You may have an idea what the word ‘depreciate’ means. It’s used to describe the fall in value of something and it’s that fall in value that we focus on when we use the word. So, for example, if you buy a car you may talk about how much it has ‘depreciated’ over the past 6 months. In other words your focus is on how much value it’s lost in that period.
In preparing financial statements we use the same idea and we focus on the spreading of that fall in value over the time that we use the asset. We allocate the fall in value to each period that we are preparing accounts for and we show that fall as a cost of running the business in that period. This cost is shown in our Profit & Loss Account (or Income & Expenditure Account in the public sector)
We depreciate ‘fixed assets’. Fixed assets are those things that we buy with the intention of keeping for the long term, say for example a computer for one of our managers. Some examples of items that are and aren’t fixed assets are as follows:
1. Cash: not a fixed asset as we hold this to spend, not to keep
2. A debtor (a customer who owes us money): not a fixed asset as we are owed this money by a customer and our intention is to receive the money from them as soon as possible.
3. A van: a fixed asset as we own this to use it in our business making deliveries.
4. A building: a fixed asset as we own this to run our business from.
5. A piece of stock (goods for resale): not a fixed asset as our intention is to sell the goods.
So we will depreciate items 3. & 4. in our accounts.
Let’s say we bought a van for £12,000 and we expected it to last 3 years. We expect that it will be worth nothing when we have finished using it at the end of year 3. We have made these estimates based on the fact that we have used a number of similar vans in the past that lasted us 3 years and were worth nothing when we’d finished with them.
We would therefore depreciate the van £4,000 each year (12,000/3). In each year’s Profit & Loss (Income & Expenditure) we would see a charge of £4,000. The same amount each year. If we were preparing monthly accounts, we would see £333.33 (4,000/12) in each month’s accounts.
For the non accountant it may seem strange that we charge the same depreciation each year. ‘Surely it depreciates more in the first year?’ says the non accountant. And if by that we mean ‘Surely it loses more market value in the first year’ then the comment is spot on. But, and here’s the difference in the way we as accountants use the word, we’re not trying to measure how much its market value has fallen. Remember that a fixed asset is something we have to keep and use in our business. Its market value is therefore not relevant to us.
What is more relevant to the accountant is that the business will be able to use the van for as many deliveries in the first year of owning it as they will be able to in the second year and the third year. Therefore the cost of the depreciation needs to be evenly spread across all 3 years. It’s true that the servicing and maintenance may be higher in years two and three, but those additional costs will also be added in to our Profit & Loss Account (Income & Expenditure) in addition to the depreciation.
The normal way of charging depreciation to the Profit & Loss Account (Income & Expenditure) is to spread the depreciation evenly over the period of ownership. This is called ‘straight line depreciation’. There are other methods that can be used where the business benefits more from the asset in some periods compared to others, but these are rarely used in practice.
So there it is, the process of depreciation spreads the cost of a fixed asset through the Profit & Loss Account (Income & Expenditure) evenly over the period that the organisation uses the asset. If you are using management accounts and you are responsible for fixed assets you will see a monthly charge for depreciation of these assets.
The accountant is more concerned with allocating the cost of the van (or any fixed asset) to the periods over which it is used.
Final points to watch for
Some practical points that may be helpful:
1. Even if you have fixed assets in the department you manage, the depreciation charge may not appear in your management accounts. This will often be the case if you don’t have responsibility for buying fixed assets.
2. Not all fixed assets are depreciated. Investments can be classified as fixed assets and they will not be depreciated. Also, land is never depreciated.
3. You may sometimes hear the term ‘amortisation’ being used. This is like depreciation for ‘intangible fixed assets’. This is a fixed asset that you can’t touch.
An example of this would be where you had bought the legal right to make commemorative mugs for the 2012 Olympics. Let’s say the right to make the mugs lasted from 2010 to 2012 (3 years) and the British Olympic Association had sold you the right to use their logo on your mugs for £300,000. This legal right will benefit our business for 3 years and at the end of this period will be worth nothing. Therefore we should spread the cost of this over 3 years. We could spread it evenly over the three years and charge £100,000 to each of the three years. The legal right is called an intangible fixed asset and the cost of £100,000 charged each year is called amortisation.