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Depreciation Basics - Accounting for Depreciation

October 10, 2016

 

What is Depreciation?

 

Depreciation is a tax-deductible business expense that allows a taxpayer to recover the cost of assets that lose value. It is an annual allowance for the wear and tear, deterioration, or obsolescence of assets. 

 

 

What Depreciation Methods are there?

 

There are 2 main methods for accounting for depreciation; straight-line and reducing balance.

 

Example #1 - Straight-line Depreciation

 

If a business owner/company purchased a computer for £1,500, they could account for the depreciation using the straight-line depreciation method. This depreciation method is used to calculate a fixed amount of depreciation for each year of the expected useful life of an asset. Let's look at an example...

 

Cost of asset (computer) £1,500

Expected useful life of asset 3 years

Residual value (expected worth after useful life) £600

 

Cost of asset - residual value =  amount to depreciate over life of asset

£1,5000 - £600 = £900

 

Depreciation of asset / asset useful life = annual depreciation

£900 / 3 years = £300

 

In the example above, the computer asset is depreciated by £300 per year for 3 years using straight-line deprecation. The video at the bottom of this page may provide clarification.

 

Example #2 - Reducing Balance (Diminishing Balance)

 

If a business owner/company purchased a computer for £1,500, they could account for the depreciation using the reducing balance depreciation method. This depreciation method is used to calculate a depreciation percentage that is charged against the asset. Let's look at an example...

 

Cost of asset (computer) £1,500

Expected useful life of asset 5 years

 

Business owner/company believes that a 20% annual deduction will provide a realistic ongoing value for the asset.

 

Year 1. £1,500(computer) * 20%(depreciation percentage) = £300(depreciation amount)

Year 2. £1,200 * 20% = £240

Year 3. £960 * 20% = £192

Year 4. £768 * 20% = £153.60

Year 5. £614.40 * 20% = 122.88

 

In the example above, the computer asset is depreciated by 20% per year using the reducing balance depreciation method. The video at the bottom of this post may provide clarification.

 

Miscellaneous Notes

 

- Depreciation is an expense (debit entry). The credit entry is booked against the asset.

- Once a depreciation method and amount is chosen, this cannot be altered.

- Spending money on maintenance and repairing assets does not remove the need to depreciate assets.

- Land is not depreciated.

 

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