Many people have heard of the term ‘depreciation’, even those who don’t work in accountancy roles. Now let’s take a look at what it really means, and how to account for it.
So what is depreciation?
To understand what depreciation is, you first need to understand what a non-current asset is: a non-current asset is an asset that has been bought with the intention to gain a long term benefit.
Simply, this means if we buy something that will be in the business for a period of over twelve months, and the business sets to gain from the purchase, we will capitalise the purchase and class it as a non-current asset. This could be a car, a piece of machinery or even a computer.
Loss of value
The asset over time will lose value, and will no longer be worth the amount we paid for it: this could be due to wear and tear, the age of the asset, and sometimes it becomes outdated or obsolete.
This is because new models get released, and the model that you have becomes out of date. This loss of value needs to be accounted for – this is the depreciation.
How to account for the non-current asset
When the purchase of the new non-current asset is bought, this needs to be entered into the accounts – the double entry will be to debit the non–current asset account, and to credit the account that it was paid from. This could be a bank account, or a loan or hire purchase.
Why doesn’t it affect the profit?
If we are buying a non-current asset with the intention to keep it for over twelve months; why should we have a year where profit is incredibly low, and the next year where profits are considerably higher?
It would be better to spread the cost of the asset over the number of years you expect to use the asset for.
Two types of depreciation
There are two types of deprecation that you need to be able to calculate and account for, these are:
- Straight Line Depreciation
- Diminishing Balance
Straight line depreciation
This method is where the amount of depreciation is the same amount each year. For example, I purchased a laptop for £1000. Over time it will lose value, but it will lose it steadily over the number of years that I intend to keep it for.
I estimate that I will keep the laptop for 5 years, and at the end of the five years I will probably be able to sell it for £100.
Calculating straight line depreciation
To calculate straight line depreciation, you take the cost of the asset and subtract the amount that you think it will be worth when you have finished using it.
You then divide this amount by the number of years you intend to keep it for. So for our example:
£1000 -£100 = £900. £900/5 = £180 per year.
Accounting for depreciation
The annual depreciation amount needs to be put into the accounts using the journal. There are two accounts that it will affect:
- The accumulated depreciation account
This appears on the statement of financial position, and reduces the amount the non-current asset is worth. When reducing an asset account you always credit it.
- The depreciation charge account
This is the cost of having the asset each year. This account appears on the Income Statement and affects the net profit. As this is an expense account it will be debited.
Calculating diminishing balance
This method is where the amount of depreciation reduces each year. For example, if I purchase a car, it will lose more value in the first few years than in the later years.
Have you ever heard people say; “a new car loses £2000 the minute you drive it off the forecourt”? It doesn’t continue to lose this amount each year- it will reduce each year.
Eventually a car will become worth a few hundred pounds as scrap, and it will never become worth nothing. Let’s say the car I have bought was for £15,000, and I have been given the depreciation rate of 20%…
To calculate diminishing balance depreciation, you take the cost of the asset, subtract any accumulated depreciation to date. and multiply it by a given percentage.
The percentage stays the same each year. So, for my example, where the vehicle has cost £15,000 and the depreciation rate is 20%, the calculation is as follows:
- Year 1 – 15,000 x 20% = £3,000
- Year 2 – 15,000 – 3,000 = 12000 x 20% = £2,400
- Year 3 – 15,000 – 3000 – 2400 = 9,600 x 20% = £1,920
As you can see, the amount of depreciation charged each year is diminishing (getting smaller).
Accounting for diminishing balance depreciation
The double entry for diminishing balance depreciation is exactly the same as for straight line deprecation.
The annual amount needs to be debited to the depreciation charge account on the Income Statement. The annual amount also needs to be credited to the accumulated depreciation account, on the statement of financial position.
Depreciation is covered in more depth on our accounting courses.