Depreciation

Depreciation is a concept that does initially cause a bit of confusion when people first look at it, as they can’t understand an expense which doesn’t cost you any cash.  It isn’t like a rent expense, where you will get the bill, and then have to pay some cash out.

It also causes a little bit of concern, because as accountants we like to think we have everything perfect, for example your bank account balances off to the penny, and everything is spot on.  The thing people don’t like about depreciation is that your depreciation figure is almost certainly going to be wrong!

So, let’s recap as to what depreciation is, why it doesn’t cost you cash, and why your depreciation figure is going to be wrong.

Depreciation

Depreciation

Depreciation is a concept that does initially cause a bit of confusion when people first look at it, as they can’t understand an expense which doesn’t cost you any cash.  It isn’t like a rent expense, where you will get the bill, and then have to pay some cash out.

It also causes a little bit of concern, because as accountants we like to think we have everything perfect, for example your bank account balances off to the penny, and everything is spot on.  The thing people don’t like about depreciation is that your depreciation figure is almost certainly going to be wrong!

So, let’s recap as to what depreciation is, why it doesn’t cost you cash, and why your depreciation figure is going to be wrong.

As items get older, more worn, or more out of date, the value of them goes down.  I like to bring my old Rover 75 into every article I write, and this is a great example of depreciation in action.  A brand new Rover 75 was £25,000 when it was released back in 1999.  Would you pay £25,000 for a Rover 75 now?  They are currently going for under £2,000 on Auto Trader.  This is because they have been used, they are worn, they have been replaced by more up to date cars, so they have fallen in value.  If we had purchased one back in 1999 and still owned it, we wouldn’t still value it at £25,000 if we held it in the accounts as we know it isn’t worth that now.  To show the fall in value of the car, we would enter a provision each year to reflect this in our accounts, and we call this depreciation.  This is only an accounting adjustment; we don’t pay any cash out for depreciation.

Depreciation is an estimate for how much we feel the asset is falling in value by.  This is where the uncertainty comes in, it is a best guess.  Something is only worth what someone is willing to pay for it, so we won’t actually know what something is worth until we sell it.  Until that point, we just have to put in a provision which we feel reflects how much an asset is falling by, and by how much.

There are two main ways in which we can depreciate an asset.  There are others, but these are the two main ones that you will come across.

Straight line depreciation.

One is straight line depreciation, sometimes known as ‘on cost’ depreciation.  This assumes that the asset is going to fall in value by the same amount each year over a set number of years.  Let’s say we have an asset that is worth £6,000, and after 3 years we feel it will be worthless.  Using straight line depreciation, we would depreciate the asset by £2,000 per year, each year for three years. At the end of the three years, it has fallen to a value of zero.  Straight-line depreciation spreads the cost of the depreciation equally over the period of use.  Large pieces of machinery are items that I would depreciate using straight line as it would typically give it’s benefit equally over the period that it’s being used.

Note: this also fits in very neatly with the ‘accruals’ concept as we are matching the cost of the machine with the benefit, we derive from owning it; spreading the cost over the period of it’s useful life.

 

This sounds relatively straight forward but there is a slight complication with straight line depreciation and that is residual value.  This is when you feel that the asset is going to have some value when you stop using it.  You may feel that someone else might buy it off you, or you might be able to sell it for scrap.  If you are going to get some economic benefit from the disposal of this asset, the amount of value that it is going to lose is going to be less.  In our example of an asset worth £6,000, if we feel that at the end of the 3 years, we can sell it for scrap metal for £1,500, then in fact, over three years it will only fall in value by £4,500, (£6,000 – £1,500).  Therefore, using straight line depreciation, each of the three years will be £1,500.  This is where the room for error comes in, as how would you know that in three years’ time you will get exactly £1,500 for the asset?  You probably won’t, and this difference is known as a profit or loss on disposal.  However, that is a subject for another day!

 

Reducing balance.

The other common method of deprecation is reducing balance depreciation.  This method allocates more of the depreciation in the first few years of ownership, and less in the later years.  This is useful for assets which fall a lot in value initially and less so later on.  An asset that I feel reducing balance is appropriate for is cars. We all know that as soon as you drive a brand-new car off the forecourt, it is immediately worth less as it is no longer a brand new car.  As it gets older though, the amount that it falls by gets less and less. Is a 9-year-old car worth that much more than a ten year old car?

To calculate reducing balance, we take a percentage off the assets value at the start of the year.  If we bought an asset for £10,000 and we decided to use 20% reducing balance depreciation, we would have depreciation of £2,000 in year one, and therefore the asset is then worth £8,000.  The difference to straight line depreciation then comes in year two.  We are now going to take 20% of the assets new value of £8,000.  Then the depreciation charge in year two will now be less at £1,600.  Then less the following year and so on, as the value of the asset falls.  However, again this is only a best guess as to how much the asset is falling in value.

One method of depreciation isn’t better than another; and there are others. You should use which ever you think would give you the best estimate of how your asset is falling in value.

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