Depreciation

Depreciation spreads the costs of fixed assets over their forecast working life. Capital allowances replace depreciation for tax relief.

The role of Depreciation

The purpose of depreciation is definitely not intended to calculate fair market values for fixed assets.

The role of depreciation is instead to apply an annual charge to profits in order to refelect fixed assets' useful working lives in the business. For example, plant and machinery which are normally regarded as having long useful lives should have low annual rates of depreciation, whereas in the case of short-term items such as computers, the rates of depreciation will be higher.

Depreciation and VAT

Depreciation is always charged to the cost of the asset excluding VAT. The one exception to this is company cars, which are costed including VAT. This is because unlike other assets, the VAT for cars cannot be reclaimed as input tax.

Calculating Depreciation

The three methods to depreciating fixed assets are – Straight Line, Reducing Balance or Salvage Value. As straight line depreciation is the most prudent approach for profits and cash flow planning this is the method applied to all Figurewizard forecasts.

Straight Line Depreciation

Take for example a fixed asset costing £5,000 (excluding VAT) to be straight line depreciated at 20% p.a. The rate of depreciation is applied to the original cost each year.

Balance B/Fwd Depreciation Balance C/Fwd
5,000 1,000 4,000
4,000 1,000 3,000
3,000 1,000 2,000


The net book value of the fixed asset will therefore be depreciated to zero in five years.

Reducing Balance Depreciation

Using the example of a £5,000 fixed asset, the 20% rate of depreciation is applied to the balance B/Fwd from the previous year; not to the original cost.

Balance B/Fwd Depreciation Balance C/Fwd
5,000 1,000 4,000
4,000 800 3,200
3,200 640 2,560


In the case of reducing balance depreciation, unless or until the asset is disposed off the net book value of the asset will continue to be reduced indefinitely.

Salvage Value Depreciation

This can be done by either the straight line or reducing balance method. The only difference will be that the salvage value for the asset is first deducted from its cost. If you elect to apply a salvage value of £500 to the example above, the opening value to be depreciated will be £4,500.

Depreciation and Corporation Tax

In the UK HMRC does not recognise depreciation as a tax deductible overhead. First year allowances (FYA) and capital allowances on residual values after FYA has been deducted are substituted when calculating the taxable profit.

FYA and capital allowances will  vary depending on the nature of the asset.

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