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Depreciation

17th July 2011

Ahead of a serious of articles regarding the Sage Accounts month end process Paul from Michael Paul Accountants Northamptonshire explains the concept of depreciation which forms part of the month end procedure.  This article is relevant to both users and non users of Sage

What is depreciation?

Depreciation can be described as a method of allocating the cost of a tangible asset over it’s useful life.

Tangible fixed assets include items such as computers, motor vehicles and business machinery.

Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn.  For example if a company buys a new piece of machinery instead of writing off the total cost in the profit and loss account in one go a proportion of the cost will be written off with the remaining value being carried forward in the balance sheet.

The proportion written off will depend on the depreciation policy applied to the asset.  For example computer equipment which losses value relatively quickly may be written of at 33.3%straight line.  This means that a third of the original cost will be written of each year until at the end of year three the assets value as shown in the balance sheet is nil and therefore it no longer attracts depreciation.  A piece of business machinery may hold it’s value better so may be depreciated at 25% reducing balance.  This means that for the first year 25% of the cost of the asset is depreciated and charged to the profit and loss account. In the following year 25% of the assets remaining value in the profit and loss will be included in the profit and loss as depreciation.  In effect the asset value never reaches nil.

Using the example of a piece of machinery purchased for £30,000 which is depreciated at 25% per year the journal entries would be as follows.

  • Year 1 – debit the depreciation account in the profit and loss and credit the fixed asset account in the balance sheet £7,500.  The value of the machine in the balance sheet (known as its Net Book Value) is now £22,500
  • Year 2 – debit the depreciation account in the profit and loss and credit the fixed asset account in the balance sheet £5,625.  The machines Net Book Value in the balance sheet is£16,875

If a company produces monthly profit and loss accounts then to ensure the figures are accurate depreciation will need to be posted on a monthly basis which could be done by either dividing the depreciation amount for the year by 12 or dividing the depreciation percentage by 12.  In the case of straight line depreciation both methods will result in the same figure.

At Michael Paul Accountants Kettering, Corby, Northampton and Market Harborough are conveniently located near to our premises in Lamport although we have clients from all over the UK.  We are a firm of Chartered Certified Accountants ensuring you receive a professional and competent service at all times.  We specialise in small businesses, medium sized businesses, sole traders, partnerships and individuals who have to file a tax return.

If you need any advice regarding depreciation or any other accounting or taxation matters please don’t hesitate to contact us.

 

 

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