What is de­pre­ci­ation? Starting off with the basics

Since the majority of a company's assets such as furniture, machines, or buildings lose value over the course of their useful life, they can only be used for a limited time. Other in­tan­gible assets such as software, licenses, patents, or blue­prints, and various current assets such as partially or fully finished goods or even company shares, may also suffer from market price decreases in the form of value di­min­ish­ments as they become obsolete. To trace such losses in balance sheets, they must always be recorded by the company’s ac­count­ing de­part­ment. All this is nowadays known as de­pre­ci­ation.

De­pre­ci­ation is an in­dis­pens­able part of ac­count­ing and tax law. However, the term often causes confusion among young en­tre­pren­eurs, who struggle not only to find the dif­fer­ence between straight-line and reducing balance methods of de­pre­ci­ation, but also have dif­fi­culties in dif­fer­en­ti­at­ing between assets which can and cannot be written off. Find the answers to these and many other question below.

The wear and tear of computers, office furniture, machines, cars, or even buildings in your everyday business activ­it­ies is a natural process causing various decreases in value, which must be sub­sequently recorded in your accounts as de­pre­ci­ation. Such wear and tear is of great im­port­ance both in a com­mer­cial and fiscal sense.

Recording de­pre­ci­ation for com­mer­cial purposes is a matter of present­ing company assets and their cor­res­pond­ing value di­min­ish­ments in a correct manner by means of balance sheets and other similar financial state­ments. On the other hand, tax de­pre­ci­ation offers the pos­sib­il­ity of reducing the amount of taxable income reported by a business. However, these two processes are not always connected.

In principle, de­pre­ci­ation can either be planned and unplanned. The former, time-based method, is the result of scheduled, regular value di­min­ish­ments, whereby the total value of an asset is divided by the estimated number of years of its useful life and de­pre­ci­ated in ac­cord­ance with this cal­cu­la­tion method. If an asset’s useful life is un­deter­min­able (which is often the case with various licenses or other similar in­tan­gible ac­quis­i­tions), it is generally scheduled for ten years.

De­pre­ci­ation of company assets can be caused by factors such as:

• Natural wear and tear
• Expiry of rights or licenses
• External forces (met­eor­o­lo­gic­al, for instance)
• Technical progress

It is not only this scheduled de­pre­ci­ation cal­cu­la­tion method, but also various unplanned de­pre­ci­ation types which pertain to current assets. If a machine endures un­ex­pec­ted, un­re­pair­able damage or suffers a loss in its market value caused by changes in stock market shares, you can subtract re­spect­ive de­pre­ciable amounts from the asset’s total value during any given financial year.

In principle, every loss in an asset’s value must be taken into account. It is, however, primarily a question of de­pre­ci­ation caused by wear and tear, or in other words, the natural de­teri­or­a­tion of objects with a limited useful life, the purchase or pro­duc­tion costs of which can be fully written off during this period. Tangibles such as office machinery, Persian carpets, or even entire factory sites and in­tan­gibles such as licenses, computer programs, or rights show just how wide the range of de­pre­ciable assets actually is.

Since each financial year must generally include de­pre­ci­ations on assets with limited useful life, the annual cal­cu­la­tion of de­pre­ci­ation is the most common when assessing value di­min­ish­ments of company assets.

In some cases, however,  so-called unit-of-pro­duc­tion de­pre­ci­ation is also a possible cal­cu­la­tion technique. In this de­pre­ci­ation method, the asset’s value di­min­ish­ment is cal­cu­lated on the basis of its ex­ploit­a­tion. A typical example of this is a truck, the value of which is assessed according to its mileage. This cal­cu­la­tion method is therefore not based on the asset’s period of use, but rather on its overall per­form­ance (just like the truck has been assessed according to the distance it covered).

Straight-line de­pre­ci­ation is the most common of all time-based de­pre­ci­ation methods. Here, the asset’s carrying value is evenly spread over its entire useful life. What this assumes is that the asset is exploited at the same rate during each of its useful life years.

In other words, the de­pre­ciable amount remains the same for each year of the asset’s useful life apart from the ac­quis­i­tion year, during which the asset’s value di­min­ish­ment is assessed on the basis of the month in which it was obtained (for instance, if the asset was purchased in April, then the first three months are not taken into con­sid­er­a­tion when cal­cu­lat­ing the de­pre­ci­ation value).

As the term “ac­cel­er­ated de­pre­ci­ation” may already suggest, when using this cal­cu­la­tion technique, the annual de­pre­ci­ation amounts increase during each of the asset’s useful life years. However, this de­pre­ci­ation method is rarely used, as it is tra­di­tion­ally only suited for fa­cil­it­ies, which generate greater income year after year (wineries).

The reducing balance method of de­pre­ci­ation is closely related to this. In this method, the amounts that you subtract from the asset’s value are con­tinu­ously reduced over the course of its useful life. Annual de­pre­ci­ation values therefore start at a higher level and then gradually decrease. This method, primarily aiming to promote in­vest­ment, was tem­por­ar­ily approved for this very purpose during the global financial crisis of 2008.

The reducing balance method of de­pre­ci­ation, which sets a fixed de­pre­ci­ation rate (20%, for instance) on the re­spect­ive book value, follows a geometric de­pre­ci­ation sequence in the process of cal­cu­la­tion. In addition to this, there is also an arith­met­ic de­pre­ci­ation sequence, in which the book value, as its name suggests, is de­term­ined using a declining numerical sequence.

In order to correctly calculate all de­pre­ci­ation-related values, you must remember that HMRC (Her Majesty’s Revenue&Customs de­part­ment) does not take into account any de­pre­ci­ation costs, but rather sets out its own version of de­pre­ci­ation called ‘capital al­low­ances’. These are amounts that a business spends on assets which can be later sub­trac­ted from what that business owes in tax.

The two most commonly used types of capital al­low­ances are the Annual In­vest­ment Allowance and Writing Down Allowance. The former allows to deduct the full value of assets used solely for business purposes (with a maximum AIA amount of £200,000). The latter, however, enables to deduct a per­cent­age of the value of an item from the profits each year. The per­cent­ages depend on three rate pools: main pool with a rate of 18%, special pool with a rate of 8% and a single asset pool with a rate of 18% or 8% depending on the item.

For the main pool, add the value of all plant and machinery, i.e. items that you keep to use in your business except things that you lease, land and struc­tures such as bridges or roads. Apply the rate of 18% on the total sum.

A lower rate of 8% is applied to integral features of buildings (lifts, space, and water heating systems, air-con­di­tion­ing, elec­tric­al system etc.), long-life items (with a useful life of at least 25 years from when they were new), thermal in­su­la­tion on buildings and cars with CO2 emissions of more than 130g/km.

Long-life items are put in the special pool if their total purchase value during single ac­count­ing period (the tax year if you’re a sole trader or partner) adds up to £100,000. However, you must put them in the main rate pool if their total value is less than £100,000.

If your ac­count­ing period does not consist of the full 12 months, adjust the amount according to the amount of months which apply to an item. For example, your limit will be £75,000 if your ac­count­ing period is only 9 months (9/12 x £100,000 = £75,000).

Single asset pools are created only if assets have a short life or are used outside your business if you’re a sole trader or a partner. It is up to you to decide whether something is going to be treated as a short-life asset or not. However, you can’t include the likes of cars or special rate items. Large numbers of very similar items can be pooled together and the pool ends as soon as you sell the asset, meaning that capital al­low­ances can be claimed over a shorter period.

If you’re still using the asset after 8 years, move the balance into the main pool in the next ac­count­ing period. As well as that, you must let HMRC know on your tax returns and on your decision to create a short life asset pool within 2 years of the end of the tax year.

• What is a de­pre­ci­ation? De­pre­ci­ation records the loss of value of in­di­vidu­al assets, i.e. the amount by which in­di­vidu­al assets have been reduced
• The current tax de­pre­ci­ation system in the United Kingdom is regulated by HMRC (Her Majesty’s Revenue and Customs)
• There are two basic de­pre­ci­ation types: planned and unplanned de­pre­ci­ation
• The most common de­pre­ci­ation methods are time- and per­form­ance-based
• 3 different dif­fer­en­ti­ation rates apply to company assets and their per­cent­age varies according to the type of asset and its useful life period.

Please note the legal dis­claim­er relating to this article.