Accounting and Tax Treatment of Computer Hardware and other Fixed Assets
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Investment in capital items such as computers, furniture, equipment and cars can cause confusion for small business owners. Since these are purchases that affect the cash flow of the business, it seems that they should be accounted for as expenses similar to office supplies or rent. There are however special rules for any acquisitions that qualify as “fixed assets”. A fixed asset, simply speaking, is an acquisition that provides a long term economic benefit to the business. In other words, any business purchases that has a useful life that extends beyond one year, will usually qualify as a fixed asset.
How to Account for Depreciation:
From an accounting perspective, fixed assets as their category implies, are reflected as assets on the Balance Sheet. This means that they when they are initially entered into your accounting system, they will have no immediate impact on your net profit. It is only with the passage of time that a portion of these costs become an expense, which requires an assessment regarding the useful life of the asset.
For example you might purchase some computer hardware that you expect to use for about 3 years after which you will need to replace it. At the end of the 3 years, however, it may still have some value (you may be able to sell it) which is referred to as salvage value. This too needs to be evaluated. Once these factors are determined (since you are not psychic, they do not have to be exact – just reasonable) you have enough information to calculate your depreciation expense. The depreciation expense is the amount by which you reduce your fixed asset value on an annual basis.
Depreciation Calculation Example Using The Straight Line Method
For example, lets assume that the value of the computer equipment, which can include desktops, laptops, hard drives, printers etc is $2,000 and the salvage value, at the end of three years, is expected to be $500. A common way of calculating depreciation is to use the” straight line method”, which essentially results in the same of amount of depreciation being taken, every year, over the three years. The calculation is as follows:
Cost $2,000
Salvage Value: $500
Net Cost: $1,500
Straight Line Depreciation: $1,500/3 years = $500 per year.
Using this calculation you would show a depreciation expense of $500 annually.
Journal Entry for Purchase and Depreciation
journal entry for Purchase of fixed asset :
Upon Purchase of the Asset:
Computer Equipment (Fixed asset) Dr. $2,000
Bank or Accounts Payable Cr. $2,000
journal entry for Depreciation Expense:
Depreciation expense (expense) Dr. $500
Accumulated Depreciation (Fixed Asset) Cr. $500
Note that the accumulated depreciation is an account created to monitor the total depreciation expense taken over time and is offset against the computer equipment (known as a contra account as it is an asset with a negative balance ). The net of the two amounts is referred to as Net Book Value.
Instead of showing the full amount as an expense in the year that you purchase the computer equipment, you stagger it over the three years over which you expect to use it. This more accurately reflects the substance of the transaction.
Tax Treatment OF Fixed Assets
Capital Cost Allowance
The Canada Revenue Agency has specific guidance as to the depreciation that is used for different types of fixed assets which it defines as follows:
Since these properties may wear out or become obsolete over time, you can deduct their cost over a period of several years. This yearly deduction is called a capital cost allowance (CCA).
This is essentially the same concept as depreciation, however, instead of using the straight line method referred to above, the CRA requires the use of the declining balance method in most cases. Each category is assigned an annual rate of depreciation. The rate is applied to the net book value remaining at the end of the previous year.
Note that the tax treatment applicable to fixed assets and CCA is the same for both unincorporated and incorporated small businesses. If using personal tax software to complete your sole proprietor (unincorporated) tax return, you will see a section for CCA. The good news is that the software will calculate the exact amount of the depreciation.
Example of CCA Calculation (Declining Balance Method)
For example lets assume you purchase a desk for your office for $750. This would be classified as furniture and equipment, i.e. class 8, which is a bit of a catch all category when there isn’t another specific classification that fits, and has a CCA rate of 20%.
Note that CRA requires the use of the half year rule in year 1 of purchase of an asset which it defines as follows:
In the year you acquire a depreciable property, you can usually claim CCA only on one-half of your net additions to a class.
Note that for purposes of the calculation below, UCC or undepreciated capital cost is simply the balance of the asset that has not yet been depreciated.
Calculation In Year 1.
Cost of Desk (Furniture and Fixtures) $750
CCA Rate (half year rule) 20%/2 = 10%
CCA Amount $75
Undepreciated Capital Cost (UCC) $675
Calculation In Year 2
UCC ($750-$75/See above) $675
CCA Rate 20%
CCA Amount $135
Undepreciated Capital Cost (UCC) $540
If the business decides to use the straight line method, there will be a difference in depreciation and CCA amounts. In this case it is important to keep track of the tax amounts as this will need to be used in tax returns and gives rise to “deferred taxes”.
Sale of Fixed Assets
If and when the asset is sold or disposed of, it must be reflected in your tax return. If the asset is sold at a loss or disposed of for $0, you are allowed to take the balance of the undepreciated capital cost and write it off as a terminal loss. If sold at a gain, the business must determine if the amount at which it is sold exceeds the depreciated value or UCC of the asset. The excess of the sale price over the depreciated (UCC) value will be a “recapture” and have to be shown as business income. A capital gain would be recorded to the extent that the sale price exceeds the original purchase price.
The tutorial below shows you how to record a sale of a fixed asset and the gain or loss:
Common CCA Classes and Rates:
Class 1: Buildings: CCA Rate = 4%
Class 8: Furniture, fixtures, appliances, tools (usually costing more than $300-$400, although there is no official guidance from CRA on this): CCA Rate = 20% For example office desks, chairs, appliances,
Class 50: Computer Hardware: CCA Rate = 55%
Class 10.1: Passenger Vehicles that cost more than $37,000: CCA Rate = 30%
Class 12: Computer Software, tools etc: CCA Rate = 100%
Small business need to keep in mind that when they make a large purchase (usually over $300) they need to consider whether it is in fact an expense or should it be more appropriately classified as an asset. If the latter is selected, then the business should have a depreciation policy (for simplicity many small businesses just use the CCA CRA tax rate and amount) and realize that even though the cash flow of the business was reduced by the full amount, the actual impact to business profit-loss/bottom line is only the depreciation expense for the year.
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