Depreciation is really important yet few bother to do it. Why? because it seems so hard to do.
But the reality is that it is really very simple.
But first we need to look at what it is, and why we need to do it.
The Value Of Assets
Everything you buy to use for your business is an asset. However, over time your assets generally lose value. A computer becomes obsolete, your vehicle’s mileage gets higher and higher and requires more and more spare parts. Something that you bought today, may be cheaper to buy a year from now.
There are many reasons of course. So why do we need to record the change in value to our assets? It is because we must always reflect a true picture of our business.
We may need to do that in order to get a loan, or to show our investors the value of the business as it stands today, or to value the business properly if we are going to sell it.
Depreciation and Tax Liability
There is one more important thing about depreciation. It is a book value item. That is, it has NOTHING whatsoever to do with tax and limiting your liability for it. This is a common misconception.
Inland Revenue services around the world deal with asset depreciation and claiming that depreciation against tax in different ways, but the most common is by giving business owners an allowance.
When you record depreciation, you are doing so only in your books. Never ever think of depreciation as some form of allowance or tax mitigating transaction. You are simply recording what you (or some valuer) really believes the loss (or gain) in value of an asset really is.
This is a good thing. You want your books to reflect reality. In fact you are legally obliged to do so. Before we get into the transactions, here’s one last reason why you must see depreciation and allowances as different things.
In many countries, if a business makes a loss, they can put off an allowance and carry it forward to a future year. So you can get the case where a business has bought, say, a computer for 500 and values it at the end of the year at 300 (if you bought a brand new computer today, how much could you sell it for tomorrow?).
The depreciation on that computer is 40% and that is what you must record in your books (don’t worry the actual transactions are coming shortly). However, your Inland Revenue service may only let your claim a 25% allowance, so you can see that the balances will already be skewed. But that is how it should be.
A worse case is where you make a loss and decide not to claim that year. In your books the computer will be worth 300 but your IR service will still have it valued at 500. The following year you will depreciate it down to, say, 200 and because you make a profit you will want to claim your 25% allowance of… 500! which is 125.
So now your book value is 200 and the IR have it as 375. The bottom line is, unless you are a tax specialist or you are submitting your own tax returns, you need not be concerned with the IR valuation. You are only concerned with recording a true and fair picture of the value of your business.
Your chart of accounts should be set up with a group called ‘Fixed Assets’. This is where you add accounts to hold the balance of assets you have bought. Each asset account should have a depreciation account associated with it. This will hold the accumulated depreciation of assets over the years (it is often called ‘Accumulated Depreciation’ for this reason).
To see the value of your assets, subtract the accumulated depreciation from the asset balance.
The reason for keeping both balances is so that you can see at a glance what your assets originally cost you (in case you need to replace them so you get a better idea of the investment needed).
There is one thing missing from this though. Where do we record the other side of the Accumulated Depreciation amount?
The answer is in the Profit and Loss account. You can set up a new group in there specially for it. Let’s call the account This Year’s Depreciation (or even P&L Depreciation to make it clear where it is going).
So make a journal Debiting This Year’s Depreciation and Crediting Accumulated Depreciation.
That’s it. That’s all there is to it.
Using the technique taught in the Accounting for Everyone course, you are simple transferring an amount From Accumulated Depreciation To P&L Depreciation.
If you want to try this out, download the trial of Business Accountz available on Accountz.com and give it a go. Use the Green books (‘transfers’) to do this or use the traditional journal. Remember you can flip between From/To and Credit/Debit in the menu option Tools > Language (choose English – Accountant for the latter).
And if you haven’t done already, sign up on the right for your free 12 week accounting course here at Accounting for Everyone. We go into depreciation in greater detail on the course, including standard ways to depreciate such as straight line depreciation and reducing balance.