They are classified as a fixed asset in the business’s balance sheet rather than an expense in the profit/loss account because they have a significant value. £500 is the suggested minimum for a small business, and different businesses will have different policies when it comes to capitalisation i.e. the decision and process of recording a purchase as a fixed asset in any business records.
Tangible fixed assets are, as the name suggests, assets that are visible and measurable. This can include cars, land, machinery, computers, buildings, furniture and fittings. Tangible assets are subject to losing their value over time as they become less and less effective, which results in them having to be depreciated in end of year accounts.
Intangible fixed assets are trickier to value, as they are unquantifiable and cannot be seen or touched. This can include copyrights, patents, brand recognition and customer data, and are grouped into two subcategories: intellectual property and goodwill. Finding the value of your intangible assets is more difficult than tangible assets as it is likely that intangibles do not have definite values.
A capitalisation policy involves deciding the minimum value for capitalising a fixed asset, and the ‘life expectancy’ (so to speak!) of each fixed asset. When we say life expectancy, we’re referring to the ‘useful’ life i.e. the length of time we expect any asset to function and still be useful.
A £500 laptop, for example, may function brilliantly for the first couple of years of its ‘life’, then become a little slower for the next couple of years, and then may end up being so slow after four years that it still works but is frustrating to use and is no longer useful to the business – but the business owner may decide to capitalise it anyway, as they might feel the need to keep a record of it in the fixed asset register.
The fixed asset register keeps a record of all a business’s fixed assets – this includes the original cost of the asset, the date it was purchased and the supplier's name. It may also include details of where the asset is located, a maintenance record or schedule and anything else the business owner feels is relevant. Each year, the assets’ depreciation is recorded which results in a net book value for each fixed asset.
Depreciation occurs gradually over time and is normally recorded by a journal entry. It is when the cost of a fixed asset is transferred from the business’s balance sheet to the profit and loss account. Businesses use depreciation to progressively reduce the recorded cost of a fixed asset so that they can identify a portion of the asset's expense at the same time that the business recognises any revenue that the fixed asset generated.
There are a couple of methods of depreciation. The first is called ‘straight line depreciation’ which is the simplest method and most commonly used, and this is when a fixed asset’s useful life expectancy can be predicted. If a business purchases a £1,000 computer which is expected to be of use for four years, the annual depreciation rate would be 25%. £250 would therefore be transferred from the balance sheet to the profit and loss account every year for those four years. After year one, the balance sheet value drops to £750 and the £250 is charged to the profit and loss sheet as depreciation. In the second year, the value drops to £500 and another £250 is charged to the profit and loss sheet as depreciation, and so on.
The other method of depreciation is called ‘reducing balance depreciation’. This is suitable for fixed assets that will gradually lose value, but their life expectancy cannot be estimated precisely. An example of a fixed asset which may fall into this method of depreciation could be a car or a van; a rough life expectancy can be estimated but there’s no way of telling exactly how long it’ll be useful for. Its value could drop by 10% in the first year but 25% in the second.
Depreciation can be considered an expense, but unlike most expenses, there is no related cash outflow. For small businesses, depreciation policy does not affect tax. Instead, HMRC has a different system for setting off fixed assets costs against tax, which is called capital allowances.
As mentioned, HMRC has a capital allowances system for setting off fixed assets costs against tax called capital allowances. This is essentially when a business can claim tax relief on tangible fixed assets by allowing them to be expensed against the company’s annual pre-tax income. Depreciation is not allowed as a deduction for tax purposes, and must be added back to net profit. If capital expenditure does not qualify for a capital allowance, then it means that the business gets no tax relief on such expenditure. Capital allowance reliefs can be set against a company’s taxable profits reducing the amount payable. Corporation tax is currently set at 19%.
As always, please do get in touch if you have any questions about fixed assets, your balance sheet or your profit/loss sheet, depreciation or any other related questions.
Written by
Nicola J Sorrell
- Effective Accounting
Founder | Xero Champion | IR35 Expert
