Last week I talked about fixed and current assets so this week I’ll look at why it’s important for a company to distinguish between the two. Basically, it all comes down to how the assets are dealt with in the company’s financial statements.

If a company deducted the whole cost of a fixed asset in the year it was bought it could distort the annual figures and give a misleading picture of the company’s finances – especially if it was an expensive purchase. This in turn can influence how outside investors view the company and management.

Plus, if all the cost was deducted in the first year it then presents a problem in the accounts the second year as the fixed asset still has a value, even though no money as such has been paid out.

So, to get round this problem, accountants apply a depreciation value to spread the cost of the asset over its lifetime.

Depreciation

Depreciation is where an asset’s value drops over time. From an accountants point of view this should be done over the entire lifetime of the asset. But, in reality, that can be hard to define so here are some ‘lifetime’ cycles which are commonly used:

• Buildings – between 20 and 60 years (depreciation of between 5% and 1.67% per year)

• Plant and Machinery – 5 to 10 years (depreciation of between 20% and 10%)

• Fixtures and Fittings – 5 to 10 years (depreciation of between 20% and 10%)

• Vehicles – 3 to 5 years (depreciation of between 33% and 20%)

Depreciation allows company accountants to divide the full amount of an asset’s cost by the number of years the product is expected to last. It is this ‘cost per year’ figure that is deducted from the company’s profits, during the lifetime of the asset. This helps make the company’s annual figures look more acceptable to outsiders if a large purchase has been made that year.

Straight Line Method

This is the most common method of recording depreciation. If an asset is purchased for £20,000 and is expect to last ten years, then the depreciation is calculated at £2,000 per year.

The Reducing Balance Method

This method identifies what the depreciation value is as a percentage of its lifetime. So, for example, let’s look at an asset that is worth £20,000 and is classed as machinery, which can be depreciated by 10% per year.

Year 1 depreciation value = £20,000 x 10% = £2,000

Because the asset has depreciated by £2,000 in year 2 the asset is now only worth £18,000. So:

Year 2 depreciation value = £18,000 x 10% = £1,800

So in year three the value of this asset is £16,200

Depreciating an asset this way takes longer than using the straight line method.

An Accounting Exercise

Depreciation is an account exercise so that the company’s profits are not distorted by what is often a large investment.

If you want to understand company finances more take a look at our Finance for Non-financial Managers course. I wholly recommend it if you run your own business or manage a department.