What are Assets and how does depreciation work?

What is a Fixed Asset?

Fixed Assets generally include Buildings, Computers, Office Furniture, Plant, Equipment, and Vehicles. The Accounting Standards generally refer them as ‘Property, Plant and Equipment’ and in Published Accounts Assets are often called ‘Tangible Fixed Assets’.

Most business set a rule for what value an item has to be before its treated as a fixed asset, for example it might be items costing more than £200, below that value the items might be expensed in the P&L.

Fixed Assets must have a life beyond the current accounting year, for example a computer might have a life of 3 years or more.

The reason we capitalise the items and turn them into a fixed asset is so that we can apportion/spread the cost of the asset over its useful economic life. This means the accounts get a fair allocation of cost each year.

This is not the same as the tax treatment, many assets qualify for Capital Allowances and of those many might qualify for the Annual Investment Allowance. The Annual Investment Allowance gives 100% tax relief immediately.

How are Assets Depreciated?

There are several methods of depreciating assets Straight Line, Reducing Balance, Units of Production and others too. The most commonly used ones are Straight Line and Reducing Balance.

You need to use your judgement to decide the rate of depreciation, for example to depreciate straight line over 4 years you would choose 25%. Rates are normally set for an entire asset class for example Computers as a whole.

Reducing balance works by taking the net asset value and apply the depreciation %

Original Value

Less Depreciation to date (accumulated depreciation)

Net Book Value

Apply Reducing Balance Depreciation %

Every year the current year depreciation is added to the accumulated depreciation the cycle repeats each year.

Depreciation is disallowed as a tax deduction, because you claim Capital Allowances instead.

Business should maintain a Fixed Asset Register listing every asset and its Original Value, Accumulated Depreciation and Net Book Value.

When an asset is sold the value from the asset register need to be used to remove its value from the accounts, any profit or loss on disposal is posted to the P&L.

When an asset is sold there may also be a tax adjustment known as a Balancing Charge, its the difference between the Tax Written Down Value and Fixed Asset Register Written Down Value.


Things you should know about Asset Revaluations

It’s a fundamental concept of accounting that the accounts must give a ‘True and Fair’ view of the state of affairs of the company at its year end.

In order to achieve this a company may need to revalue its fixed assets, it could be Plant or Property, larger companies will refer to International Accounting Standards and Financial Reporting Standards but most SME’s use FRSSE http://www.frc.org.uk/documents/pagemanager/asb/FRSSE/FRSSE%20Web%20optimized%20FINAL.pdf

Accounting Explained gives a good summary of the entries related to revaluations http://accountingexplained.com/financial/non-current-assets/revaluation-of-fixed-assets

Here are some things you need to know:

  1. Revaluing Assets does not create a tax liability
  2. Revaluing Assets does not create a profit (it creates a revaluation reserve)
  3. Depreciation Rates may need to be reviewed (as they could be too high if you need to revalue regularly)
  4. Revaluation will increased the Net Worth of your business
  5. The Directors can revalue the assets but the value needs to be carefully worked out as an arms length market value


Capital Investment Appraisal, Tax and Depreciation – The Basics

How can you decide whether to buy a fixed asset or to rent it? How do you evaluate and compare capital expenditure requests?

There are 4 key techniques used:

1. Pay Back Period – how many years does it take to get back your initial investment in profits – for normal investments anything less than 3 years is considered good

2. Average Rate of Return (ARR) – this method of appraisal takes the average of the profits made over say a 3 year period (or the life of an asset) and shows the result as a % of the initial investment

3. Net Present Value/Discounted Cash Flow – this method of appraisal takes into account the time value of returns, its often considered the best and most precise way to assess returns, to calculate the Net Present Value you create a cash flow table year 0, shows the investment as a cost, then the net profits are shown in the subsequent years and a factor is applied to remove the effect of inflation, the higher the NPV the better the investment

4. Internal Rate of Return – this is also described as the effective interest rate, to calculate this we increase the Discount Rate in the DCF (3 above) until the NPV equals zero and that produces the return rate

Many businesses will seek to match the funding of the asset to its useful economic life through either a loan or lease, as the life of the asset will normally exceed the pay back period, this should lead to increased profits compared to renting the asset.

Assets are depreciated in the business accounts

Depreciation means the cost of the asset is spread, so it is written off against the profits of several years rather than just the year of purchase. Depreciation is not allowable for tax. Instead you may be able to claim the cost of some assets against taxable income as capital allowances.

The most common methods of Depreciation are Straight Line (depreciation is the same amount in each year) and Reducing Balance (the amount of depreciation decreases each year and is a percentage of the net book balance).

From April 2012 the rates of capital allowances will be reduced from (a) 20% to 18% and from on the Main Rate Pool (b) 10% to 8% for  ‘special rate’ expenditure respectively. At the same time the maximum amount of the Annual Investment Allowances (AIA) will be reduced to £25,000 a year (currently £100,000). So you might want to consider buying assets prior to April 2012 to take advantage of the current rates.

Click to access bn04.pdf

There will be a timing difference between Depreciation and Capital Allowances and the Tax on the difference in rates is calculated and shown in the accounts as a Provision for Deferred Tax.