Just like your phone, computer, or car, most things lose value over time. While this loss of value is unavoidable, businesses can harness an asset’s lifetime and depreciative worth to enhance their overall financial health.
This process is called depreciation, and it helps manage both your tax and your asset lifecycles. The Office of Tax Simplification defines it formally as the “systematic writing down of a tangible fixed asset to determine the carrying value of an asset in a business’s financial accounts.” By calculating the cost of an asset over its lifetime, businesses can yield many practical and financial benefits.
Read on and discover these benefits, as well as what qualifies as a depreciable asset, the diverse types of depreciation methods you can use, and how to calculate depreciation.
Suppose you have recently started a construction business. To get things moving, you need clients, a workforce, and the tools and equipment to carry out your hard-won contracts. Depending on the project’s size, this could involve purchasing a range of heavy machinery, including diggers, cranes, excavators, and bulldozers.
This also means a large bill for you to foot at the beginning of your company’s lifespan.
While these are necessary costs, there are ways to mitigate them. Depreciation is one such useful strategy. By depreciating your assets, you spread their costs over their respective lifetimes. This means that, in your accounting books, the overall cost of an asset is spread out over the years rather than being recorded as a single, exorbitant sum.
Depreciation helps businesses match the cost of using an asset with the revenue it generates, making huge purchases more manageable and carrying certain tax advantages.
Depreciation does not impact the initial cost of the assets you purchase for your business purposes.
What it does do, however, is offer certain tax and practical bookkeeping benefits, such as:
Understanding how depreciation works in accounting is essential for any business. It can become a little complicated, so here’s a breakdown to guide you through the main points.
When you purchase an asset, its overall cost is spread across the number of years that you expect it to remain useful. You calculate this as the total cost of the asset divided by its predicted life expectancy.
For instance, if you purchase a £10,000 printer for your magazine business and it has an expected lifespan of 10 years, then your financial statements will list this printer at a cost of £1,000 every year for 10 years, after which you’d expect to replace it.
Typically, you can calculate taxable profit by working out your overall cash turnover minus your tax-deductible business expenses. When you have a depreciable asset, the cost of this is also negated from your taxable profit, which means more money for your business at the end of every fiscal year.
For instance, if you report an annual turnover of £150,000, but your tax-deductible business expenses equate to £80,000, then £70,000 of your profits will be taxed.
But if you have depreciable assets totalling £30,000, this number adds to your tax-deductible expenses, meaning only £40,000 of your profits will be taxed.
However, the UK government approaches depreciation and tax differently through a system of capital allowance.
In the UK, the government does not account for depreciable assets as a valid form of tax relief. This means that, in the UK, you don’t deduct depreciation directly from your taxes. Instead, you claim back money lost through depreciation by applying for capital allowance (CA).
There are several forms of capital allowance that you can apply for when filing your annual tax return:
Through these allowances, you can either get a tax refund on 100% of the cost of the asset (covered by an AIA) or have part of its value returned to you year-on-year (covered by a WDA at fixed rates). Capital allowances can be claimed for:
While these terms are often used interchangeably, they are different:
Understanding the difference between these terms is essential, as business owners can often confuse the distinction between depreciation and devaluation.
Depreciation is a helpful way of managing your books by calculating the annual loss of value for a particular asset up until the end of its useful life. There are three principal ways by which you can measure depreciation in your business accounting :
Straight-line depreciation is the most easily understood and recognisable form of depreciation in accounting, which spreads the cost of an asset equally over its expected years of service.
If you bought an industrial loom for £50,000, and it was expected to last for 10 years with good regular maintenance, then its depreciative value year-on-year would be £5,000, or 10%.
Eventually, the value of the loom would reach £0, at which point it would be replaced with a new asset.
Also known as declining balance depreciation, this method calculates depreciation as a fixed percentage of its remaining book amount rather than its initial cost.
Take the £50,000 industrial loom once more. With a fixed depreciation rate of 10%, it would be worth £45,000 after year 1. After year 2, it would be worth 40,500. Year 3 = 36,450. After 10 years, the loom would still be worth £17,433.92.
Through this method, the asset’s value decreases most dramatically in the first years of its lifespan before lessening over time. This means that the value of depreciation decreases year by year rather than remaining constant.
This method calculates depreciation based on the asset’s actual output rather than applying fixed rates of depreciation. This is useful for gauging depreciation as it is affected by use rather than generalised wear and tear.
This method relies on calculating the specific unit value of the asset. To do this, you need to know the residual value of the asset (what you expect it to be worth at the end of its lifetime) and the estimated units of production (how many units it is likely to produce in its lifetime).
Say you expect the £50,000 loom to be worth £10,000 by the end of its life, and it is designed to produce 100,000 units of clothing over its entire lifetime. You would subtract £10,000 from £50,000 to get £40,000, and then divide this number by 100,000 to get £0.40 per unit.
If the loom makes 15,000 clothes in the first year, then 15,000 x 0.4 = £6,000 (first-year depreciation value).
Use the table below to gauge which depreciation method is best suited for your business needs.
Smaller businesses can substantially benefit from depreciation methods. Whether you are just beginning your entrepreneurial journey or you have been in operation for a few years, anyone can profit from learning depreciation as an accounting technique to help bolster your finances and gain crucial asset and financial management skills.
Get started with depreciation accounting by following this short guide:
Identify all the tangible items your business possesses that are used in your operations, have a lifespan of more than two years, and are not consumed within the company.
Now identify which of these assets are depreciable and covered by the UK government’s capital allowance scheme using the list provided by gov.uk .
Using any of the three main depreciation accounting methods above, calculate the depreciative value of each of your assets and record them in your books.
If you want to get tax relief from your business assets straight away, consider choosing an AIA. If you want to gain fixed tax relief from your assets over a long-term timespan, consider selecting a WDA instead.
Make sure to keep detailed bookkeeping on all the assets you have calculated depreciation for and are claiming relief through capital allowances.
Complete your business’s tax return and claim capital allowance for the assets that are eligible for tax relief. HMRC may request evidence, so ensure that your bookkeeping is up to date and accurate.
Now you have a deeper and more complete understanding of depreciation accounting and how it can meet your business needs.
Still unsure which depreciation method to use or how to claim capital allowances? Our team can help you get set up smoothly – contact us for expert guidance, or start your business with Rapid Formations today.
There are three main types of depreciation methods:
In the UK, you can’t directly deduct depreciation from your taxable profit. Still, you can claim tax relief through capital allowances, which you can apply for on your tax return, provided your assets meet governmental criteria.
Depreciation is a useful method for keeping track of your financial wellbeing, managing your assets, and gaining valuable tax relief to reduce your business costs.
You can use any of the three main depreciation methods to calculate the depreciation value of your equipment. If you wanted to use the straight-line method, for example, you would divide the total cost of your equipment by its predicted lifespan to work out its annual depreciation value.
Yes, small businesses in the UK can claim depreciation through capital allowances. This allows small businesses to claim tax relief on their qualifying assets, including vehicles, machinery, and industrial equipment.