In relation to a small business, depreciation means the decrease in value of something your business owns (an ‘Asset’).
For example, you might own a Macbook Pro that cost £2100. It will certainly last more than a year (you’d hope!). So, depreciation is used in the accounts to show how the value of the MacBook drops over the years.
These accounting rules are needed because otherwise your accounts would potentially look like you were:
a) Making too much money (not taking into account the drop in value)
b) Making not enough money (if you wrote the whole cost off in one year).
Two common methods of depreciation
There are two common methods of showing this in the accounts:
- the ‘straight line’ method
- the ‘reducing balance’ method
Both show the loss of value over time.
The straight-line method
This is probably the most common of the two. It works like this.
- First we calculate how much an asset (equipment) is worth at the end of its life
- We work out what that lifespan might be, say, say for example 5 years
- We then divide the purchase cost over 5 years in equal instalments
- This way, we write the piece of equipment off over that 5 year period
The reducing balance method
The ‘reducing balance’ method does the same thing, but reduces by a set percentage each year. This means you generally have a larger depreciation charge early on, which reduces later. Some owners may feel this more accurately reflects the life of the piece of equipment.
Deprecation: an example
For example, let’s say your brand new MacBook Pro (other laptops are available!) will be worth £100 on eBay for parts in 5 years’ time.
Under the ‘straight line’ method, the depreciation would look like this in the accounts:
- £2100, less the eventual scrap value of £100 = £2000
If we divide by 5, this then gives us the yearly ‘charge’.
|Depreciation Charge||MacBook Accounts ‘Book Value’|
As you can see, the ‘book value’ comes down each year. This doesn’t always reflect market value, as your MacBook might be be worth less then £900 in year 3. It’s just the way the accounts deal with the reduction in value.
If you were to sell or dispose of the laptop, the value might be different from the book value. This gets adjusted in the accounts at the time you do that, so it is not a problem.
How does depreciation work in regard to tax?
HM Revenue & Customs don’t allow depreciation as a tax deduction. They have a special set of rules called the ‘Capital Allowance’ rules. These are basically the HMRC version of depreciation.
You still follow the accounting rules for depreciation. When your tax is worked out by HMRC, the depreciation in the accounts is ignored and replaced with a separate calculation for Capital Allowances.
The allowances work in different ways, from allowing you 100% of the cost against your tax in one year, to giving you 6% each year of the cost.
The details of depreciation and tax are more than we can cover in this short blog. As a rule of thumb, most equipment your business will buy (vans, laptops, drills etc) will be eligible for capital allowances. These ‘good’ capital allowances allow you to deduct 100% of the cost from your profits before they are taxed, all in year 1
At the time of writing, as a limited company, if you buy new equipment you may qualify for 130% tax relief under the ‘Super Deduction’ rules up until 2023.
Depreciation key takeaways
Our key takeaways for you:
- The accounting depreciation rules are there to make sure your accounts mean something. Without them, you wouldn’t accurately be able to tell the true profit your business makes.
- When looking at accounts, you can see the ‘book’ value of the assets won’t always be their current market value because of the way depreciation works.
- Depreciation isn’t allowable against your tax bill, but the Capital Allowances rules that replace this can be quite generous.
Help to appreciate depreciation
Ask your accountant or book a consultation with us to help you make the most of asset depreciation.
We offer a paid 1-hour, 1-2-1 consultation so you can ask simple questions of an accountant. There’s no obligation and you don’ need to be a client of ours, so it’s a great way for you to get the help you need, when you need it.