Depreciation is the amount an asset has reduced depending on age, wear and tear, and current market value. It is a core part of bookkeeping, and usually applied at year end (for larger businesses it is often calculated every month as part of management reporting).
When you record the purchase of an asset such as equipment or buildings for use in a business, you place it in the Fixed Asset section of your Chart of Accounts. Whenever you look at this section, you can see at a glance how much your assets originally cost.
However, in order to account correctly for your business, you need to record the change in value of those assets. This can be because the item is no longer new, and is therefore worth less than originally paid. It can also be due to wear and tear or damage.
On top of that, an asset could also be stolen, exchanged for another or simply sold. All of this needs recording.
It can be recorded directly in the asset’s account itself, so a check on the transactions and the balance in that account will show its original value followed by its reduction in value over the years, or, more usually, a separate account will be opened to record those changes. This extra account is called an Accumulated Depreciation account (because the amount the asset reduces by over time is added together to give a total balance).
This continues until the Asset’s account its corresponding depreciation account cancel each other out. Whilst the asset still has a value, we can look at the two accounts together to show the current value of the asset.
Usually, assets are classified into general groups (eg. Office Equipment, Motor Vehicles) to keep the number of accounts as small as necessary to accommodate reporting requirements for both the Inland Revenue and management.
Strictly, any asset should be valued at its actual market price when the depreciation needs to be reported. In reality, that can often be hard to do, so there are a few conventional ways to make this easier. The two most used forms of depreciation are:
- Straight Line
- Reducing Balance
Straight line means reducing the asset by a fixed value until the asset balance is zero. For example, at 25% per year, it will take 4 years to reduce the asset to zero. This is the most common way to depreciate assets.
A reducing balance means the asset never gets to zero. Using the same 25% rate, the reduction is applied to the last known value. So if an asset starts at 400, then after 1 year at 25% it will be worth 300. At this point it is the same as the Straight Line method. However, in year 2, it will be 25% of 300 (slightly less than 100 taken in year 1).
The reducing balance method is more accurate since it could be argued that whilst you still have the asset it will always have a value, however small.
Depreciation is a bookkeeping exercise. It has nothing to do with tax liability. Instead inland revenue services around the world offer tax benefits, an example of which is Capital Allowances (UK). You can choose to take the allowance or not depending on whether you have made a profit. That means the allowance will often be completely out of kilter with the book value.
From a business perspective, it is the book value that is important. It tells the business owner how much it would cost to replace those assets should it become necessary to do so.
Bookkeeping for Depreciation
There are 3 main sections in any set of books for any business. They are:
Assets is where we store the value of all equipment, vehicles or other purchases of substantial value that we intend to use in the business. Assets represent the things the business owns. Some of those things may be items we buy with the intention of selling them for a profit. This is our stock (also known as inventory). However, those are not the assets we use to report depreciation on.
Whilst they too (stock bought fo resale) decrease in value if they’re not sold, they are accounted for in a slight different way, which will be covered in another article.
What we’re interested in right now are those things the business buys that will last longer than 1 year and that are used either in the business, or to add value to the business.
Office Equipment is the most common, since this is one thing every business (that has an office) is likely to buy – even if it’s on hire purchase or lease-buy type contracts.
If the business is the legal owner of that equipment (regardless of whether it has been paid of in full) then it will be recorded on the balance sheet as an asset, and it will also have a separate account created for it that shows by how much its value has decreased since it was purchased.
In other words we will be using 2 accounts in our bookkeeping system to record its total current value. For something like office equipment, these are usually called:
- Office Equipment
- Office Equipment Depreciation
When we purchase office equipment we credit the bank (assuming that’s how we paid for it) and we debit Office Equipment. If we value of our equipment was, say, 1000, then the balance of the Office Equipment account at that point in time would be 1000.
If we decided to depreciate office equipment using the straight line method by 25%, we would add a new transaction crediting Office Equipment Depreciation by 250 (1000 x 25%).
Since every credit must be balanced by a debit, the other side of this double entry would be a debit to Office Equipment Depreciation Expense. This will affect our profitability, which is what we want – the company has in effect lost 250 of its value during that period of time, which is now reflected in the P&L account.
To get the current value of our asset we add the balances of the 2 accounts together: 1000 – 250 = 750. We are saying that the value of that office equipment (were we to try to sell it at the time we depreciated it) would be 750. This is typically done at the end of each financial year.
In year 2, we would add the same depreciation transactions, and so the combined balances of the 2 accounts would drop to 500. In year 3 the balance would be 250. And in year 4 it would be zero.
That fall is also recorded in the profit and loss account as explained, which ultimately ends up in the Equity section of our balance sheet. The equity section represents what the business owes its owners, so if you’re following along, you can see how that happens from the entries we have been making.
In reality that never happens because we will very likely have bought more office equipment in the meantime. Plus any equipment that has depreciated to zero (ie. that has been on the books for 4 or more years) will either have been thrown or given away, or sold.
The last thing we need to do to complete an asset that has no value in the books is to remove its original cost from, in this example, the Office Equipment account, and its total depreciation in the Office Equipment Depreciation account. We do that by crediting Office Equipment for the assets full value and debiting Office Equipment Depreciation by the same amount.
If an asset is sold, and the price we got for it is worth more than the book value (the ‘book value’ is literally the total balance in our books of the asset using those 2 accounts introduced earlier) then we must also report a gain. We have in effect made a profit on the sale of our assets. So that gain will be recorded in our profit and loss account under a new account named something like: “Gain On Sale Of Assets”.
If we sold it at a loss, it would also be recorded in the profit and loss account, but this time in an account named something like: “Loss On Disposal Of Assets”.
The other side of this transaction will debit the account that received the money from the sale (eg. a bank account).
And once that was done, we would then Credit Office Equipment and Debit Office Equipment Depreciation to zero out the value of the original asset and its total depreciation (leaving the rest of the Office Equipment assets and depreciation as they are to reflect the current values).
Sale Of An Asset With No Loss Or Gain Example
Suppose we bought an asset for 1000 with cash, depreciated it at the end of the year 1 by 250, and then sold it for 750 for cash. Since the value of the asset at the end of year 1 was 750, and we sold it at that point for 750, no loss or gain has been made. Here’s all the transactions you would have made to account for everything including the original purchase:
- Credit Cash, Debit Office Equipment for 1000 (buying the equipment).
- Credit Office Equipment Depreciation, Debit Office Equipment Depreciation Expense for 250 (value lost in year 1 through depreciation).
- Credit Office Equipment Depreciation, Debit Cash for 750 (the cash we got for selling the asset).
- Credit Office Equipment, Debit Office Equipment Depreciation for 1000 (to zero the asset and its total depreciation value).
If these were the only transactions in our bookkeeping system, we would have the following final balances in our 4 accounts:
- -250 Cash (Assets)
- 250 Office Equipment Depreciation Expense (Equity)
- 0 Office Equipment (Assets)
- 0 Office Equipment Depreciation (Assets)
Since the -250 cancels the +250 we know the books balance. And that is how it always must be.
In the UK and most countries in the world, you cannot claim capital purchases as a direct expense of the business. This is simply because assets like these usually last more than a year (so you still have the asset and it’s still worth something, so you cannot write its full value off against tax – that’s what it all boils down to – does the thing you bought still have some value and do you still own it at year end).
However, as it depreciates in value over time, you must still record that in your books – as explained above, and it would be wrong that you could not claim that depreciation against tax. But rather than doing the obvious – which is just to respect its value in the profit and loss account, governments over the years have chosen to make it a special case.
And so with a special case you need a special tax, and in the UK its called a Capital Allowance. None of this is recorded in your books. It’s purely a tax thing, not a business value. As a result, if you make a loss one year, you won’t want to claim the depreciation against tax – you can do that next year instead if you make a profit. Because of this discrepancy, your books can show one value for your assets, and the Inland Revenue another.
In the USA different names are used. As it’s also complicated, take a look at the Wikipedia entry for it here.
If you want to know more about depreciation and capital allowances, join the Accounting for Everyone online bookkeeping course today:
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