What is depreciation?

Managing the finances of a small startup, a large enterprise, or something in between? You need to understand how your assets factor into your finances, including what happens as these assets inevitably depreciate. But what is depreciation? How does depreciation work, how is it calculated, and how does it affect your business’s financial statements and future?

Here, we answer all your depreciation-related questions, helping you to get a better grasp of your business finances and potentially saving you money in the process. 

What is depreciation and how does it work?

Depreciation is an accounting concept that represents how assets lose value over time. Almost every asset — from computers and heavy machinery to vehicles and structures — wear out, become outdated, and lose value from year to year. 

Depreciation acknowledges this and works by spreading the cost of an asset over its useful life, rather than recording the entire expense when you first buy it. As a result, it gives you a much more accurate picture of your business finances, helping you to match the expense of using an asset with the revenue it generates during its lifetime.

Understanding your company’s depreciation can help to reveal your true financial position beyond your initial purchase costs, and show you how your asset values evolve over time.

What items depreciate the most?

Assets lose their value at different rates. Some depreciate quite quickly, with their value declining substantially over relatively short periods of time, while others lose their value more gradually.

• Technology and IT equipment typically lose between 50 and 60% of their value within the first year, and often become nearly obsolete within three to five years. This is largely because of how quickly technology advances — a brand-new laptop today will likely start to look like a relic before the decade is up. 
• Vehicles depreciate significantly, with new cars commonly losing between 20 and 30% in the first year and up to 50% by year three.
• Heavy machinery and industrial equipment depreciate at varying rates depending on how intensely they’re used and the technological innovation seen in their relevant sector. 
• Office furniture typically depreciates more moderately, often at 10 to 15% every year, particularly for standard items. Bespoke items can have more variable rates of depreciation.
• Buildings and structures generally depreciate at the slowest rate, with commercial buildings often losing just 2 to 3% of their value annually.

There are a number of factors that accelerate the rate at which assets depreciate, including rapid technological advancements, their usage, harsh operating environments, regulatory changes, and an oversupply of similar used assets.

Is it better to depreciate or expense?

The choice between expensing an asset upfront or depreciating it over time depends on several important points:

• The status of your cash flow: Expensing provides immediate tax relief, and reduces your tax liability in the current year. Depreciation spreads this benefit over several years, creating a more gradual tax advantage. 
• Your business’s lifecycle: Start-ups might prefer expensing to maximise early tax benefits, while established businesses may benefit from the steadier financial picture depreciation provides.
• Your tax planning: Current tax incentives like the Annual Investment Allowance may make it worth expensing your assets immediately. Be conscious of ensuring that this aligns with your broader tax strategy, though. 
• Your financial reporting processes: Depreciation often presents a more accurate picture of business performance by matching costs with the revenue those assets help generate over time.
• The value of your assets: Higher-value assets (generally above £1,000) are typically depreciated, while smaller purchases can be expensed to make your financial administration simpler.

There isn’t a one-size-fits-all approach to depreciation, and the route you choose will depend on your business circumstances, current tax legislation, and long-term financial goals. If you’re unsure, speak to your accountant. They’ll be able to guide you on the method that suits you best.

What are the different methods of depreciation?

And how is depreciation calculated?

OK, so how do you calculate depreciation? There are several different methods you can use, each with their own characteristics that are uniquely suited to different types of assets and business circumstances. 

No matter which method applies to your situation, you’ll always need several key pieces of information, including:

• The asset’s initial cost
• Its estimated useful life
• Its expected residual value (if applicable)

Let’s explore these methods one at a time, and take a look at how they work in practice. 

Straight-line depreciation

This is the most straightforward approach, and refers to instances where an asset’s value decreases by equal amounts every year during the course of its useful life. This method is particularly suitable for assets that depreciate steadily over time, like office furniture or buildings. Straight-line depreciation’s calculation looks like this: 

(Cost – Residual value) ÷ Useful life = Annual depreciation

So, if a £10,000 machine has a residual value of £1,000 and a useful life of five years, the annual depreciation would be (£10,000 – £1,000) ÷ 5, which equals £1,800.

Reducing balance depreciation

This method is also called declining balance, and it applies a fixed percentage to the asset’s remaining value each year. It creates larger depreciation expenses in earlier years that gradually diminish. As a result, it works well for assets that lose value more quickly in their early years, like vehicles or IT equipment. To calculate it:

Net book value × Depreciation rate = Annual depreciation

Using the same machine example with a 30% rate, the first-year depreciation would be £10,000 × 30% = £3,000, leaving a remaining value of £7,000. Second-year depreciation would be £7,000 × 30% = £2,100, and so on.

Sum-of-years-digits (SYD)

This is an accelerated depreciation method that allocates higher depreciation expenses in earlier years. It involves creating a fraction where the numerator is the remaining years of useful life, and the denominator is the sum of all digits in the useful life:

For our five-year machine, the denominator would be 15 (1+2+3+4+5). 

First-year depreciation would therefore be (5/15) × £9,000 = £3,000, second-year would be (4/15) × £9,000 = £2,400, and so on.

Units of production

calculates depreciation based on actual usage rather than time. This method is ideal for machinery or equipment whose wear relates directly to their production volume rather than their age.

(Cost – Residual value) ÷ Estimated total production = Depreciation per unit

Depreciation per unit × Units produced that year = Annual depreciation

Each method will affect your financial statements differently, so choosing the appropriate approach depends on the nature of your assets, your reporting needs, and the tax regulations that apply to your business or sector. Again, chat to your accountant if you need a little clarity.

How does depreciation affect your business’s financial statements?

Depreciation influences how your business’s financial position is presented and interpreted. It significantly impacts three key financial statements:

• The income statement (profit and loss): Depreciation appears as an expense, reducing your reported profit without affecting your cash flow. This expense represents the portion of an asset’s cost consumed during the accounting period. Higher depreciation charges lower taxable profit, potentially reducing your tax liability, while providing a more accurate picture of your true operational costs.
• The balance sheet: Assets are recorded at their historical cost less accumulated depreciation, showing as net book value. As depreciation accumulates over time, the carrying value of fixed assets decreases, reflecting their declining value. This affects important financial ratios like return on assets and asset turnover ratios that investors and lenders monitor.

• The cash flow statement: Depreciation is added back to net profit when calculating operating cash flow, as it’s a non-cash expense. This adjustment helps reconcile accounting profit with actual cash generated by operations. That’s why a business with substantial depreciation charges may show modest profits but strong cash flow.

The depreciation method you choose can substantially affect your reported profits, particularly if you work in an asset-heavy industry. It’s important that you apply your depreciation policies consistently if you’re going for meaningful financial analysis and comparison between different accounting periods.

Quickfire summary

What is depreciation in simple words? Well, depreciation reflects how assets lose value over time, allowing you to spread your business costs across an asset’s useful life rather than absorbing the full expense when you buy it. There are several methods to choose from to calculate depreciation, and which one you select should align with your specific assets and business needs:

• Straight-line is for steady depreciation
• Reducing balance is for assets that lose value quickly in their early years
• Sum-of-years-digits is for accelerated depreciation
• Units of production is for usage-based calculations

Understanding your depreciation provides a more accurate picture of your business’s financial health, affects your tax position, and influences key financial ratios. Master this concept, and you’ll make more informed business decisions and set your business up for success.