Last edited 20 Nov 2020

Depreciation

Over time the value of assets declines or depreciates, ultimately to the point where the value is Nil.

For businesses it is important to recognise this fact by reducing the value of assets shown on the balance sheet in accordance with the depreciation policy set by the directors. Because some types of asset lose value at a faster rate than others, businesses may have different rates of depreciation for different classes of asset.

For example, the value of a company car may be reduced over 4 years or at 25% per annum, whilst fixtures and fittings may be depreciated over 10 years or at 10% per annum.

Businesses are free to decide their own depreciation rates and because depreciation is merely an accounting entry which does not involve expending actual funds, but which still reduces profit, it effectively provides a fund for replacing the asset at the end of its useful life.

However, in calculating taxable profits, the value of the depreciation is ignored and is replaced by capital allowances which are set according to statutory rules. The reason for this is simply that HM Revenue and Customs do not allow businesses to set their own depreciation in such a way that would provide tax relief earlier than they believe should be the case.

For example if electrical equipment is purchased for £10,000, and the business decides to depreciate the value by 100% in year 1, leaving the full depreciation in the calculation would provide tax relief upon the entire value of that equipment in the year of purchase. Instead, by using pre-determined capital allowances the equipment may be depreciated in full - but over a much longer period of time. Tax relief is therefore available over the same extended period.

Where equipment has capital allowances applied at a rate of 25% on a “reducing balance” basis it results in the entire value being written off for tax purposes over 7 years.

It can be seen therefore that there is a connection between depreciation for accounting and replacement purposes on the one hand, and the use of predetermined capital allowances set by HM Revenue and Customs on the other for the calculation of tax payable by a business.