What Is Depreciation?

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What Is Depreciation?

An Introduction to Depreciation

As a small business owner in the UK, you may have heard of the term "depreciation" but aren't quite sure what it means. To put it simply, depreciation is the wearing out, or decrease in value, of an asset over time. This decrease in value is due to normal wear and tear, obsolescence, or depletion. For businesses, depreciation is used to account for the declining value of an asset on the balance sheet.

Now that we've got a basic understanding of depreciation, let's take a closer look at how it works and what it means for your business.

How Depreciation Works
The calculation of depreciation is based on the projected useful life of an asset, its salvage value (or resale value), and its original cost. The projected useful life is the number of years an asset is expected to be used by a business before it must be replaced. The salvage value is the estimated amount that can be received for an asset at the end of its useful life. And finally, the original cost is, well, the original cost of purchase for the asset.

There are two common methods used to calculate depreciation: straight-line method, and reducing balance method.

The straight-line method results in equal amounts of depreciation being deductible each year over the course of the asset's useful life.

The reducing balance method results in higher depreciation deductions in early years and declining deductions in later years.  

What Depreciation Means for Your Business
From a tax perspective, depreciation is not an allowable expense, however Capital Allowances are. Capital Allowances are the tax return equivalent of depreciation and there are more strict rules around how to claim Capital Allowances. Business owners can deduct depreciation expense on their annual accounts and the way a business depreciates its assets will impact the Balance Sheet.

Accounting for depreciation can also give business owners a better idea of how much money they will need to reinvest into their business in order to maintain or improve Operations—which can be helpful when planning for future expenses and budgeting for capital expenditures.

Depreciation is an important concept for small business owners to understand not only from a tax perspective but also from an accounting standpoint. By taking into account the projected useful life of assets and their salvage value—as well as utilising one of two common calculation methods—businesses can get a better idea of how much money they will need to reinvest back into their company down the road.

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About the Author

Annette Ferguson 

Owner of Annette & Co. - Chartered Accountants & Certified Profit First Professionals. Helping online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.