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24 Nov 2016
Depreciation is defined as “an accounting method of allocating the cost of an asset over its useful life.”
An important facet of depreciation is that it is a “non cash” expense. It is a book entry that transfers a portion of an asset’s cost from capital assets to an expense. As such it does not result in any cashflow, but it does affect the profit of the entity for the period.
Good business practice is to set aside a cash reserve fund equalling the depreciation expense on an asset, to more readily provide funds for replacement of the asset when it becomes obsolete or is replaced.
Most NZ businesses use tax depreciation rates to calculate the current year’s expense claim. These rates are published by the IRD and available on their website, and are the rates that must be applied for income tax purposes. However, some organisations consider these rates don’t meet their accounting obligations, and will maintain both a book asset schedule for their published accounts and a tax schedule to calculate their depreciation claim for tax purposes. This results in differing tax and accounting profits and the need to account for deferred taxation.
There are 2 ways to calculate depreciation – straight line (SL) or diminishing value (DV). The SL method, which is also known as the cost price or prime cost method, spreads the depreciation evenly over the life of the asset. It is based on the original cost of the asset. The DV method loads a higher depreciation amount over the earlier years, decreasing over the life of the asset. This occurs by calculating the depreciation on the opening book value of the asset (cost price less accummulated depreciation) for each period. Depreciation is prorated in the first year for the number of months owned. Over the life of the asset, the 2 methods should produce the same total depreciation. However the DV method is acknowledged as giving a truer representation, as most assets will depreciate more rapidly in the earlier years of their life.
For example take a car with a cost of $40.000 purchased at the beginning of the year. The IRD depreciation rates are 21% SL or 30% DV. In the first year SL depreciation is $8,400 while DV is $12000. In year 2 the depreciation is the same under both methods at $8,400. By year 4, the DV amount is $4,116, while SL remains at $8,400. At the end of that year the book value of the car is $9,604 under DV and $6,400 under SL.
This leads onto the question of what happens when you sell an asset you have depreciated. If at the beginning of year 5 our car was sold for $9000, a square up occurs. Under the DV method, a loss on sale of $604 would be claimed. Under the SL method we would have a depreciation recovery of $2,600, which would be taxable income in the year of sale. In effect the same total amount of $31,000 has been expensed over the period of car ownership.
Any business asset costing more than $500 (GST exclusive) with an expected life exceeding 12 months must be capitalised and depreciated for tax purposes. If multiple small assets, with the same depreciation rate purchased from the same supplier on the same day, exceed the $500 in total, they must be capitalised e.g. loose tools when setting up a business. If a purchase is less than $500, but is part of a larger asset being established, it must also be capitalised.(e.g. can’t expense the nails when building a shed).
Since the beginning of the 2012 tax year, buildings have a depreciation rate of 0%, where the building has an estimated life of 50 years or more. However, any depreciation claimed prior may still be recovered on disposal. This can result in a major tax cost when disposing of a business. However building fitout can still be depreciated.
Apart from buildings which have special rules, when an asset is disposed of a depreciation wash up occurs. Disposal can include receipt of insurance proceeds, obsolesence, irreparable damage, transferring an asset to non business use or to an associated entity, as well as a normal sale. In a number of these instances the deemed market value must be used as the sale price.
Depreciation can be a minefield. Get specific advice from your tax advisor.
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