I get asked about Xero's tax depreciation more than any other aspect of the software. It's not something you see in any other accounting software platform, and is the source of much confusion. A good understanding of the concepts will make it much easier to set up and maintain your depreciation.
Depreciation & Income Tax
Before we get to Xero's features, it's worth taking a look at what depreciation is, and how it pertains to taxation in Australia. The core precept of depreciation is to provide report readers with information useful to decision making. Capital Expenditure is not represented on the profit and loss, and yet the value a business invests in plant & equipment is still relevant to profitability.
Suppose I form a new company, win a freight contract, and buy a new prime mover for $500k. My major expenses are going to be diesel, and maintenance, as well as a myriad of other sundry running costs. However, in any given period the business will consume a portion of the value of the prime mover, and depreciation is the model by which we determine how much of that value has been consumed in a given period. The listed value of the asset in the balance sheet is reduced by the portion which the business has consumed. We determine a "useful life" for the asset, and then derive the appropriate decline in value according to a variety of available methods. In this way, report readers can see that the asset is no longer valued at it's original purchase price but something less, and that this decline in value impacts the profitability of the business.
The key here is that the primary function of depreciation is informational, we're not talking about taxable or assessable income.
However, things start to get murky when we consider that S40.25 of the Income Tax Assessment Act 1997 allows you to claim a tax deduction for decline in value. Additionally, the legislation provides a variety of measures for calculating your deduction which have nothing to do with modelling the decline in value of the underlying assets.
For example, we might determine that the prime mover mentioned above has a useful life of 10 years, so using the diminishing value method it would decline in value at a rate of 20% per year. However, S380 of the act provides a Small Business Entity Pool which completely ignores the actual value of specific assets and simply provides a rate of 15% in the first year and 30% in subsequent years.
The Small Business Entity Pool provides a better lower assessable income for the business and therefore a better tax outcome, but the deduction it provides, and the closing value for the pool, aren't useful for report readers and therefore have no place in your performance or position reports.
Xero's Ledger vs Tax Depreciation
Depreciation in the ledger is designed to model actual decline in value, while tax depreciation calculates deductions which are allowable according to tax law. These two aspects are configured separately in Xero's fixed assets.
This is simple enough, but the main source of confusion for Xero users is the question of how tax depreciation effects ledger entries, and where it appears in financial reports.
Tax depreciation has no place in your ledger, there's no journal entries for tax depreciation. Therefore in your statement of financial performance, the ledger depreciation values will be listed, with no mention of tax depreciation amounts.
When producing Special Purpose Financial Reports to support the preparation of a tax return, Xero includes a Tax Reconciliation Statement, which adds back ledger depreciation and applies a deduction for decline in value. This report is included in Xero's SPFR report packs, but you'll need to fill in the details manually.
An Example
Let me show you a super simple example to break down how this might look in a set of financial statements.
Suppose a small business with a turnover of $30k buy's a new vehicle for $20k on the first day of the period, which is eligible for immediate writeoff.
Profit & Loss Statement (abridged)
| Account | $ (000s) |
|---|---|
| Income | 30 |
| Gross Profit | 30 |
| Expenses | |
| Depreciation ($20k @ 25%) | 5 |
| Other Expenses | 4 |
| Total Expenses | 9 |
| Net Profit | 21 |
The profit & loss statement includes ledger depreciation, not tax depreciation.
Balance Sheet (exerpt)
| Account | $ (000s) |
|---|---|
| Non-Current Assets | |
| Motor Vehicles | 20 |
| Less Acc Depn | 5 |
| Total Non-Current Assets | 15 |
Accumulated Depreciation is the sum of all ledger depreciation previously applied to the profit & loss statement.
Tax Reconciliation Statement
| Item | $ (000s) |
|---|---|
| Net Profit | 21 |
| Add | |
| Ledger Depreciation | 5 |
| Subtotal | 26 |
| Less | |
| Immediate Write Off | 20 |
| Taxable Profit | 6 |
The Tax Reconciliation Statement is the only place your pools will be shown in a set of Special Purpose Financial Reports. It's included in Xero's report packs, but you have to fill in the details manually. You simply add back the ledger depreciation and apply the tax depreciation amounts.
Take Aways
Briefly, ledger or book depreciation models the real world decline in value of assets, xero uses this configuration to make ledger entries which will show on your profit and loss.
Tax depreciation models allowable deductions according to relevant legislation, xero calculates these deductions for you, and you include them in a Tax Reconciliation Statement in your financials.