The cost of the fixed assets of a business can be written off over a period of time. The amount of the cost that is written off is called the ‘depreciation’.
Although it is possible to approach the tax office if you feel that you need to use a special rate of depreciation for a specific (usually a long life item, like real estate) asset, most fixed assets are written off at 25% of the book value each year. The book value of an asset is simply the cost price less depreciation to date.
If the company buys a lathe for £5,000, for example, the business can write off £1,250 depreciation against corporation tax in the first year of ownership. In the second year, the depreciation write off will be £937.50 or £(5,000 – 1,250) x 25%. This method of depreciation, although arbitrary, does reflect the higher loss of resale value of an asset in the early years and removes the old problem of assets remaining in the books of account at zero value.
Most businesses will maintain an asset register in which the values of assets will be recorded. This register will also allow for the revision of value should an asset be significantly enhanced (not repaired) or become more valuable because of its nature (real estate, for example).
Depreciation helps to prevent asset acquisition adversely affecting the business net profit. For example, to write off 25% of the lathe, in the example above, means that the accounts will show a profit enhanced by 75% of the cost of the lathe. If the full cost was written off in one year, the net effect could be to wipe out any profits and give a false impression of the viability of the business or the effectiveness of the management.
Because depreciation is allowed against corporation tax, it is important to record the selling price of an asset at disposal. If the selling price is less than the book value, generally, the difference can be written off as a loss on disposal. Such losses are often investigated by the tax office if they seem excessive. Any profit on disposal created by a sale above book value must be reported in the accounts as a profit on disposal and will be subject to corporation tax.
Depreciation is a method of deferring capital expenditure to properly reflect the profitability of the business, in effect.