Why is depreciation important in accounting?

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Why is depreciation important in accounting?
Delivery vehicles are subject to depreciation, which is offset against tax liability. (Michael Blann/Lifesize/Getty Images)

Depreciation is used by accountants to reflect the diminishing value of a business asset. An asset is a single item that is used year after year. Depreciation of assets should be taken into consideration as it affects the value of a company. Simplistically, if a business purchases a van, the overall value of the business increases by the price of the van (in actuality, this won't be so, because the cost of the van will be reflected elsewhere in the accounts as a debit). Over time the value of the van will decrease. The amount of depreciation in any one year is called the “Written Down Allowance,” or “WDA.” The percentage that can be written back is determined by HMRC.

What items attract depreciation

Assets able to be depreciated are any assets that have monetary value after purchase. For instance a purchase of printer paper would not be depreciated because it is a consumable product and would have no appreciable resale value. However, a laser printer will have some value after a year. Other examples of assets are vehicles, machinery, high-value tools, catering equipment and computers.

Why is depreciation important in accounting?
Catering equipment is an example of a business asset. (Erik Snyder/Digital Vision/Getty Images)

Straight-line depreciation

There are two ways to calculate depreciation, and which one you use depends on the asset itself. The first and simplest method is “straight-line depreciation.” A good example to use would be a computer. If you spend £999 on a laptop and decide that in three years it will be worth nothing, simply divide the purchase price by three and use that figure on the balance sheet. Therefore, £999/3 = £333. After three years, the asset is not included on the balance sheet.

Why is depreciation important in accounting?
Depreciation of computers is best calculated using the straight-line method. (Jupiterimages/Photos.com/Getty Images)

Reducing balance depreciation

This method would apply to assets that are likely to have residual value. It is also useful where assets, such as motor vehicles suffer from high depreciation in the first years. A fixed percentage rate is applied to calculate the depreciation, and then that figure is deducted from the purchase price of the asset to estimate its value after one year. The following year the depreciation is deducted from the previous year's value, and so on.

Using the company delivery van and an annual depreciation of 20 per cent (as set by HMRC) as an example:

Purchase price: £10,000. Year 1 depreciation: £2,000 (£10,000 × 20 per cent). Year 2 depreciation: £1,600 (£10,000 - £2,000 = £8,000 × 20 per cent). Year 3 depreciation: £1,280 (£8,000 - £1,600 = £6,400 × 20 per cent)

After three years the van is deemed to have a value of £5,120 (£6,400 - £1,280) for accounting purposes. However, if the van is sold for more than that value, the difference is taxable.

Annual Investment Allowance

Since 2008, HMRC has introduced an Annual Investment Allowance (AIA). This means that every business has an allowance (check the HMRC website for the current AIA) that can be spent on assets every year and claimed against tax liability at the current rate. For small business, this means that they can offset every purchase made during that year. For further information consult your accountant.

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