Depreciation is the accounting term for the devaluation of assets over time. Here we look at how any assets you may buy (such as a new server or PC) are treated for tax purposes in your company accounts.
What is depreciation?
Any asset that you buy for your company whether it be machinery, furniture, computers or vehicles will reduce in value during the period of ownership, and depreciation is used to write off the cost of an asset over its useful lifetime. It is not the movement of actual money but simply an amount used within the company accounts to reflect the cost to the company of an asset during any given accounting period. Depreciation effectively turns the cost of the asset into a company expense. Here we will consider in more detail how the depreciation of assets is dealt with in your company accounts and the ultimate effect that it has on your bottom line.
What constitutes an asset and how does it differ from a company expense?
First of all, it is important that we distinguish between an asset and an expense. It is generally accepted that a purchase be considered an asset rather than an expense if it is an item that has an on-going use from year to year such as the examples given above. Assets are ‘capitalised’ and included in the company balance sheet as assets rather than being written off to profit and loss as an expense would be.
A valid expense is 100% tax deductible which means that a company can claim tax relief on it but depreciation charges on an asset are not. A company can instead claim ‘capital allowances’ on the cost of their equipment and these capital allowances are set in the budget each year and will vary depending upon the type of asset. Read on to find out more about Capital Allowances
How does the accountant know how much depreciation to record?
The amount of depreciation that is recorded in the accounts is an estimate which is arrived at by taking into consideration the initial cost of the asset, its estimated salvage value when the company has finished with it and its useful life.
If the cost of an asset is to be written off completely over its useful life then depreciation will be accounted for on a “straight-line” basis. This means that the initial cost is divided by the expected number of years of usage to arrive at a figure for depreciation to reflect the cost of the asset to the business each year. This is the method of depreciation most commonly used.
The alternative method of accounting for the depreciation of your assets is known as ‘reducing balance’ depreciation. This option is considered for any asset that has high usage in the early part of its life and therefore depreciation is calculated using a higher rate to begin with and reduces as time goes on, thus the amount of depreciation reduces as the life of the asset progresses. Accountants choose the most appropriate method depending on the asset and your business.
What are Capital allowances?
An accountant’s ability to pick which method of depreciation to use means that different companies’ accounts will vary as to how assets are treated for depreciation so HMRC have their own method of depreciation called Capital Allowances which brings uniformity to the treatment of depreciation in the computation of corporation tax.
Your accountant will record an amount for the depreciation of an asset in your accounts each year but when they are submitted to HMRC for your corporation tax calculation, that amount is removed. Removing the depreciation amount will make your business appear to have made more profit than it actually has and therefore more tax would be due but you won’t lose out because HMRC replaces depreciation with Capital Allowances.
As mentioned above, Capital Allowances are set in the budget each year and will vary depending upon the type of asset but they are a good thing and give your business increased flexibility. Whereas an amount for the depreciation of assets must be included in your company accounts each year, for the purpose of your corporation tax calculation you can choose whether or not to use your capital allowances in any given year or save them for the future.
Why might it be a good idea to save capital allowances for the future?
Well, suppose that your business makes a loss or only a very small amount of profit this year and there is therefore little corporation tax to pay, you can save your capital allowances until you are making healthy profits again and use them to reduce the amount of tax that you pay on that profit. For this reason, together with the fact that capital allowances are set each year in the budget and vary depending upon the type of equipment, the amount of depreciation showing in your company accounts will almost always differ to the capital allowances claimed and so it follows that your accounts company profit will also very rarely, if ever, match your profit for tax purposes.
Your responsibilities as a director
As a director it is your responsibility to record the purchase of assets in your company records and ensure that your accountant has a schedule of fixed assets on file. This schedule will be used to prepare the corporation tax calculation and capital allowance claims and must be available to HMRC should queries arise in respect of your corporation tax or capital allowances.
This guide was kindly written for us by Freestyle Accounting, a firm of Chartered Certified Accountants offering an all-inclusive service to contractors and freelancers.