Depreciation of assets: what limited company contractors need to know
Let’s start at the beginning because it’s not the most widely-understood of accounting terms in contractor circles, writes Graham Jenner, co-founder of chartered accountancy firm Jenner & Co. What is depreciation?
Depreciation is the writing off of an asset over a period of time. Usually, it will be something tangible and substantial, and which will benefit the business for more than one year.
How to understand depreciation in your accounts
One way of looking at depreciation, to understand it in your contractor company’s accounts when you’ve got an asset, is the following:
Depreciation attempts to spread the cost of that asset across the years over which the company's business will benefit from its use.
Contractor case study: a £1,000 laptop
A good example of depreciation for a contractor is a laptop, purchased (let’s say) on the first day of your accounting year. Let's also say the laptop costs £1,000 and is expected to be used in the business for four years, after which it will be scrapped for nil value.
Depreciation of £250 per year would be charged by the contractor /company director (or their accountant), in the company’s Profit and Loss (‘P&L’) account.
In the accounts, the asset-cost would be shown as £1,000 in the balance sheet. At the end of the accounting year, the asset would be 'depreciated' by £250, bringing its value (Written Down Value or WDV), to £750. The depreciation of £250 is charged in the accounts against the profit of the company for that year.
In the next year, the asset would be depreciated by a further £250, bringing its WDV to £500. The depreciation is again charged in the accounts against the profits of that year. A similar charge happens in years three and four.
But at the end of year four, the asset is fully written down in the balance sheet, and the cost of £1,000 has been spread – evenly -- across the company’s P& L accounts of the four years.
P&L, Resale and Realisation
For such an asset (the £1,000 laptop), this treatment is seen as presenting a fairer view of the company’s profitability than if the full cost of £1,000 had been charged to the P&L accounts in the year of asset acquisition with no charge made in the remaining three years of its use in the business.
Where the asset is expected to have a resale value after it has finished being used in the business, then the amount of depreciation to be charged over that time will be the difference between its cost and its expected resale value.
Taking an example of a larger piece of equipment used in the business that might cost £5,000 and expected to be disposed of in three years for £2,000; well, £1,000 would be charged to the P&L in each of the three years. At the end of the three years, the asset would have been written down to £2,000 -- its expected resale value. If it is sold for say £1,800, then the difference of £200 compared would be charged to the P&L at the time. Similarly, if the asset was sold for, say, £2,300, then the ‘profit’ of £300 would be credited to the P&L at that time.
Where, over time, it is realised that either the estimate of the useful life of the asset, or its estimated disposal value have been incorrectly estimated, correcting adjustments might be necessary in the accounts. But note, this ought to only be necessary where these are ‘material’ to a proper understanding of the company’s results.
Us accountants and our key terms contractors shouldn’t be fazed by
Despite us accountants always being on stand-by to help, it is the directors of the company who determine the depreciation policy that the company adopts, and that is often different for different categories of asset.
Where depreciation is charged at the same amount per year, it is known as ‘Straight Line’ depreciation. For some assets, an alternative, known as ‘Reducing Balance’ may be more appropriate. Under this accounting policy, the amount written off is a percentage of the WDV rather than the original cost, so that, say, 25% is written off in year one, leaving 75%. In year two, 25% of the 75% is written off and so on. The idea behind this is that as the asset gets older and more worn out, the repair and maintenance bills may rise and so the reducing balance attempts to average out the overall costs of the use of that asset.
That’s the accounts treatment, but what about tax treatment?
As can be seen from the above, the accounts treatment is subject to various estimates. As this could be used to manipulate the company’s tax liability (though, realistically, not to any material extent for most contractors), HMRC requires the use of a standardised form of depreciation for tax purposes, known as ‘Capital Allowances.’
For most assets, this means writing-off the asset at 25% of its net value (i.e. take the cost and then subtract capital allowances to date) each year.
This is the Reducing Balance method, like that mentioned in the points above regarding accounting treatment.
HMRC (and other) incentives
From time to time, incentives are offered through the tax system which will allow, let’s say, a 100% writing down allowance on a particular type of asset. Under such a scheme, an asset that qualifies can be written-off for tax purposes, wholly in the year of acquisition. The thought-process is that, if the tax relief is accelerated (and bear in mind it is only accelerated – there is no additional tax relief overall), businesses will be incentivised to acquire an asset they wouldn’t otherwise buy -- at that time.
This may be to encourage businesses to invest in technological equipment, to stimulate the economy or for other political reasons.
It should be borne in mind that the net effect is only a cashflow benefit - and often quite insignificant. Obtaining 100% writing down allowance on an asset costing £1,000 that otherwise would be subject to 25% capital allowances, means tax relief in year one of £1,000 instead of £250. With corporation tax at 19%, the actual tax saving in year one is only £142.50. But the tax of the following years will be higher. Is that really enough impact on cashflow to warrant buying the asset earlier than you otherwise would?
It’s business, not tax
Relating to tax incentives, there is a saying in accountancy – ‘Don’t let the tax tail wag the dog.’ In other words, make decisions for business reasons, not for tax reasons. If you need the asset and you were going to buy it anyway, there might be some benefit in buying it sooner, if it then qualifies for an acceleration of the capital allowances, but, otherwise, don’t.
One final but related point for contractors to consider – because capital allowances replace depreciation for the purposes of taxation, depreciation has no impact on the tax payable by a company.