A very common concept in accounting is the separation of capital expenses and revenue expenses. Capital expenses are things such as the purchase of assets & setup costs, while revenue expenses are the day-to-day expenses to keep the business running. When arriving at profits, accounting policies dictate that only revenue expenses are to be deducted from income to arrive at the profit, as profits should be a reflection of the businesses’ day-to-day operating efficiency.
However, strictly prohibiting all capital expenses is not fully realistic either, as the capital expenses are (usually) incurred to run the business. Things like purchase of equipment, or paying a 1-time fee for software license to be used in the process of generating revenue for the business. Therefore, the concept of depreciation was created!
In this blog, we will tell you all the basics of depreciation, and how it should be treated in taxation!
Depreciation
The justification of depreciation is 2-fold:
1) The idea that a piece of equipment, through wear & tear, will lose its asset value, whether it be for resale or for the value it could generate for the business. In the pursuit of being prudent, the value of the asset should be reduced in the books accordingly to reflect this loss of value.
2) The reality that old or obsolete equipment will eventually be replaced by a newer or better piece of equipment, therefore putting an effective useful life on all assets purchased for use in the business, making the capital expense still an expense, just over multiple accounting periods.
Of course, some assets do not lose their value as quickly as others, while some assets do not drop, but instead rise in value as time goes on (like land). Therefore, different depreciation rates are applied to different classes of assets, based on their expected useful life. The most common expected useful life is 5 or 10 years, but each business should evaluate the rate to be used based on their operations.
Accounting Depreciation
When calculating depreciation, 3 formulas are acceptable depending on the situation:
1) (Asset Purchase Price - Scrap Value)/Useful life. This creates a even expense over the years that represents how much value the asset will lose in each of its years in use.
2) If the asset can be expected to have 0 scrap value, the calculation can be simplified to Purchase Price/Useful Life, or use a flat % rate on the asset's purchase price.
3) Alternatively, to reflect that assets’ lost value is usually logarithmic (meaning it gets smaller/slower over time), a flat % rate applied to the assets’ remaining book value is also acceptable.
The depreciation shall then be recorded as an expense in the income statement & accumulated in the balance sheet as a asset value reducer. The resulting reduced value of the asset is known as the Net book value.
In the event of a disposal of the asset, businesses need to calculate a profit/loss on the disposal of the asset, using its resale/scrap value compared to its book value. If there was a profit on the disposal, it means the depreciation on the asset was too much, and so an income will be recognised to offset the excess depreciation in previous years; in case of a loss, that means the depreciation was not high enough in previous years, and so an expense is recognised instead.
Capital Allowance
To account for capital expenses in tax computations, the government has decided to disallow all depreciation on tangible assets. The justification is that businesses can have very varied depreciation policies, and ensuring businesses’ deprecation policies are reasonable for each business would be too complicated. Therefore, when preparing the tax computation, depreciation has to be added back to net profit to arrive at the business's adjusted income.
In the tax terminology is called a capital allowance, allowing qualifying capital expenses (known as Qualifying Expenditure) to be expensed off over time. Malaysia’s capital allowance is split into 2 rates:
1) Initial Allowance (IA): This rate is only applied to the year of the purchase of the asset.
2) Annual Allowance (AA): This rate is applied annually on top of the IA until the qualifying expenditure is reduced to 0. Bear in mind, IA is only for the first year when the asset is purchased for business use.
Different asset classes have a set of capital allowance rate. IRB also allows accelerated capital allowance for specific asset classes depending on what is being encouraged by the government, so taxpayers are advised to keep close attention to any potential changes to the capital allowance & accelerated allowance rates.
Conclusion
While capital expenses are, in principle not deductible in arriving at the profit of the business, in the end, all monies spent in the business should ultimately be in generating revenue for the business. Therefore both the accounting standards & the tax authorities agree that businesses need a way to expense of capital expenses into the income statement to accurately reflect the performance of the business.
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References
Public Ruling 6/2022 (ACCELERATED CAPITAL ALLOWANCE): https://www.hasil.gov.my/media/3h0i14yq/pr_6_2022.pdf
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