Depreciation explained is the process of spreading the cost of a business asset over its useful life. It shows how much value an asset loses as it is used over time. This guide helps beginners understand depreciation, its importance, and how to calculate it for small businesses and freelancers.
What Is Depreciation?
Depreciation is the reduction in value of a tangible asset over time due to wear, tear, or obsolescence. Assets like equipment, vehicles, and computers lose value as they are used.
Recording depreciation ensures your financial statements reflect the true value of your business assets.
Why Depreciation Matters
Depreciation is important because it:
- Shows the real value of assets
- Helps calculate accurate profits by including asset costs
- Reduces taxable income legally
- Provides better insights for budgeting and replacement planning
Without depreciation, financial statements may overstate asset values and profits.
Types of Depreciation
There are common methods to calculate depreciation:
1. Straight-Line Depreciation
- The simplest method
- Asset loses an equal amount of value each year
- Formula: Depreciation Expense = (Cost of Asset – Residual Value) ÷ Useful Life
Example:
A computer costing ₦150,000 with a useful life of 5 years and no residual value:
₦150,000 ÷ 5 = ₦30,000 depreciation per year
2. Declining Balance Depreciation
- Accelerates depreciation in the early years
- Useful for assets that lose value quickly
- Formula: Depreciation Expense = Book Value at Beginning of Year × Depreciation Rate
3. Units of Production Depreciation
- Based on asset usage rather than time
- Useful for machinery or vehicles
- Formula: Depreciation Expense = (Cost – Residual Value) × (Units Produced ÷ Total Estimated Units)
How to Record Depreciation
Recording depreciation uses journal entries:
Example (Straight-Line):
- Debit Depreciation Expense ₦30,000
- Credit Accumulated Depreciation ₦30,000
Accumulated depreciation is a contra-asset account, reducing the asset's book value on the balance sheet.
Calculating Depreciation Step by Step
- Determine Asset Cost – Include purchase price, installation, and delivery fees
- Estimate Residual Value – The value at the end of its useful life
- Decide Useful Life – How long the asset will be productive
- Select Depreciation Method – Straight-line, declining balance, or units of production
- Calculate Annual Depreciation – Apply the formula for the chosen method
- Record in Books – Make journal entries each accounting period
Common Assets That Depreciate
- Computers and software
- Office furniture and equipment
- Vehicles and delivery trucks
- Machinery and tools
Assets like land do not depreciate because their value typically increases or remains stable.
FAQ About Depreciation
Q: Can I depreciate small assets?
A: Yes, but many small expenses can be fully expensed instead of depreciated for simplicity.
Q: What is residual value?
A: The estimated value of an asset at the end of its useful life.
Q: Which depreciation method is best?
A: Straight-line is simplest, while declining balance suits assets losing value faster early on.
Q: Does depreciation affect taxes?
A: Yes, depreciation reduces taxable income, lowering the tax burden.
Q: How often should depreciation be recorded?
A: Usually monthly or annually, depending on accounting practices and reporting needs.
Common Mistakes to Avoid
- Forgetting to include installation or delivery costs in asset cost
- Using an incorrect useful life estimate
- Applying depreciation to land or non-depreciable assets
- Not updating accumulated depreciation annually
Accurate calculations and regular updates ensure financial statements reflect true asset values.
Benefits of Tracking Depreciation
- Reflects real asset value over time
- Helps plan replacements and capital expenditures
- Provides accurate profit calculation
- Supports better tax management
Depreciation ensures financial reports remain reliable and actionable for business decisions.
Conclusion
Depreciation explained shows how assets lose value over time and how to account for this loss in your books. Understanding depreciation helps freelancers, small business owners, and career switchers maintain accurate financial statements, reduce taxes, and plan for asset replacements. Recording depreciation correctly ensures your business finances reflect the true value of resources and supports better decision-making.
