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Why are capital allowances different to depreciation?

2 March 2010 One Comment

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Often there’s little logic in tax law

If you ever look closely at your accounts and tax return (you do look closely, don’t you?) you may notice that they include depreciation and/or capital allowances. And you may notice that the bottom line figure for depreciation and/or capital allowances is usually different.

That’s because depreciation is calculated based on established accounting practices, and capital allowances are based on the rules set out in the Taxes Acts. And no matter which method you are following, these rules only apply to the major items in your business, the things that last for a few years. That means things like motor vehicles, furniture and computers.

Generally speaking, accountants will take the cost of a capital asset (like your new £2,500 super computer) and spread the cost equally over 4 years. Whether or not that truly reflects the depreciation of this item the accounts will show a depreciation figure of precisely £750 in each and every one of the consecutive 4 years.

supercomputer

HM Revenue and Customs do things differently. So at the outset, they ignore the depreciation figure in the accounts and treat the accounts as if that amount wasn’t there. This is called “adding back the depreciation”. Then they take off the capital allowances.

Capital allowances are currently calculated on a 20% reducing balance system. There are a few other special rules (as you might have guessed), but for now we’ll take that £2,500 super computer and write off 20% of it. That gives you a capital allowance in year 1 of £500 and a balance of £2,000. In year 2, the 20% allowance will then be £400 and so on.

Under the capital allowances method, you never quite get down to Zero. With depreciation you know you’re going to hit a value of Zero after 4 years.

And if you ever wanted to compare the capital allowances figures to the depreciation figures, you would need to do a reconciliation every year, starting with year one of the business. The records should be there in all the copies of the accounts and the tax returns. Alternatively, you could just trust your accountant!

Posted on 2 Mar 2010 by The Proactive Accountant Dot Com

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