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Depreciation and Taxes

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Companies purchase and use different assets in their daily routine such as furniture, fixtures, machinery, buildings, equipment, cars, parking lots and many other assets of use in their business. The cost of these assets is paid only at the time they are purchased or constructed, but recording this cost in the income statement as a whole is not right as because the asset is used for more than one accounting period and charging the whole cost of the asset to one accounting period is not right as it is against the matching concept.(ACCAPaper F7, 2009).

It is known that a certain portion of the cost of the asset is used in the process of every accounting period, i.e. a year, a month, etc. This portion, which is used up is disclosed as Depreciation expense in the income statement. Actually as long as the cost of the asset is in the balance sheet, it is not recognized as an expense incurred by the business and its effect cannot be seen on the profits. Depreciation charges the cost of the asset used to the income statement. As a result, depreciation spreads the asset’s cost over the useful life of the asset and does not charge it to a single year.

Effect of depreciation on equipment cost

The cost of the asset is allocated in a systematic manner as depreciation to each period of the useful life of the asset, which starts when the use of the asset begins. To make a reasonable estimate of depreciation, following things should be known:

Cost of the asset

Expected residual value of the asset

Estimated useful life of the asset

Reasonable depreciation method

The calculation of depreciation involves two major principles; each of them has their own limitation and implications. Some details of these principles are mentioned below.

1.   Cost principle

The requirement of this principle is that depreciation expense in the income statement and cost of the asset in the balance sheet should be disclosed on the asset’s cost. (IAS 16, ACCA F7, 2009, p193)

2.   Matching principle

The requirement of this principle is that the cost of the asset is charged to depreciation expense over the asset’s life. Actually the application of matching principle results in the division of the cost of the asset over the life of the asset in various accounting periods. This is the result in the matching of the cost of the asset to the revenues earned by the asset during a certain period.(IAS 16, ACCA F7, 2009, p193-194)

Several depreciation methods are allowed for this purpose.

The depreciation methods can be categorized in to two main categories; straight line depreciation method and accelerated depreciation method. One important thing to note is that, due to the fact that land is assumed to have an indefinite life, it is not depreciated. The most common method used in practice for financial statement purpose is the straight line method. So an example of the straight line method is given as follows. This example will demonstrate how the depreciation affects the asset cost in the balance sheet and profits in the income statement.

Effects of depreciation on Tax

The effects of depreciation on tax are quite wide ranging, which include issues such as deferred taxation, but the most common impact is the reduction in accounting profit and hence reduction in the tax, but there is a complication in this case. The depreciation for tax calculation purposes and for accounting purposes is different. Tax authorities use capital allowances, which they give on asset purchase for the calculation of tax, while company calculates tax according to the profit after deducting depreciation. If the tax allowances and the company depreciation rates are the same, then tax calculated is the same.But if these rates differ then deferred tax arises which should be dealt in the financial statements.(ACCA F7, 2009, p232 & 353)

According to the miller and Modigliani’s model, financial decisions are irrelevant in perfect capital market.(ACCA Paper F9, 2008, p511-512). On the other side, it is the fact that there is no existence of perfect capital markets at all. All the businessesaretrading to semi strong or weak form of capital markets. In this case, deprecation accounting can play a material role in the equipment cost and taxes. Depreciation accounting can manipulate the amount of taxes, because it automatically decreases the book value of assets on yearly basis. That’s why the tax authorities do not allow the deprecation accounting for tax purposes. They assume that, normal depreciation accounting does not give the right value to taxes.

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