What is a Fixed Asset?
Alright, folks, let’s dive into the world of fixed assets. Imagine fixed assets as the big-ticket items in your business – the ones that stick around for a while and help you generate revenue. We’re talking about things like buildings, machinery, vehicles, and even that snazzy office furniture.
Capitalisation: When you purchase these assets, instead of expensing the full cost immediately, you capitalise them. This means you spread the cost over their useful life.
Intangible assets, which are non-physical things like goodwill, patents and copyrights, can also be depreciated (or amortised). They’re incredibly valuable to your business and that value gradually shrinks as they near their expiry.
Revenue vs. Capital expenditure: Here’s a simple way to differentiate:
- Revenue expenditure is your day-to-day spending that keeps the business running, like repairs and maintenance (where you are not improving the value of your office space but simply maintaining it at its current value)
- Capital expenditure is for the long-term items, like buying a new piece of equipment or upgrading your office space.
What is Depreciation?
Now, let’s talk about depreciation. Depreciation is the process of allocating the cost of a fixed asset over its useful life. It’s like spreading out the joy (or cost) of owning a fixed asset across multiple years. It helps you to understand the true cost of doing business.
Why do we do this? Well, it helps match the expense with the revenue the asset generates, giving a clearer picture of profitability.
Types of Depreciation methods
There are a few ways to slice this cake. Here are the most common methods:
- Straight-Line Depreciation: The simplest method. This method spreads the cost of the asset evenly over its useful life. If you buy a piece of machinery for £10,000 with a useful life of 10 years, you would depreciate £1,000 each year.
- Reducing balance: Also known as the declining balance method, this approach applies a fixed percentage to the reducing book value of the asset each year. This results in higher depreciation expenses in the earlier years and lower expenses in the later years. For instance, if you use a 20% rate on a £10,000 asset, the first year’s depreciation would be £2,000, and the second year’s would be 20% of the remaining £8,000, and so on.
Calculating the depreciation based on ‘Rate’ (%) vs ‘Effective life’ (in years):
Deciding whether to use a fixed percentage rate or the effective life of the asset depends on the nature of the asset and your business strategy.
- Fixed percentage rate (%): This is common in the reducing balance method. The percentage rate represents the portion of the asset’s value that is depreciated each year. For example, if the rate is 20%, it means 20% of the remaining value is depreciated annually. This method is beneficial for assets that lose value quickly.
- Effective life in years: This approach estimates the number of years an asset is expected to be useful to the business. In the straight-line method, the cost of the asset is divided by its effective life. For example, if a vehicle is expected to last 5 years, you would depreciate 20% of its initial cost each year.
How do I pick which method to use?
Straight-Line is simple and consistent, making it easier to forecast expenses and match them against revenues.
Reducing Balance front-loads depreciation, which can be advantageous for tax purposes if higher deductions are needed earlier on.
An asset’s value can be adjusted to zero at any time if it’s lost, stolen or damaged. So always let your accountant know if you have purchased or sold an asset.
Fixed Asset register
Keeping track of your fixed assets is vital. Enter the Fixed Asset Register (FAR) – your best friend in managing these assets. It helps you monitor the acquisition cost, depreciation, and the current value of each asset.
For those using Xero, their Fixed Asset Register software is a lifesaver. It automates the process, ensuring accuracy and saving you tons of time. No more messy spreadsheets or missed entries!
Tax implications
Depreciation isn’t just an accounting concept – it has significant tax implications too. HMRC doesn’t allow businesses to deduct depreciation when calculating taxable profit. Instead, they use a system of capital allowances.
What does this mean for you? Essentially, you’ll need to add back any depreciation expenses to your profits for tax purposes. Then, you calculate your capital allowances separately. Capital allowances allow you to deduct a portion of the cost of your fixed assets from your taxable profits, reducing your overall tax bill.
Different types of capital allowances include:
- Annual Investment Allowance (AIA): This allows you to deduct the full value of qualifying items, such as machinery, up to a certain limit. For 2024, the limit is £1,000,000.
- Writing Down Allowance (WDA): If you exceed the AIA limit or if the assets do not qualify for AIA, you can use WDA. This allows you to deduct a percentage of the remaining value of the asset each year.
- First Year Allowance (FYA): Certain energy-saving and environmentally beneficial assets qualify for 100% deduction in the first year.
Using these allowances effectively can significantly reduce your tax bill, freeing up more cash for your business. If you want to read up more directly with HMRC, please use this link.
By breaking down these key points, we hope to make the concept of fixed assets and depreciation not just understandable, but even a bit fun.
Remember, at DNA, we’re all about making accounting lively and approachable. So, let’s embrace these colourful financial tools and use them to our advantage!
