Accounting and Tax Treatment of Computer Hardware and other Fixed Assets
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. Below I discuss the accounting and tax treatment of fixed assets.
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 bottom line. 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.
In our example above, suppose that the value of the computer equipment, which can include mobile phones, 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.
The journal entry for the fixed asset is as follows:
Upon Purchase of the Asset:
Computer Equipment (Fixed asset) Dr. $2,000
Cash or Accounts Payable Cr. $2,000
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.
What is the Tax Treatment of Fixed Assets:
My video below discusses fixed assets and depreciation, how it impacts the balance sheet and profit-loss and how to calculate the depreciation, using the declining balance method, in excel
In this tutorial we will look at what are fixed assets and how to enter them as well as the impact on the Balance Sheet. We then review the two most popular depreciation methods, how to calculate the depreciation using the declining balance method which is used by Revenue Canada (CRA) with a spreadsheet and how to enter depreciation in QuickBooks Online. Finally we will review the impact on the profit and loss and balance sheet.
The Canada Revenue Agency has specific guidance as to the depreciation that is used for different types of fixed assets. This is referred to as capital cost allowance or 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. For example 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%.
Calculation In Year 1.
Cost of Desk (Furniture and Fixtures) $750
CCA Rate (half year rule – see below) 20%/2
CCA Amount $75
Calculation In Year 2
Net Book Value ($750-$75) $675
CCA Rate 20%
CCA Amount $135
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.
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 net book value 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 of UCC of the asset. If so, 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.
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.
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 $30,000: CCA Rate = 30%
Class 12: Computer Software, tools etc: CCA Rate = 100%
It is important to note that most of the classes use a “half year rule”, which means that regardless of when you purchased the asset, depreciation allowed in the first year of purchase is only half of the allowable percentage.
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 Revenue Canada 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.
Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.
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