Section 6: Understanding depreciation

Depreciation is an accounting method used to allocate costs to the business over the life of the asset.

It is used in business to correctly allocate the costs to the usage. If you were to expense your purchases at the time of acquisition then you would have large costs hitting your P&L and will likely report a loss due to investment into your business. This would not show a true reflection of your performance and is not standard accounting clinic.

There are 2 methods of depreciation that are most commonly used in business:

Straight line: This is calculated by dividing the asset equally over a set period of time e.g. 36 months

Reducing balance: This is calculated by reducing the value at a higher rate in the earlier years of the asset.

It is important for you to understand the assessment of the life of an asset to ensure you maintain and use the equipment in accordance with the lifespan of an asset.

If you under estimate the life of your asset then you will pay larger costs throughout the period that the asset depreciates and would be left with a period of time that you are using the asset to generate revenue but have no cost associated to it.

If you over estimate the life of your asset then you may end up with a large expense if you have to dispose of an asset that still has value in your balance sheet.

Your accountant would be able to assist you in the correct treatment of the assets acquired and ensure that you appropriately assign the best possible lifespan to them.