Financial Explainer — depreciation and amortisation

Not all small company owners are financial experts. In this instance, it can help to have the advice of a financial consultant, accountant, business coach or business advisor — although only if budgets allow.

This is why we've put together a series of short blogs that goes through and explains the various components of your financial statements in a clear and simple way.

This instalment deals with depreciation and amortisation — what they are and how they're applied.

Depreciation and amortisation are essentially the cost of the use of your fixed assets over their useful life.

Depreciation: Applies to tangible fixed assets, e.g. buildings and equipment.

Amortisation: Applies to intangible assets, e.g. patents or computer software licences.

There are different ways to calculate each depending on the asset:

• Straight-line method: Where the total cost is spread equally over the life of the asset. This is applied when an asset loses value steadily over time, e.g. buildings.

• Accelerated method: When a larger proportion of the total cost is recognised in earlier periods. This is for assets that initially lose value quickly and then more slowly over time. A new car or computer would be a good example.

How they're presented in your balance sheet:

• Gross cost: The original amount you paid to buy or build the tangible or intangible asset

• Accumulated depreciation/ amortisation: The total amount of depreciation/ amortisation applied since you acquired the asset.

• Net book value: The remaining cost of the asset after deducting the accumulated depreciation/ amortisation.

The annual charge for depreciation and/or amortisation will be treated as an expense in your income (profit and loss) statement. So you'll have a charge each year until you've fully expensed the asset and it's considered to have come to the end of its useful life.

Not all assets are depreciated or amortised

This applies to assets that do not lose value or wear out in the same way as other tangible or other intangible assets.

Here are some examples:

• Land: This asset can often appreciate in value over time (depending its type and location).

• Goodwill (in some situations): Under IFRS (International Financial Reporting Standards), goodwill is considered to have an indefinite life. In this instance, it is subject to impairment testing each year. If it's value is considered to have decreased it will be 'written down' in your balance sheet with the impairment value treated as an expense in your income statement. However, under UK GAAP (UK Generally Accepted Accounting Practice), goodwill is amortised systematically over a period of no more than ten years. So treatment will depend on the accounting standards you use.

• Trademarks (with an indefinite life): Trademarks can have a finite or indefinite life. If they have an indefinite life they will not be amortised but instead tested for impairment annually.

• Certain licences and franchises (with indefinite life): This type of asset can have an indefinite life perhaps because it can be renewed. Again, in this instance, there'll be a test for impairment.