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HMRC internal manual

Business Income Manual

Stock: valuation: depreciation in stock

Depreciation in trading stock

For financial statements properly to reflect business costs they have to take account of the wearing out or other reduction in the useful economic life of fixed assets. Depreciation is a measure of this and is charged against income in arriving at the commercial profit. For tax purposes depreciation of fixed assets is a capital matter and therefore must be added back in the tax computation.

The applicable accountancy

Following the House of Lords decision in the joined cases of HMRC v William Grant & Sons Distillers Ltd and Small (HMIT) v Mars UK Ltd [2007] 78TC442 (see below), the HMRC view is that depreciation in fixed assets which relates to the production of unsold stock will be added back in the tax computation when the stock is disposed of and the depreciation is deducted in arriving at the profit for the year of the disposal.

In his judgment on those cases, Lord Hoffmann said that the applicable accounting standard for depreciation is FRS15. Paragraph 77 of FRS15 requires that the depreciation charge for each period is recognised as an expense in the profit and loss account for the period unless it is permitted to be included in the carrying amount of another asset. Hoffmann explained what this means by reference to the principle that the determination of profit for an accounting period requires the matching of costs with related revenues. Hoffmann went on to say:

`This fundamental principle is given effect by taking the revenue which has arisen in the relevant year and deducting from it only those costs which are attributable to those sales. These costs may have been incurred in the year in question, or they may have been incurred in earlier years and carried forward in accordance with the general principle, to be matched with the related sales when they occur. The costs of stocks which remain unsold at the year end are not deducted for the purpose of computing profit in that year but are carried forward to be matched against revenue from their sale in future years.’

Paragraph 17 of SSAP9 says that the cost of stocks includes not only the cost of purchasing the materials but also the ‘costs of conversion’. These are defined to include costs ‘specifically attributable to units of production’, including ‘production overheads’. Paragraph 20 of SSAP9 specifically provides that such overheads should include the depreciation of assets ‘which relate to production’.

Both Mars and Grant prepared their accounts in accordance with these standards. They divided the depreciation which occurred during the year or was carried in the opening stock into two parts:

  • the first part was depreciation in fixed assets which related to the production of goods sold during the year, and
  • the second part was the depreciation in fixed assets which related to the production of unsold stocks.

Both Mars and Grant deducted the first part depreciation from the year’s revenue and carried forward the second part as part of the cost of unsold stock. Expert accountancy evidence on both sides agreed that:

  • this was the way the computations had been made, and
  • that the resulting statement of profits was in accordance with the standards, and
  • gave a true and fair view.

On this basis Hoffmann considered it `plain and obvious’ that only the first part depreciation had been deducted in arriving at the profit for the year.

Practical matters

You will need to consider whether the business has in place appropriate mechanisms to ensure that depreciation is added back in the computation for each year/period of disposal of the stock in question.

Where there are only a small number of relatively large items in stock businesses will find it easier to track the depreciation within stock and so ensure that on the disposal of the stock in question the relevant depreciation is correctly included in the tax computation.

Where the stock comprises a very large number of individual items each of relatively modest value, businesses may find the record keeping requirements to be burdensome when the new depreciation in stock approach is adopted. They must however follow the method approved by the House of Lords and cannot use the former method.

The accounting standards relevant to the cases considered in this section were FRS15 and SSAP9. Other accounting standards dealing with similar issues are sections 13 and 17 of FRS102, IAS2 and IAS16 none of which would result in a substantially different accounting treatment.