A Guide to Asset Depreciation

Most assets will lose value over time, this is known as depreciation. Depreciation is caused by age and wear and tear.

For most businesses only fixed assets are eligible; that is assets that are used for more than one year in the normal process of business. Fixed assets can be either tangible or intangible :-

• Tangle assets are physical goods or items, such as commercial buildings, vehicles and machinery.
• Intangible assets are none physical, such as software and patents.

Assets will depreciate at different rates depending on the type of asset they are. Some will depreciate quickly while others depreciate at a slower rate.

For example, IT equipment will tend to depreciate at a quicker rate than industrial machinery, which can hold its value for longer.

When using different types of assets for security, asset depreciation will varying influence how much you can borrow. Due to the differences in depreciation between assets types.

The amount of value, known as equity, you have available in your assets will also influence whether you use secured or unsecured finance.

Most fixed assets will deprecate over time, the most common types are;

• Fixtures & fittings
• Plant & equipment
• Land & property
• Motor vehicles
• Intangible assets (such as IT software)

There are several types of assets that do not depreciate or are not eligible for depreciation on a company’s accounts.

• Leased property
• Land
• Current assets such as receivables, cash in hand
• Investments such as shares  and bonds
• Stock

There are 2 main methods used in the UK to calculate depreciation on eligible assets.

Which type of depreciation method used will be determined by the type of asset, its expected lifespan and the expected value at the end of its lifespan.

For example, a laptop could have an expected lifespan of 3 years, whereas industrial machinery could be 30 years. The rate of depreciation is calculated over the assets expected lifespan, sometimes referred to as its useful economic life.

The term “useful” is used to describe how long an asset can be used to generate income for a business.

Realistically a laptop is likely to last longer than 3 years, however how productive will it be at this point? It would most probably suffer from poor performance and this would reduce its productivity.

Straight line depreciation is the easiest way to calculate depreciation.

You need to consider if the asset will a have a resale value at the end of it use, also known as residual value. Whether there is a residual value or not will determine which of the below formulas to use. 

No residual value: Depreciation = Cost of Fixed Asset / Useful Life of Fixed Asset

Residual value: Depreciation = (Cost of fixed asset – residual value) / Useful Life of Fixed Asset

For example, you purchase office furniture for £5,000 and expect to use it for 2 years.

You do not however expect it to have any residual value at the end of its usage.

Depreciation = £5,000 / 2 = £2,500 per year

If the same furniture was expected to have a residual vale of £1,000 at the end of its usage.

Depreciation= (£5,000 - £1, 000) / 2

£4,000 / 2 = £2,000 per year

Reducing balance depreciation is used when an asset drops in value quicker earlier on in its lifespan, for example a car.

When working out the amount of depreciation you need to decide on a percentage to apply.

For example, you purchase a vehicle for £15,000, it has an expected lifespan of 6 years and will be subject to 25% depreciation per year.

You would calculate 25% of £15,000, this is the amount of depreciation for year one. You then work out 25% of the current value every following year.

 

Year	Asset Value	Reducing Balance	Depreciation	Accumulated Depreciation
1	£15,000	25%	£3,750	£3,750
2	£11,250	25%	£2,813	£6,563
3	£8,438	25%	£2,109	£8,672
4	£6,328	25%	£1,582	£10,254

The overall effect of depreciation on secured business loans or asset finance comes down to the amount of equity available.

The amount of equity is not what you purchased the asset for, but what it is currently worth. Many people miscalculate the funding amount they can secure, either due to assuming they can obtain a finance amount in relation to purchases prices, or their depreciation calculations do not reflect the current market value.

This is one of the driving factors why lenders always carry out valuations to ensure that the loan amount accurately reflects the amount of available equity.

In addition, lenders will also deduct any outstanding finance secured on the asset from the amount of equity available.