What is a tangible fixed assets depreciation policy?

Unlike some queries from limited company contractors which can be answered with ‘Yes,’ ‘No’ or ‘Maybe,’ this one is different!

In fact, the question ‘What is a tangible fixed assets depreciation policy?’ is perhaps best-tackled by defining each of the terms contained within, writes Graham Jenner of chartered accountancy firm Jenner & Co.

Tangible

An asset can be tangible -- i.e. it is physical, you can touch it; or intangible – i.e. it has no physical form e.g. goodwill, a brand, intellectual property.

Fixed Asset

Fixed assets are assets that are held for use within the (contractor’s) business. 

The Fixed asset will have a use to the business of more than a year -- otherwise they are a consumable.

Depreciation

Depreciation is the process of writing off an asset over its useful life within the business.

A part of the cost is set against profits of the years during which it is used. The theory is that the accounts show a ‘true and fair view’ of the profit in any particular year after charging part of the asset costs that have helped generate the profits.

Policy

‘Policy’ in this instance simply means that a decision has been made on how the assets are to be depreciated.

So, a ‘tangible fixed assets depreciation policy’ is a stated method of charging to the profit and loss account, a proportion of the cost of physical assets that are used within the business.

While this would apply to any business with tangible fixed assets, it is most relevant to a business operated through a limited company.

The policy will have been decided by the directors (usually with guidance from the company’s accountants), and will be stated in the notes to the accounts each year.

Example

An example of a tangible fixed assets depreciation policy is below:

Tangible fixed assets depreciation policy for A.N. Other Limited

Tangible fixed assets are depreciated over their expected useful economic life, as follows:

File servers, network infrastructure and other central IT equipment - 5 years

Office equipment - 5 years

Motor vehicles - 4 years

PCs & Laptops – 4 years

Note the following from the above:

1. Reference is made to the “expected useful economic life.”

So a decision needs to be reached as to how long the asset will be used in the business. The implication is that, once the asset is no longer economic to be used in the business – because it is too worn out - it will be sold or scrapped, and probably replaced.

2. The policy has been outlined for groups of assets, as opposed to individual assets.
3. The policy refers to the number of years over which the asset will be depreciated but it could refer to a percentage of the value that will be depreciated each year e.g. Four years could be stated as 25% per annum.
4. Depreciation does not have to be even over the lifetime of the asset.

By this, I mean that in some cases, assets will be depreciated on what is known as a ‘reducing balance’. If the policy is 25% on a reducing balance basis, the 25% of the cost is charged in year one, reducing the balance to 75%. It follows that in year two, 25% of 75% is charged, and so on. The thinking is that the asset might have larger repair bills in the later years, so the overall cost of the asset and its maintenance will be charged fairly evenly over the years of its use in the business.

Shorter (or longer) economic life than expected

Of course, the economic life used is only an estimate. 

If it is realised that the estimated economic life is different to that originally thought, then the estimate can be changed. Technically, this would not constitute a change of policy, just a change in the estimate of the economic life.

Assets with an expected value at the end of the economic life

Where an asset is expected to have a resale value at the end of its economic life in the business, it is only the expected fall in value (i.e. the cost less the expected resale value) that needs to be written off over the economic life.

It all comes out in the wash!

There are a lot of estimates used in deciding a depreciation policy.

The Companies Act requirements are that the accounts show a “true and fair view” not an accurate view, and so, as long as reasonable policies are adopted, that is acceptable. 

When the asset is finally scrapped or sold, any remaining balance will be written off.  Therefore, the cost of the asset, less its actual sale proceeds (if any), will have been charged to the profit and loss account.

Depreciation and tax

Perhaps because there are so many estimates involved in a depreciation policy, HMRC does not accept, for tax purposes, the depreciation charge in a company’s accounts. Instead, they allow a deduction for a standardised form of depreciation, known as ‘Capital Allowances.’

Does it matter?!

If depreciation is not relevant for tax and so many estimates are used, does it really matter what depreciation policy is adopted by your own limited company?! This could be another question worthy in itself of the sort of breakdown I’ve attempted at the outset.

The short answer, is that for IT contractors, assets used in the business are likely to be limited to IT equipment. The effect on the profit and loss account of adopting one policy over another, is unlikely to be material.

So, from a practical point of view, it is simply a matter of adopting a sensible policy for the type of assets in the business. Happy policy-drafting contractors!