Capital allowance vs. depreciation: how to explain the difference

Accountants are familiar with dealing in figures, regulations and HMRC guidelines. They can become so used to talking about complicated details, it can then become hard to explain complex issues to someone who has no financial background knowledge because it is something that the accountant doesn’t usually have to explain. 

In this article, we will discuss the difference between capital allowance and depreciation so that the concept is easy to grasp, even for clients or business owners that have zero accounting experience. You can use this article if you are a business owner yourself, to understand these accounting terms, or if you are an accountant as a guide for explaining the following areas:

• What are capital allowances?
• What is depreciation?
• How do capital allowances and depreciation work in a business setting?

Capital allowances are a method of saving tax for when a business buys a capital asset. Capital allowances act in a similar way as business expenses. The expenses and capital assets are taken off the total profit (if the items are tax-deductible) and this way the business only pays tax on the money it’s made after all operating costs have been taken into consideration.

Simply put, capital assets are large purchases companies make, usually which support running the business, like a piece of equipment or a vehicle. These assets are items that will be useful to the business long-term (a good rule of thumb is will this item be useful for longer than two years).

Capital assets can be something that is physical, such as machinery or something intangible that cannot be touched such as a patent or intellectual property rights. Capital assets are also commonly known as ‘fixed assets’, and business owners will most frequently see this term listed on company balance sheets.

When a business buys something that has a sizable value, such as an expensive piece of equipment, it can be tax-deductible through capital allowances. 

When the business pays its tax bill at the end of the year, the cost of the capital asset will be taken off the total profit for that year. Using a capital allowance this way ensures the business is only paying tax on profit made, not the profit used to buy items that are necessary for the running of the business.

Depreciation is a method of accounting where the cost of a capital asset is spread over a period of time. The period of time chosen is the length of time that the asset will be useful to the business.

So say a local bakery buys an industrial oven. This could be a high cost for the business to have come off their profit. So, when using financial reports for their accounting they divide the value of the oven over the number of years it should last. This turns the asset’s value into a day-to-day running cost on financial reports and reduces profit over the years that the business will use it, instead of having the chunk come off the profit at one time.

The point of using depreciation for accounting is to show the cost of the item over time so that it matches up on the financial reports with the profit the asset’s use is creating. Using the bakery example, spreading the cost of the oven over the years the bakery uses gives an accurate representation of the value vs. the revenues created with its use.

This process is called depreciation for tangible assets (physical things) and amortisation for intangible assets.

So why do businesses use depreciation? First of all for reporting purposes, because depreciation reduces the value of the asset on the business’s balance sheet. The point of doing this is to show that the value is less over time because if you sold the asset you wouldn’t be able to sell it for as much as you bought it for.

The depreciation is also not allowable for tax. This is why capital allowances are used to compensate for having a large purchase come out of the profit. Capital allowances allow the business to deduct the asset value from the profit before paying tax on it since they cannot use the ‘over time’ depreciation method for tax purposes.

In the UK there are two ways accountants will use to calculate depreciation. 

First, the easiest way is ‘straight-line depreciation’. This is when the cost of the asset is divided by the number of years it will be useful to the business, and the resulting figure is what is used in yearly financial reports. 

For example, say a laptop costs £1,000. The business owner expects the laptop to last five years, so depreciation would be 1,000 divided by five = £200 per year.

The other method of calculating depreciation is called ‘reducing-balance depreciation’. 

This is where the business reduces the balance they ‘owe’ for the item using a percentage, over the years they use the asset. 

So for example, a business owner might buy a car for £5,000. They choose to depreciate it at 20% reducing balance. So the first year the business owns the car, the depreciation would be:

£5,000 x 20% = £1,000

The second year the business owns the car, they would then use their starting value as the original cost (£5,000) minus the first year’s depreciation (£1,000) to get a £4,000 reduced balance. Then to calculate the second year depreciation, they’d do the following:

£4,000 x 20% = £800

The business would continue doing this for the years they use the asset until the ‘balance’ is reduced. This method means that the value of the asset is reflected more accurately over time, because the longer the businesses use it, the less money they’d get if they sold it.

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