When you use capital to purchase an item for your business, if it is not a consumable, overhead or cost of sale item, it is normally treated as an asset of the business. By being an asset, it retains a portion (if not all) of its value and in the event of the business ceasing to trade, could be sold to realise the value and pay back creditors/shareholders.
Assets take many forms, but the majority will be tangible assets such as buildings, vehicles, plant and machinery, furniture or IT equipment. Some of these assets can actually increase in value over time, property for example typically rises in value, but the majority will never be worth as much as what you pay for them. From an accounting perspective, you need to account for the initial purchase but then add in a transaction for each year you hold the assets, to reduce the value to the business. This is because the actual value of the business (to some extent) will have reduced.
As an example, the business has £100 in cash. That £100 is worth £100. It uses the money to purchase an asset for £100. Theoretically the business still has £100. But after a year, that item is only worth £50 because it is now second hand, used. Therefore, the business no longer has £100, it only has £50. Whilst the business has had the benefit of using that item for 12 months, the value has dropped and therefore the business has effectively ‘lost’ £50. This is reflected in the balance sheet – the snapshot valuation of the business.
This ‘loss’ of value is called depreciation and in the annual accounts you will be required to show the reduced value of the assets. In days gone by, certain assets had far greater value than they do today. Take office furniture as one example. The resale value for office furniture used to be far higher than it is today. The covid pandemic has actually accelerated the reduction in value of desks and chairs because so many companies closed their offices down due to lack of demand, with more staff working at home. The market was awash with office desks and chairs and the prices tumbled – along with the asset values for all those companies with desks!
So over time, the rules of depreciation have had to change to reflect the market values. Back in the 80s, a company would have readily added their desks to the asset register and may have depreciated them over 5 or even 10 years – its usable life. Now, that period may be 12 months or 2 years but is unlikely to be much more because desks have become slightly more ‘disposable’ and the resale market determines that lower resale value.
Straight line or incremental reductions?
When determining how to reduce the value of an asset there are typically two methods. Straight line depreciation suggests that the value will drop evenly over a defined period e.g., 10% per year for a decade. At the end of the decade, the asset is deemed not to hold any value. The alternative method of depreciating assets is an incremental process. Going back to our desk example, you may say that the value will drop quickly after purchase but that over time it will always have some value – even if it’s £10 at a car boot sale! In this example you may decide to reduce the value by 50% in year one and then step the reduction down over the next 36 months but maintaining a residue value of 10% at the end. The likelihood is a single business will have different rules for different categories of asset, writing furniture down faster than plant and machinery for instance.
Who sets depreciation rules?
There are no fixed rules to determining depreciation rates. It is ultimately down to the business owners to set the rules for their company and each and every business will be different. There are of course best practice examples and your accountant will be able to offer guidance, but how you manage the reduction is a local decision. That said, one of the issues we’ve seen in global terms in the last 20 years is businesses over estimating their value. Back in 2008, the banks were caught out because their assets – the value of their mortgage business and investments – were seriously overvalued. What their balance sheets said and what was actually the case were worlds apart.
Whilst the bank’s mortgages and investments were a different type of asset, the concept is the same. Therefore, when setting depreciation rates for your business, the rules should be realistic and tied to the expected usable life of the asset. Like desks, IT depreciation has tumbled in recent decades with the expected lifespan of a desktop computer now deemed to be no more than 3 years. A depreciation rule that went beyond this, unless it was assuming a nominal residual value, would legitimately be open to challenge if somebody were considering the actual value of the business.