How to calculate depreciation using three methods

How is depreciation calculated? This question has always been crucial for entrepreneurs. Asset depreciation can be accounted for in various ways, with the final amount depending on the chosen method. In the UK, depreciation itself is not directly deductible. Instead, businesses use capital allowances to gradually offset the cost of eligible assets over time.

What purpose does calculating depreciation serve?

Depreciation is a key accounting practice that accounts for the gradual reduction in the value of business assets over time. It enables businesses to spread the cost of an asset over its useful life, helping with financial reporting.

However, for tax purposes, depreciation is not recognised as a deductible expense in the UK. Instead, businesses can claim capital allowances to reduce taxable profits by offsetting the cost of qualifying assets.

To better understand the concept of wear and tear, check out this article on the basic principles of depreciation, which covers key aspects of depreciation. To summarise:

• Business assets (e.g., machinery, vehicles, office equipment, and buildings) naturally lose value over time due to factors such as wear and tear, obsolescence, or usage.
• Intangible assets (e.g., patents, copyrights, and software) also depreciate, although they are typically amortised instead.
• For tax purposes, businesses can claim capital allowances.

What are capital allowances?

In the UK, capital allowances allow businesses to deduct the cost of certain capital assets from their taxable profits. Instead of claiming depreciation, businesses use capital allowances to spread the cost of assets over time. Key types include:

• Annual Investment Allowance (AIA): Allows businesses to deduct the full cost of qualifying assets up to a set limit in the year of purchase.
• Writing Down Allowance (WDA): Applies a percentage-based deduction on the asset’s value each year, typically 18% (main rate) or 6% (special rate).
• First Year Allowance (FYA): Provides a 100% deduction for qualifying energy-efficient and environmentally friendly assets.

These allowances help businesses reduce their taxable profits and manage investment costs efficiently.

How is depreciation recorded?

Depreciation is recorded as an expense on the income statement and reduces the book value of the asset on the balance sheet. Over time, the cumulative depreciation is reflected in a contra-asset account called Accumulated Depreciation.

Types of depreciation in the UK

There are three primary depreciation methods used in this country:

1. Straight-Line Depreciation (SLD): Spreads the asset’s cost evenly over its useful life.
2. Declining Balance Method (DBD): Accelerates depreciation by applying a fixed percentage to the remaining book value each year (e.g., Double Declining Balance - DDB).
3. Units of Production Method (UPD): Bases depreciation on asset usage, such as machine hours or miles driven.

In the UK, businesses generally use capital allowances for tax purposes, rather than depreciation methods like those mentioned above. However, for financial reporting, straight-line depreciation is commonly used to reflect the reduction in value of assets over time.

How to calculate depreciation with examples and tips

To calculate depreciation accurately, you need to know:

• The asset’s purchase date
• The asset’s acquisition cost
• The asset’s estimated useful life (expressed in financial years)

Straight-Line Depreciation (SLD) calculation

Straight-line depreciation spreads an asset’s cost evenly over its useful life. In the UK, businesses generally use straight-line depreciation for financial reporting purposes, though there are different rules for tax purposes under capital allowances.

Annual Depreciation Expense = (Acquisition Cost - Salvage Value) / Useful Life (in years)

Example: Depreciating a laptop purchase

Let’s assume you purchase a business laptop in June for a net value of £900.

• Under UK tax law, laptops are typically classified as plant and machinery and may qualify for capital allowances.
• The Annual Investment Allowance (AIA) could allow businesses to deduct the full cost of the laptop in the year of purchase, subject to the annual limit.
• If you’re using straight-line depreciation for financial accounting, you may choose a useful life of 3 years, as per company policy or industry practice.

Using straight-line depreciation (for financial reporting):

Annual Depreciation Expense = 900 / 3 = 300

First year (prorated):

Since the laptop was bought in June, depreciation is calculated for 7 out of 12 months:

First-Year Depreciation = 300 × (7 / 12) = 175

Second & third year:

The full £300 depreciation applies each year.

Fourth year:

Any remaining balance:

£900 - £175 - £300 - £300 = £125

At this point, the laptop is fully depreciated for accounting purposes.

How to calculate units of production depreciation

The units of production method is a depreciation technique used for assets whose wear and tear depends on usage rather than time. Unlike straight-line or declining balance depreciation, this method records actual asset consumption, making it ideal for assets with variable production rates.

• Depreciation is based on the asset’s total estimated usage (e.g., miles driven, units produced, machine hours).
• The deducted depreciation values are not time-related but rather calculated based on actual performance.
• This method is typically used for manufacturing equipment, vehicles, and machinery where wear and tear is usage-dependent.

Example: Depreciating a truck using units of production

Let’s assume you purchase a van for £120,000 with an estimated useful life of 300,000 miles.

Step 1: Calculate depreciation per mile

Depreciation per mile = Cost of asset / Total estimated miles

Depreciation per mile = £120,000 / 300,000 mi = £0.40 per mile

Step 2: Calculate first-year depreciation (30,000 miles driven)

First-year depreciation = Miles driven × depreciation per mile

First-year depreciation = 30,000 mi × £0.40 = £12,000

Following years:

• Depreciation is calculated based on actual miles driven per year.
• The process continues until the total mileage limit (300,000 miles) is reached.

Declining balance method of depreciation

The declining balance method is an accelerated depreciation method that applies a fixed percentage to the book value of an asset at the beginning of each year. This results in higher depreciation expenses in the early years of the asset’s life and smaller depreciation amounts in later years.

The key characteristics include:

• More depreciation upfront: Higher expenses in the initial years, which is useful for assets that lose value quickly.
• Based on a constant percentage: The depreciation is always calculated as a percentage of the remaining book value, not the original cost.
• Commonly used for capital allowances: Businesses may use the reducing balance method for claiming capital allowances for tax purposes, which works similarly to the declining balance method.

Formula for declining balance depreciation:

Depreciation Expense = Beginning Book Value × Depreciation Rate

• The depreciation rate is usually a multiple of the straight-line rate (e.g., double declining balance (DDB) = 2 × SLD rate).
• Salvage value is not considered initially, but depreciation stops once the asset reaches its salvage value.

Example: Depreciating machinery using 20% declining balance

Let’s assume your company purchases machinery for £100,000 with an expected useful life of 10 years and uses a 20% declining balance rate.

Each year, depreciation is calculated based on the remaining book value. The asset never fully reaches zero under this method. Businesses often switch to straight-line depreciation in later years when the straight-line amount is greater than the declining balance method.

Imputed costs versus normal depreciation

Imputed costs (also known as opportunity costs) are internal estimates used for decision-making purposes but are not recognised in UK accounting or tax rules. In contrast, depreciation is a regulated expense that allocates an asset’s cost over time and is recorded in financial statements and tax filings. Depreciation methods such as straight-line, declining balance, or units of production can be used for financial reporting under UK accounting standards, while capital allowances (e.g., Annual Investment Allowance (AIA), Writing Down Allowance (WDA)) apply for tax purposes. Replacement costs cannot be used for depreciation or capital allowances calculations—only the historical acquisition costs of assets are used for tax and financial reporting purposes.

Please note the legal notice for this article.