What are the common mistakes to avoid when calculating depreciation?
Depreciation refers to the reduction in the value of your inventory items over time due to factors like wear and tear, obsolescence, or market demand shifts.
For businesses dealing in second-hand goods, understanding how depreciation works ensures that your inventory valuation reflects reality and that you don’t overstate your profits.
Having trouble understanding how it affects your business?
Don’t worry, in this post I’ll share everything you need to know about depreciation for your small business so you won’t be stranded.
You’d love that? Awesome then. Let’s continue.
What does Depreciation really mean for my business?
Depreciation is how your business accounts for the natural loss in value of your inventory over time. Factors like wear and tear, mileage, and market demand all chip away at their value.
Recording depreciation correctly helps you understand the true worth of your inventory and gives you a clearer picture of your business’s financial health. It also ensures you don’t overstate profits, which can affect how much tax you pay.
Keeping track of depreciation means you’re better prepared when it comes time to file taxes or make informed decisions about pricing and restocking.
How do I calculate depreciation on my inventory?
Calculating depreciation on your inventory is crucial for accurate accounting and tax reporting.
It helps you spread the cost of your assets over their useful life and reflect their true value on your balance sheet.
How to Calculate Depreciation for Inventory
Choose a depreciation method
Straight-line method: Divide the cost of the asset by its expected useful life.
Example: If a used car costs £12,000 and you expect to sell it in 4 years, annual depreciation = £12,000 ÷ 4 = £3,000 per year.Reducing balance method: Apply a fixed percentage to the asset’s remaining value each year. This method accounts for faster depreciation early on.
Example: With a 25% rate, Year 1 depreciation = £12,000 × 25% = £3,000; Year 2 = (£12,000 - £3,000) × 25% = £2,250, and so on.Record depreciation accurately
Keep a depreciation schedule to track accumulated depreciation each year. This helps avoid mistakes and ensures your books reflect the asset’s current value.Understand tax implications
HMRC allows depreciation to be recorded as a capital allowance rather than an expense for tax purposes on some assets. This means you may claim tax relief on the cost, but only in certain ways and timelines. For detailed HMRC guidance, visit the official page on Capital Allowances.Use accounting software
Tools like QuickBooks, Xero, or Sage can automate depreciation calculations and track inventory values, reducing errors and saving you time.
What are the tax implications of inventory depreciation?
When your inventory loses value over time, whether because of damage, obsolescence, or market changes, this depreciation can sometimes be claimed as a business expense, helping reduce your taxable profits.
In the UK, however, depreciation on inventory isn’t always straightforward. Unlike fixed assets (like equipment or vehicles), the general rule is that you cannot claim depreciation as a direct tax deduction for inventory. Instead, inventory is usually expensed when sold (cost of goods sold), not when it decreases in value while sitting in stock. This means if your cars or goods lose value while unsold, you can’t directly claim depreciation against your income tax.
That being said, if inventory becomes obsolete, damaged, or lost, you may be able to write it off or adjust its value in your accounts. This reduction in inventory value will then affect your cost of goods sold, potentially lowering your taxable profits. It's important to keep thorough records and evidence of the loss or devaluation to support your claim with HMRC.
For example, if you purchase a used car for resale but discover it’s damaged beyond repair or unsellable, writing it off or reducing its book value can be reflected in your accounts to avoid overstating profits. Always consult your accountant or tax advisor to ensure these adjustments comply with HMRC rules.
What are common depreciation mistakes small businesses make?
One common mistake is not tracking depreciation at all. Some small businesses skip depreciation, thinking it’s only for big companies. But ignoring depreciation means your accounts won’t show the true value of your assets, and you might miss out on tax relief available on things like equipment, vehicles, or even improvements to your property.
Another frequent error is using the wrong depreciation method or rate. Different assets require different approaches - some depreciate quickly, others slowly. Using an inaccurate rate can overstate or understate expenses, leading to unreliable profit figures and tax calculations. For instance, a car used for business usually depreciates faster than office furniture.
Some businesses fail to update their depreciation schedules when assets are sold, disposed of, or upgraded. This leads to assets staying on the books longer than they should, distorting your financial picture.
Also, many overlook capital allowances, which are tax reliefs that can reduce your taxable profits when you buy certain assets. Missing out on these allowances means leaving money on the table.
Finally, poor or incomplete record-keeping makes it hard to calculate depreciation correctly or justify it during a tax audit. It’s crucial to keep detailed purchase invoices, maintenance records, and disposals documented.
Avoiding these mistakes will help you maintain accurate accounts, make better business decisions, and stay compliant with tax laws.
For more detailed guidance, check out HMRC’s page on capital allowances and consult your accountant regularly.
Conclusion
Avoiding common mistakes like ignoring depreciation, using incorrect rates, or poor record-keeping will save you stress and money in the long run. Use the right tools, keep your records organised, and seek professional advice when needed.
At Rhombus Accounting Firm, we help small businesses like yours navigate depreciation confidently and keep your finances on track. Contact us today to find out how we can support your business and help you stay on top of your finances.
Hope you found this useful!
Meet Lewis
Lewis is a professional accountant and the founder of Rhombus Accounting. He regularly shares his knowledge and best advice here on his blog and on other channels such as LinkedIn.
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