 with a scrap/sell value of 1,000.
Your depreciation percentage is 10%.
First year this will depreciate by 1000.
Second year it will depreciate by 900.
And so on.
We get 900 in year 2 because we are depreciating from the value at the start of the second year. Which is 9000, this is the initial value minus the depreciation from year 1.
This is because each year you are depreciating by the assets current book value (what the asset is worth at the current point in time), rather than basing depreciating on its original purchase value.
Choosing the right method of depreciation
Choosing the appropriate method of depreciation is easy for most businesses.
Because most of them will use straight line for every asset!
They’ll do this simply because it’s easy to calculate, requires no readjustment and can be used for all fixed, tangible assets!
You might be thinking:
“If every business uses straight line, what’s the point of the other methods?”
And this is a completely valid question.
In theory, using reducing balance is a better option for some other types of assets.
I briefly alluded to this at the end of the last section.
Ever heard the saying?: “You lose 20% of a new car’s value as soon as you drive it out of the dealership”.
This applies to depreciation too. Assets such as vehicles are more likely to experience heavier depreciation in the first few years.
Which, at least in theory, makes straight line rather inaccurate for vehicles.
In this case, reducing balance would be more appropriate as vehicles depreciate faster at first, then level off over time.
Reducing balance will ultimately give you a more accurate and realistic depreciation rate for assets of this kind.
And more accurate data will help you make better decisions in the long run.
In its simplest form, depreciation is a way of spreading out the loss of value of an asset over the course of its useful life.
Sell and/or scrap value need to be estimated. If there’s any estimated value left in the asset at the end of its useful life then you’ll need to adjust your depreciation formulae accordingly.
The two most popular methods of depreciation are straight line and reducing balance.
Straight line works by dividing the cost of an asset (minus any sell/scrap value) by the length of it’s useful life.
Reducing balance is a little more complex, where the depreciation occurs at the same percentage rate annually, but is based on the book value of the asset rather than its original cost.
Reducing balance will be more suited to assets that depreciate more early on and less as time goes on – for example a vehicle.
Straight line is more suited to assets which depreciate in a more even nature – for example buildings.
If you’re a small business and can put the time into it, using a mixture of the two is the way forward as it’ll give you more accurate data to make better decisions. Alternatively tools like Brixx can automate depreciation, with a choice of methods all in just a few clicks!