Understanding Business Accounting For Dummies, 2nd Edition (102 page)

Plant, equipment, fixtures and fittings, and motor vehicles - at rates varying from 10 per cent to 33 per cent.

By the way, keeping two depreciation schedules is an example of
keeping two sets of books
. In some situations a person using this term is referring to the illegal tactic of keeping one set of accounts for the actual amounts of sales revenue and expenses and keeping a second set of fictional accounts for income tax purposes. (We've never seen two sets of books in actual practice - although, we have seen cases of skimming sales revenue and inflating expenses on the books to minimise the taxable income of a business.)

Note:
Taxation laws can change at any time and can get extremely technical. Please use the following information for a basic understanding of the procedures and
not
as tax advice. There are a number of annual income tax guides, such as
Tolley's Tax Guides
, published by Butterworths.

HM Revenue and Customs' rules give guidance on which of two depreciation methods to use for particular types of assets:

Straight-line depreciation method:
With this method, you divide the cost evenly among the years of the asset's estimated lifetime. So if a new building owned and used by a business costs £390,000 and its useful life is 39 years, the depreciation expense is £10,000 (1⁄39 of the cost) for each of the 39 years. (See the example of Tesco's above.) You must use straight-line depreciation for buildings and may choose to use it for other types of assets; once you start using this method for a particular asset, you can't change your mind and switch to another method later.

Accelerated depreciation method:
Actually, this term is a generic catch-all for several different kinds of methods. What they all have in common is that they're
front-loading
methods, meaning that you charge a larger amount of depreciation expense in the early years and a smaller amount in the later years.
Accelerated depreciation method
also refers to adopting useful lives that are shorter than realistic estimates (very few cars are useless after five years, for example, but they can be fully depreciated over five years).

One popular accelerated method is the
double-declining balance
(DDB) depreciation method. With this method, you calculate the straight-line depreciation rate and then you double that percentage. You apply that doubled percentage to the declining balance over the course of the asset's depreciation time line. After a certain number of years, you switch back to the straight-line method for the remainder of the asset's depreciation years to ensure that you depreciate the full cost by the end of the predetermined number of years. See the sidebar ‘The double-declining balance depreciation method' for an example.

By the way, the salvage value of fixed assets (the estimated disposal values when the assets are taken to the junkyard or sold off at the end of their useful lives) is ignored in the calculation of depreciation for income tax. Put another way, if a fixed asset is held to the end of its entire depreciation life, then its original cost will be fully depreciated, and the fixed asset from that time forward will have a zero book value. (Recall that book value is equal to the cost minus the balance in the accumulated depreciation account.) Fully depreciated fixed assets are grouped with all other fixed assets in external balance sheets. All these long-term resources of a business are reported in one asset account called
property, plant, and equipment
(instead of fixed assets). If all its fixed assets were fully depreciated, the balance sheet of a company would look rather peculiar - the cost of its fixed assets would be completely offset by its accumulated depreciation. We've never seen this, but it would be possible for a business that hasn't replaced any of its fixed assets for a long time.

The straight-line method has strong advantages: It's easy to understand and it stabilises the depreciation expense from year to year. But many business managers and accountants favour the accelerated depreciation method. Keep in mind, however, that the depreciation expense in the annual profit and loss account is higher in the early years when you use an accelerated depreciation method, and so bottom-line profit is lower until later years. Nevertheless, many accountants and businesses like accelerated depreciation because it paints a more conservative (a lower, or a more moderate) picture of profit performance in the early years. Who knows? Fixed assets may lose their economic usefulness to a business sooner than expected. If this happens, using the accelerated depreciation method would look good in hindsight.

Minimising taxable income and corporation tax in the early years to hang on to as much cash as possible is very important to many businesses, and they pay the price of reporting lower net income in order to defer paying corporation tax as long as possible. Or they may use the straight-line method in their financial statements even though they use an accelerated method in their annual tax returns, which complicates matters. (Refer to the section ‘Reconciling Corporation Tax' for more information.)

Except for brand-new enterprises, a business typically has a mix of fixed assets - some in their early years of depreciation, some in their middle years, and some in their later years. So, the overall depreciation expense for the year may not be that different than if the business had been using straight-line depreciation for all its fixed assets. A business does
not
have to disclose in its external financial report what its depreciation expense would have been if it had been using an alternative method. Readers of the financial statements cannot tell how much difference the choice of depreciation method made in that year.