adjustmentstothefinalaccountsofbusinessorganisations 12 120930154311 phpapp01

8/10/2019 Adjustmentstothefinalaccountsofbusinessorganisations 12 120930154311 Phpapp01

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Adjustments to the final accounts of business organisations

In this section we cover the following topics:

Capital and revenue expenditure Accounting for accruals and prepayments Bad debts, recovered bad debts and provision for doubtful debts

Bad debts Provisions for doubtful debts Bad debts recovered

Depreciation Meaning of depreciation Calculation of straight-line and reducing balance methods of

depreciation Deprecation adjustments for profits and balance sheets Calculation of profits and losses on asset disposal

Classification of expenditure

All firms spend money in their business operations. However, not all thisexpenditure will appear immediately in the profit and loss account as anexpense. The reason this happens is due to the classification of allexpenditure into one of two kinds either capital expenditure or revenueexpenditure.

Capital expenditure

Money spent on fixed assets or any other long term projects is likely to beclassified as capital expenditure. The purchase of a fixed asset involvesmoney being spent on an item which is going to be (hopefully) used formore than one period of time. Therefore, including it as an expense in thecurrent profit and loss account would be misleading and would violate theidea of the accruals concept (where expenses are matched to the periodin which they 'belong'). The accruals concept is covered in more detail on

3.2

As a result, capital expenditure appears on the balance sheet. Forexample, the purchase of new equipment would be capitalised and listedas a fixed asset. Money has been spent on this asset and the bank or cashfigure would be reduced, but it initially appears as though the cost of theasset does not appear as an expense. However, the asset does appear asan expense but this is done over time and will appear as depreciation (aprovision, not an expense - don't worry, both provisions and expenses arededucted as though they are expenses in the profit and loss account).


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Capital expenditure would also include costs involved in getting the assetinto working condition. For example, these costs would all be classified ascapital expenditure:

1. Delivery costs for asset2. Installation costs3. Legal fees involved with the purchase of an asset

Revenue expenditure

Money spent on day-to-day running costs would be classified as revenueexpenditure. This is because the expense can be linked to belonging to a

specific period of time. The expense is 'used up' during that period of timeand will not be carried forward into the next period of time. Any items ofrevenue expenditure will appear as an expense in that period's profit andloss account

If the expenditure does not add value to the firm or have any long-lastingimpact then it is likely to be revenue expenditure.

The following table illustrates examples of capital and revenueexpenditure:

Capital expenditure Revenue Expenditure

Installation of heating system, Annual costs of heating system

Upgrades to computer system Power cost of computing system

New premises Repairs to premises

Painting new premises Repainting existing premises

Carriage inwards on new equipment Carriage inwards on stocks for resale

Installation costs of machinery Running costs of machinery

One-off license fee Annual road tax

Differences between the two types of expenditureCapital expenditure is capitalised. This means that it does not appear inthe profit and loss account as an expense but goes straight on to the

balance sheet. However, the cost of a fixed asset will appear in the profitand loss account as an expense, but this will be on the form of


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'depreciation' which we will cover in this module. Revenue expenditurewill appear in the profit and loss account in the period in which it isincurred:

Type of expenditure Where it should appear

Revenue expenditure Profit and loss account - expense

Capital expenditure Balance sheet item - asset

Capital and revenue income

Similarly, incomes for the firm will be classified as either capital income orrevenue income.

Revenue incomeThis usually includes the revenue from the sale of stocks, but may alsoinclude money received from items such as commissions received, orinterest received. Revenue incomes will all be included in the profit andloss account (sales revenue appears in the trading account section of theoverall account). Any other forms of income would be credited to theprofit and loss account normally added on to the gross profit before theexpenses are deducted.

Capital incomeThis refers to one-off sources of income. The sale of a fixed asset wouldbe treated as capital income. This means that the revenue from the saleof a fixed asset, the money raised through the issue of shares, or moneyobtained in the form of a loan would not be included as income in theprofit and loss account.

Implications in classification of expenditure

If any item is incorrectly classified as capital expenditure then there willfewer expenses included with the other revenue expenses in that year'sprofit and loss account. In other words, profits will be higher this year asa result. However, once the expenditure has been capitalised on thebalance sheet, it will require depreciation over time. Hence, future profitswill be lower (maybe not by much - this will depend on how long a periodthe asset is written off over).

Although the distinction between 'revenue' and 'capital' appearsstraightforward, it is not always easy to classify items as one or the other

and the classification will partly depend on whether or not a firm regardsan expenditure as a significant amount of expenditure or not. For


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example, when a firm buys a set of chairs, for example, then technicallythese should be regarded as an asset which will provide a benefit over thenext few years i.e. it is a capital expenditure which should be put on thebalance sheet and depreciated. However, if the cost of the chairs is only afew hundred pounds the firm may write them off in one go i.e. treat themas revenue expenditure and put the total expenditure on the profit andloss this year (this is the concept of materiality, covered in 3.2)

In the case of items such as research and development some firms willtreat this as a revenue expenditure on the basis that the benefits of thishave been used up this period. Other firms will treat research anddevelopment as capital expenditure on the basis that it will hopefullyprovides a benefit in the future if the research is fruitful. This lack ofclarity about what is and what is not a capital expenditure gives somefirms increased scope for 'window dressing' their accounts so as topresent the firm in a particularly flattering way. For example, by decidingto classify an item as a capital expenditure rather than as revenueexpenditure this year's costs will be reduced and profits increased simplybecause of a change in accounting policy.

As a result, the accounting profession has developed a series ofregulations which state which items of expenditure can and which cannotbe capitalised on the balance sheet. These regulations are covered inmodule 6. For example, in the case of Research and Development costs

'SSAP 13' states that R & D expenditure can only be capitalized if certainconditions are met".

Exam tips - capital and revenue expenditure

Examination questions do not normally focus solely on the distinctionbetween capital and revenue expenditure. This topic is likely to be testedin the context of some other topic - such as the effect on profits of thepurchase of a fixed asset.

The distinction between capital and revenue expenditure (and incomes)may be tested in terms of their effect on cash flow and profits at thesame time.

Accruals and prepayments

The profit and loss account for any firm should show the income and

expenses belonging to the time period in which account claims torepresent. In most cases, the profit and loss account is drawn up for a


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year - this means that it should show all the income earned and all theexpenses incurred for that year even if they have not all been paid andreceived.

This idea is contained within the accruals (or matching) concept - that weshould account for income and expenses when they are incurred (i.e.used up), not when they are paid and received. In other words, if an itemof income or an expense belongs to a period of time (e.g., car insurancefor a year) then it would appear as an income or expense for that period -regardless of the amounts actually paid or received.

So far, we have only applied this concept to sales and purchases - salesare included as income and purchases are included as an expense eventhough they are usually on credit terms and the money from these

transactions may not be paid or received until the next accounting period.For example, credit sales made on 20th December 2001 would counttowards the profits of the year ended 31 December 2001, but the cashgenerated by this sale is unlikely to be received until 2002. The accrualsconcept must also be applied for any expenses and any incomes. Thisleads to some new definitions:

The implications of these for the profit and loss account is that thisaccount should show the income that should have been received and theexpenses that should have been paid when the transaction was originallymade, even if this does not correspond with the money paid in orreceived.

If expenses are paid immediately when they are incurred and income isreceived immediately when it is also earned, then we have no need foraccrual and prepayments. For example, if we assume the annualelectricity bill was 750 and commission received for the year of 2001was 500, then the ledger accounts would appear as follows:

Electricity

2001 - 2001 -

Dec 31 Bank 750 Dec 31 Profit & loss 750

Electricity appears on the debit side of the profit and loss account (as anexpense).

Commission Received


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2001 - 2001 -

Dec 31 Profit & loss 500 Dec 31 Bank 500

Commission received appears on the credit side of the profit and lossaccount (as income).

If you are not using bookkeeping, then you should be aware of thefollowing:

Expenses - Debit balances

Incomes - Credit balances

In the above example, Rent would appear as a debit (expense) andcommission received would appear as a credit (income) in the profit andloss account.

If we allow for accrued expenses and prepayments then this will involvediscrepancies between the amount that appears in the profit and lossaccount and the amount that was actually paid or received. The followingexamples include situations taking this into account.

Concepts covered

1. Accrued expenses (or accruals) are expenses incurred during afinancial period but not yet paid for, i.e. expenses owing

2. Prepayments are expenses paid in advance of the current financialperiod (i.e. paid now for the next period).

3. Accrued revenue refers to income which is still owing to firm(similar to debtors)

4. Prepaid revenue refers to income which the firm has received inadvance of when it was due

Adjustments without bookkeeping

The same examples as above are now explained without the use ofbookkeeping.

Remember the profit and loss account has to deal with the amounts that


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were due to be either paid or received. Therefore the adjustments neededfor accruals and prepayments in expenses will be as follows:

Profit and loss entry = amount paid + accrued expenses still

owing Profit and loss entry = amount paid - prepayment for next period

For incomes and revenues received by the firm, the treatment will be asfollows:

Profit and loss entry = amount received + accrued revenue(amount still owing to us)

Profit and loss entry = amount received - prepaid revenue(received in advance for next period)

Dealing with more than one year

So far we have considered examples where the outstanding balance onlyoccurs at the end of the year, It is perfectly possible to carry theseforward and to have outstanding balances at the start and at the end ofthe year.

We can use our knowledge to determine how much should actually beentered in the profit and loss account for the particular period.

Consider the following examples (as before, follow the links to theexamples):

Balance sheets

On the balance sheet, only the amount that is either an accrual or aprepayment should be included in current assets and current liabilities.Normally, prepayments should appear in current assets after bank andcash. Accruals should appear in current liabilities after creditors and bankoverdrafts.

Accrued expenses or prepaidrevenue

Prepaid expenses or accruedrevenue

Credit balances Debit balances

Current liabilities Current assets


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In questions where the data is presented in the form of a trial balance,the amount actually paid or received will appear within the trial balance.Information relating to accruals and prepayments will be given at thebottom of the trial balance with the closing stock and other information

Exam tips - accruals and prepayments

To calculate the amount to be included in the profit and loss account,think about the amounts that belong to that period - irrespective ofwhether they have been paid or not.

Be careful in case there are outstanding balances from both the start and

the end of the period - the amounts will need adjusting for both.

Accruals and prepayments will always generate an item for the balancesheets

Bad debts

Credit sales and credit purchases are normal business transactions, where

goods are exchanged between supplier and customer, but the money forthe transaction is exchanged at a later date. These credit terms offeredgives firms valuable 'breathing space' where they can pay for the goods ata time when the firm may have more money available (most credit termsexpect payment within one month).

The business offering credit terms is taking the risk that some customersmay never pay for the goods sold to them on credit. Any debtor'sbalances that remain unpaid (after a specified period of time has elapsed)are classified as a bad debt.. The process of cancelling a debt because

payment is not expected to be received is known as 'writing off' the baddebt. Bad debts are an unfortunate, but not unusual business expense,and must be charged as an expense to the profit and loss account in theperiod when the firm decides to cancel the debt from ledger accounts

Bad debts are a profit and loss expense in the period in which theyare written off

Firms would not offer credit to any firm they know would not pay, butmany firms will experience financial difficulty - and may have to closedown - thus making bad debts an inevitable part of the business world.


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When a debt is found to be bad, the balance on the debtor's accountceases to have any real value and must be closed down as an assetaccount (here we are trying to show a realistic value of the assets of thefirm - the prudence concept - covered in 3.2). This is done by creditingthe debtor's account to cancel the asset and increasing the expensesaccount of bad debts by debiting it there.

Sometimes the debtor will have paid part of the debt, leaving theremainder to be written off as a bad debt. Alternatively, the firm mayreceive part of the outstanding debt in full settlement. At the end of theaccounting period, the total of the bad debts account is later transferredto the profit and loss account as an expense.

The double entry for bad debts is as follows:

Debit Credit

Bad debts Debtor

During 2005, the following sales were made all on a credit basis.

January 15, sales of 750 were made to G Flitcroft

March 11, sales of 490 were made to G ElliotApril 27, sales of 160 were made to P Krugman

The entries for these sales would appear as follows:

G Flitcroft

2005 - 2005 -

Jan 15 Sales 750 - - -

G Elliot

2005 - 2005 -

Mar 11 Sales 490 - - -

P Krugman


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2005 - 2005 -

Apr 27 Sales 160 - - -

(N.B. The sales account would receive the credit entry for each of thesesales)

On the 31 December of that year it was decided that the followingaccounts would be written off as bad debts:

G Flitcroft

G Elliot

At 31 December, P Krugman had been declared bankrupt during the yearand a payment of 25p in the was received by cheque in full settlementof this account.

The debtor's account would now appear as:

G Flitcroft

2005 - 2005 -

Jan 15 Sales 750 Dec 31 Bad debts 750

G Elliot

2005 - 2005 -

Mar 11 Sales 490 Dec 31 Bad debts 490

P Krugman

2005 - 2005 -

Apr 27 Sales 160 Dec 31 Bank 40

- - - Dec 31 Bad debts 120

- - 160 - - 160

With the P Krugman account, a settlement of 25p in the means that we


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have received 25p for every 1 owing to us - the other 75p in the isrewritten off as a bad debt.

To complete the entries, the amounts are transferred to the debit side of

the bad debts account. This account is then transferred to the debit sideof the profit and loss account - as an expense.

Bad debts

2005 - 2005 -

Dec 31 G Flitcroft 750 Dec 31 Profit and loss 1360

Dec 31 G Elliot 490 - - -

Dec 31 P Krugman 120 - - -

- - 1360 - - 1360

In a trial balance, the entries for bad debts will always be in the debitcolumn.

This means that the bad debts have already been deducted from thedebtors figure in the trial balance and therefore you should not deduct thebad debt from he debtors figure. Only if the bad debt has not beenrecorded in the books would the debtors figure need to be reducedbecause of bad debts.

Provisions for doubtful debts

The profit and loss account and the balance sheet are the final accountsof the firm. One of the main aims of producing these statements is toshow a true and fair view of the firm's financial position. One way inwhich we achieve this is by showing realistic values for any assets that

the firm has. Any debtor balance which is unlikely to be collected shouldbe written off as a bad debt and the overall total for debtors will thereforenot contain amounts that we have given up hope of collecting.

However there is a problem with the debtors figure as it appears on thebalance sheet. Although the debtors figure contains the total amount thatwe aim to collect from our customers, the firm will probably recognisethat, over the course of the next year, some of these debtors will becomebad debts and have to be written off.

The firm will have no idea (although it may suspect) which of the firm's


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debtors will become bad debts (surely it would not have given creditterms to any customer who is unlikely to pay), but it will have to face upthe fact that bad debts are a common business occurrence. In mostcases, the debtors would be wiling to pay, but simply cannot (maybebecause the customer's firm has had to close). As a result, the debtorsfigure on the balance sheet does not show a 'true and fair view' of theactual amounts that will be collected by the firm from the customers.

Therefore to be prudent, the firm should try to aim to show a morerealistic figure for the amounts likely to be collected over the near future -in other words, it should try to estimate the size of any future bad debts,before they actually occur. This can be done by creating a provision fordoubtful debts.

This provision is supposed to reflect the likely size of the future bad debtswhich means that this can be deducted form the debtors figure on thebalance sheet so to give a more realistic figure for the amounts likely tobe collected.

The provision for doubtful debts is not the same as the amount of baddebts. Bad debts are actual sums of money that have been written off.The provision for doubtful debts is an estimate of the size of future baddebts - it has not happened. The firm may actually over or underestimatethe size of the future bad debts when creating this provision. This doesnot matter, as long as the estimate is a reasonably realistic prediction ofwhat will happen then it does not matter if the actual bad debts in thefuture are not exactly the same as the provision for doubtful debts.

Calculating the size of the provision for doubtful

debts

When trying to estimate a figure for doubtful debts, a firm would want to

take into account the following:

1. The amounts of debts outstanding from each customer2. How long each debt has been outstanding3. Economic climate - incidences of business failure

Firms will have different experience when it comes to bad debts. Somefirms will operate in industries where bad debts are more frequent thanothers. Therefore the estimates will differ between firms.

Generally, the longer a debt is owing the more likely it is that it will


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become a bad debt. This can be seen in an aged debtors schedule whichranks and classify amounts owing to the firm by the length of time thatthey have been outstanding.

Example: Ageing Schedule for Doubtful Debts

Period debtowing Amount

Estimated percentagedoubtful

Provision fordoubtful debts

- %

30 days or less 10,000 1 100

1 month to 2months 6,000 2 120

2 months to 6months 800 5 40

6 months to 1year 300 10 30

Over 1 year 180 50 90

Total debtorsamounts 17,280 - 380

This balance of 380 for the provision would then be deducted from thevalue of the debtors figure on the balance sheet - giving us a morerealistic value of the amount that we will collect from the debtors.

As far, as most examination questions go, the provision for doubtful debtsis likely to be a percentage of the overall debtors figure. For example,some firms may always maintain a provision for doubtful debts of 2 or 3%of their outstanding debtors totals.

Accounting for provisionsA provision is an amount charged against profit (i.e. treated as anexpense) to record a reduction in the value of an asset - even if the exactfall in value is uncertain. Whether you have studied bookkeeping or not,the accounting entries for provisions are unlike any other types of entriesthat you will make in terms of their effect on the profit and loss account,as well as on the balance sheet.

There are three main types of provisions that are studied:

1. Provisions for doubtful debts


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2. Provisions for depreciation3. Provision for unrealised profit on stock

If a firm's asset has lost, or is expected to lose value, then we would wantto show this loss in the accounts. The balance sheet value can bereduced, but we also want to show the effect of this loss on the profits aswell. Therefore a provision will appear in the profit and loss account as anexpense - even though no money has been spent. If you imagine thatyou'd lost some money - you would treat this as a loss for yourself, eventhough you haven't actually spent any money.

Although a provision will appear as an expense in the profit and lossaccount, it is only the adjustment to the provision that appears as anexpense. Therefore, if the provision is kept at he same level over a fewyears then, apart from when the provision is created, there will be nofurther expense in the profit and loss account - only when it was firstcreated.

It may help if you think of it as money you put aside. If last year you hadput aside 200 out of profits, and this year you want the same amount tobe 'aside' then you don't need to deduct anything from this years profits.The 200 is still there - it was on last years balance sheet and it will be onthis years' too, unless it is adjusted.

Provisions are always credit balances and they are kept in the firm'sbooks until the firm decides to eliminate them from the entries. If aprovision is to be increased then a further credit entry will need to be'added' on the existing balance. If the provision were to be reduced thenthere would need to be a debit entry to reduce the overall balance.

If the provision were actually reduced between one year and the next,then this reduction in the provision would actually be treated as incomeand would be added on the year's gross profit.

The rules for provisions are as follows:

Profit & loss account Balance sheet

Show change in provision onlyIncreases = expensesDecreases = revenues

Deduct full provision from relevant asset


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Accounting entries for provisions for doubtful

debts

When the decision has been taken as to the amount of the provision to bemade, then the accounting entries needed for the provision are:

Debit Credit

Profit & loss Provision for bad debts

Increasing the provisionThis provision that was created will be kept on the firm's books and canbe adjusted both upwards and downwards to meet changingcircumstances.

If we assume that as at 31 December 2002 the debtors figure had risento 16,000 (see example 1 link above) then the provision may well beadjusted upwards to take into account the increased likelihood of baddebts.

If we maintain the provisions at 3% of debtors, then the provision would

be increased to 3% x 16,000 = 480. However, because there is alreadya provision in existence of the 450, we simply need to add on another30 to the credit side of the provision for doubtful debts account.

Provision for doubtful debts

2001 - 2001 -

Dec 31 Balance c/d 450 Dec 31 Profit & loss 450

2002 - - 2002 - -

Dec 31 Balance c/d 480 Jan 1 Balance b/d 450

- - - Dec 31 Profit & loss 30

- - 480 - - 480

Therefore the rule for increasing the provision is as follows:

Debit Credit


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Profit & loss

with the increase in the provision

Provision for bad debts

with the increase in the provision

Profit and Loss Account (extract) for the year ended 31 December2002 -

-

Gross profit xxx

Less Expenses: -

Provision for doubtful debts 30

Balance sheet (extract) as at 31 December 2002 - -

Current assets

Debtors 16,000 -

Less Provision for doubtful debts 480 15,520

Reducing the provisionThe provision is always shown as a credit balance. Therefore, to reduce itwe would need a debit entry in the provision account. If the firm's debtorsfigure was lower than in the provision year, or the firm had decided thatthere was a reduced risk of bad debts then the firm may wish to reducethe overall provision.

In our example, on 31 December 2003, the debtors figure was 14,000,and the provision was to be maintained at 3% of debtors. This means thatthe provision would be reduced down to 14,000 x 3% = 420.

As the outstanding credit balance on the provision for doubtful debtsaccount is 480, we will need to debit that account in order to reduce theprovision. This is completed as follows:

Provision for doubtful debts

2001 - - 2001 -

Dec 31 Balance c/d 450 Dec 31 Profit & loss 450

2002 - - 2002 - -


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Dec 31 Balance c/d 480 Jan 1 Balance b/d 450

- - - Dec 31 Profit & loss 30

- - 480 - - 480

2003 - - 2003 - -

Dec 31 Profit & loss 60 Jan 1 Balance b/d 480

Dec 31 Balance c/d 420 - - -

- - 480 - - 480

- - - 2004 - -

- - - Jan 1 Balance b/d 420

The entries needed for when the provision is to be reduced are as follows:

Debit Credit

Provision for bad debts

with the decrease in the provision

Profit & loss

with the decrease in the provision

Profit and Loss Account (extract) for the year ended 31December 2003 -

-

Gross profit xxx

Add -

Reduction in provision for doubtful debts 60

Balance sheet (extract) as at 31 December 2002 - -

Current assets

Debtors 14,000 -

Less Provision for doubtful debts 420 13,580

For non-bookkeeping students...

Even if you are not using the bookkeeping entries in this module, therules for accounting for the provisions for doubtful debts can still confuse.


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As long as you remember then distinction between the entries in theprofit & loss account and the entry for the balance sheet than you shouldbe alright.

Profit & loss account Balance sheet

Show change in provision fordoubtful debts only:

Increases = expenseDecreases = revenue

Deduct full provision from debtors figure -show workings in current assets

Bad debts recoveredIt is not uncommon for a debt written off in previous years to berecovered in later years. The entries needed to record this can be splitinto two stages:

First reinstate the balance on the debtors account in thesales ledgerThis may appear odd, but the main reason for restoring the balance onthe debtor's account is to give a more detailed record of the debtor's'history'. The fact that the bad debt has been recovered may influence thedecision in the future as to whether the firm offers credit terms to thissame customer again.

Entry to reinstate the balance on the debtor's account

Debit Credit

Debtor's account Bad debts recovered account

Show the effect of the payment being received in thecashbook and in the debtors accountPayment received from debtors

Debit Credit

Cash/bank Debtor's account

At the end of the financial year, the credit balance in the bad debtsrecovered account will normally be transferred to the credit side of the


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profit and loss account (as income)- it would be added on to the grossprofit

Normally, we try to match income to the period in which it was generated,

or the expense to when it was incurred. However, with bad debtsrecovered this procedure is ignored. Rather than add the bad debtrecovered as income for the period in which the sale was made, weinclude the income in the period in when it was recovered instead.

To summarise: Bad debts recovered

Trial balance entry Effect on net profit

Credit Added as income

Exam tips - bad debts and provision for bad

debts

Remember, it is the change in the provision that will appear in theprofit and loss account.

The full provision will be deducted on the balance sheet.

Although related, it will be easier if you treat the bad debts and theprovision for any bad debts as completely separate items when makingcalculations.

This topic can be integrated into the construction of the final accounts.

Meaning of depreciation

Fixed assets are those assets, which are:

1. of long life, and2. to be used in the business, and3. not bought with the main purpose of resale.

Although they represent an expense when they are purchased in the

sense that they cost money, purchases of fixed assets are items of capitalexpenditure and therefore will not appear directly in the profit and loss


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account during the period in which they are acquired. However, we stillneed to show the effect of a fixed asset purchased in the final accountsand this is achieved through the use of depreciation.

The main reason for charging depreciation to the profit and loss account isto satisfy the accruals concept - that the profit and loss account shouldreflect the expense incurred in that period of time. Therefore if an asset isused over a period of time then there should be a charge in the profit andloss account to reflect this usage. However, depreciation is not really a'true' expense because it does not involve any cash being paid out by thefirm. Depreciation is actually a provision not an expense. This means thatit is supposed to represent an amount equal to the loss in value of theasset.

Therefore, when a fixed asset is purchased we will not enter the fullpurchase price of the asset as a profit and loss account expense. We will,however, enter a proportion of the asset's charge as a depreciationprovision, for each year that we make use of the asset. This provision willappear as an expense and will also be deducted from the value of theasset on the balance sheet - in order to show the reduced value

Causes of depreciation

Why do assets lose value over time? The main reasons to explain a loss invalue are as follows:

1. Wear & tear2. Obsolescence3. Passage of time4. Depletion

Wear and tearMost fixed assets will deteriorate over time (i.e. they wear out). This isespecially true for vehicles, machinery and equipment. Property does notwear out as quickly and land may never wear out. Freehold land - landthat is owned outright - does not have to be depreciated).

ObsolescenceAdvances in technology will mean that assets will lose value. This isbecause, as new innovations are launched into an industry, assets usingolder technology will become out of date and therefore will have lessvalue. This does not mean that the equipment is worthless, some firmsmay buy the older assets and use them because they cannot afford to buy

new up-to-date equipment.


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Passage of timeIntangible assets are those which do not exist in a physical sense.Leasehold property and goodwill are examples of intangible fixed assets.These assets may have a legal life fixed in terms of years. For instance,

you may agree to rent some buildings for 20 years. This is normally calleda lease. After twenty years has elapsed the lease is worth nothing to you,as it has finished. Whatever you paid for the lease is now of no value.

A patent allows the holder to exploit an innovation or invention for a fixedperiod time (usually 16 years) without any threat of others copying. Thiscould also be considered a fixed asset - if it is purchased, as it is likely tohelp the firm to generate more income in the future. Here though, insteadof using the term depreciation, the term amortisation is often used forthese intangible assets.

DepletionSome assets, especially land, will lose value as they are used more andmore. For example, a mine will lose value the more the resources areextracted from beneath the surface. Therefore it is the rate at which theresources are depleted which will determine how quickly the asset losesits value.

What happens if the depreciation is wrong?

No one can accurately determine the value of a tangible fixed asset in anumber of years time. Depreciation is based on estimated values.Estimates are made for the expected lifespan and any scrap value thatmight be received for the asset when it has reached ht end of its usefullife. Neither of these is likely to be known with certainty. Does thismatter?

It would be ideal if the asset did last as long as was estimated. However,this is not a crucial issue. As long as the estimate that is made is realistic

then it does not matter. If the asset does not last as long as was expectedthen when the asset is disposed of, the firm would include, the loss of thevalue as an expense (the loss would be based on what the asset wasworth at that moment in time - the net book value).

Similarly, if the asset last longer than was expected then the asset wouldappear to have no value according to the firm's accounts. This is not aproblem. For many years, the entire fleet of Concorde (the supersonic jet)was valued on British Airways' balance sheet as having zero value.

If the lifespan of an asset is estimated to be longer then the annual


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depreciation expense will be smaller - as the value of the asset is 'spread'over a longer period of time. This means that a smaller amount willappear in more years than if a shorter lifespan had been estimated. Somefirms have been accused of using this as a means of 'window dressing'their accounts - by exaggerating the lifespan of an asset, the profits canbe higher by only charging a smaller amount of deprecation against theannual profits. Auditors are supposed to check this and question anyunusually long estimates for expected lifespan.

If the depreciation policy (the method, the lifespan, and so on) issuspected to be highly misleading then it is possible for the firm tochange methods. However, the concept of consistency means that thechange should be a one-off change, and the change should be disclosed inthe 'notes to the accounts' in the annual report and accounts of thecompany (only for limited companies).

Depreciation and accounting concepts

According to the historical cost concept. All fixed assets should be shownat cost value. However, all fixed assets, with the exception of land, shouldbe subject to depreciation.

The prudence concept states that we should not overstate the value of

our assets and therefore depreciation is the method by which we show amore realistic value for asset. Some students are under the impressionthat the depreciation of assets is undertaken purely to show realisticvalue for fixed assets. This is not the case. The main reason for providingfor depreciation is concerned with the matching concept.

The matching concept (also known as the accruals concept) implies thatbusiness costs and revenues should always be accounted for in the periodin which they are incurred. If a firm has to pay annual rent, then thisexpense will appear in that year's profit and loss account - even if not all

of it has yet been paid. Likewise, we include sales as income for a period -even if the debtors have not yet sent us the money for the sales.

Similarly, the cost of a fixed asset should only be included as an expensefor the period in which we benefit from he use of the asset. However, ifwe benefit for many years then we should spread the cost of the assetover this longer lifespan - i.e. through the use of annual depreciation. Allitems of capital expenditure will not appear as an expense in the period inwhich they are purchased but will be 'written off' over their useful life.

Finally, once a depreciation method is selected, the policy should not be


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changed. This is an application of the concept of consistency. This statesthat changing methods would make comparisons with previous year'saccount much harder and could be subject to distortions. Thereforechanges should only take place in unusual circumstances.

Appreciation

What about the assets that increase (appreciate) in value? It is normalaccounting procedure to ignore any such appreciation, as to bringappreciation into account would be to contravene both the historical costconcept and the prudence. Nevertheless, in certain circumstancesappreciation is taken into account in partnership and limited companyaccounts, but this is left until partnerships and limited companies areconsidered.

There is an intense and lasting debate on this issue within the accountingprofession. The profession appears generally to have accepted the use of'current values' on the basis that this gives more meaningful informationto the users of the statements. The system used in the UK at present canbest be described as a 'hybrid' one which uses a mixture of historical costand revaluations. At present the choice is left to the preparers of thestatements.

Methods of calculating depreciation

There are a variety of different methods used by firms when calculatingthe depreciation for fixed assets. However, the two main methods in useare:

1. Straight line method2. Reducing balance method

We will consider how each of these two methods is calculated

Straight-line method

This method, also known as the fixed instalment method, is the mostcommonly used method of depreciation. It is also the easiest method toaccount for.

Once the annual depreciation provision has been calculated, this willremain the same for each year the asset is in use. The formula forcalculating the annual rate of depreciation is as follows:


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The scrap value (sometimes known as either residual value or disposalvalue) will, in most cases be an estimate. It is common, keeping in linewith prudence to have a zero scrap value - due to the uncertainty of anyestimate.

Example 1A delivery vehicle was bought for 25,000 and we thought we would keepit for five years and then trade it in for 3,000 (in effect the trade in valuebecomes the scrap value).

Once you have had a go at this, check your answer against ours. If youhave made some mistakes, make sure you work out carefully where youhave gone wrong.

Straight-line as a percentageIt is fairly common to express straight-line depreciation as a percentage.This simply means that a percentage of the original cost of the asset willbe charged as the deprecation. For example, if an asset cost 10,000 anddepreciation is to be calculated at 10% on cost - this would mean that weshould charge 10% x 10,000 (1,000) as the annual deprecation foreach year that we have the asset.

The percentage quoted under the straight-line method will also tell ushow long we expect the asset to last, for example:

10% - 10 years

25% - 4 years

20% - 5 years

Reducing balance method

In this method, the annual deprecation is based on apercentage of the asset's net book value (i.e. what the assetis worth in the firm's accounts). The net book value of anasset is calculated as follows:

Net book value = original cost - accumulateddepreciation

As the deprecation charged against an asset builds up overtime, the net book value of an asset would decrease.


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Therefore, although the percentage used in this methodremains constant, the depreciation charge (in ) will becomesmaller, the longer we have the asset.

This method is also known as the diminishing or decliningbalance method.

The percentage rates chosen for reducing balance may seemas if they are chose randomly, without any real explanation.There is a formula which takes into account the cost, thescrap value, the expected lifespan of the assets. This formulacalculates the percentage that should be used. We do notinclude it here because it is not a requirement of the coursefor you to know the formula and it is, without any doubt, one

of the most complicated formulas you would be likely to see.

With both methods, there may be variations used. Some firmswill charge depreciation for each month that the asset isowned. In this case, an asset bought half way through theyear would only have half of one year's depreciation chargedfor it. Some firms may charge a full year's depreciation forany assets, regardless of whether it was owned for the fullyear. Some firms will not charge depreciation in the year ofsale, or in the year of purchase. Each question should tell youwhich of these rules the firm is applying - keep on the lookout!

Example 2Equipment is bought for 15,000 and depreciation is to becharged at 20 per cent per annum using the reducing balancemethod

Remember, both methods can be quoted using percentagesfor the depreciation.

Straight line is a percentage of the cost of the asset

Reducing balance is a percentage of the net book value of theasset.

Choice of method

Notice that with the reducing balance method, the

depreciation provision per year will start off relatively largeand will gradually get smaller. It has been commented that


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this method of depreciation is superior to the straight-linemethod because it is more realistic with asset valuations -assets do lose more of their value in the earlier rather thanthe later years. However, the counterargument is thatcalculating annual amounts for depreciation should not beprimarily concerned with providing realistic values for assetvalues - it is simply a way of 'spreading' the cost of the assetover its useful life.

Example 3A firm has just bought a machine for 30,000. It will be keptin use for four years, and then it will be disposed of for anestimated amount of 2,000. They ask for a comparison ofthe amounts charged as depreciation using both methods.

Straight-line method: (30,000 - 2,000) ( 4 = 7,000 perannum Reducing balance method: 50 per cent will be used.

Have a go at calculating the figures for both methods andthen follow the answer link below to see how you got on.

Depreciation adjustments for profits and

balance sheetsOnce you have mastered the ability to calculate depreciation,you will then need to enter this into the double entryaccounts. As with other provisions, depreciation will always bea credit balance.

All provisions are credit balances

Unlike the provision for doubtful debts, the total depreciationprovision is never reduced (unless a mistake has been made)and therefore, we will only credit the depreciation account,while we have the asset.

The double entry record for annual depreciation is as follows:

Debit Credit

Profit & loss Provision for depreciation

No entry is ever made in the actual asset account - unless we


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decide to purchase more of the same type of asset, or decidethe sell some of this type of asset.

The double entry tells us that the depreciation charge will

appear on the debit side of the profit and loss account asthough we were paying an expense. However, the creditbalance on the provision for depreciation account will be keptand maintained, and added to, as long as the firm still has therelevant asset.

Example 1

On 1 January 2001, a firm purchases a machine for 10,000,paying by cheque. It chooses to depreciate the machine at25% on cost using the straight-line method.

Show the asset, the provision for depreciation account andthe extracts from the balance sheet for each of the four years,the firm has the asset for.

AnswerThe annual depreciation will be 25% x 10,000 = 2,500 (i.e.the machine is expected to last for four years).

The entry in the asset account is easy, it will look as follows:

Machinery

2001 - - 2001 -

Jan 1 Bank 10,000 Dec 31 Balance c/d 10,000

This balance will be carried forward in this account until thefirm either sells the machine or buys more machinery.

The first entry in the provision for depreciation account wouldappear as follows:

Provision for depreciation

2001 - - 2001 -

Dec 31 Balance c/d 2,500 Dec 31 Profit & loss 2,500


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The profit and loss account is therefore 'charged' with 2,500.We know it is a 'charge' because given the credit entry in theprovision for depreciation account, the other half of the entrywill be on the debit side of the profit and loss account

The balance on this account is carried forward (unlike expenseaccounts which are normally 'emptied' at the end of each yearand transferred in full to the profit and loss account) andadded to in each of the next three years. The full account forthe four-year period would appear as follows:

Provision for depreciation - machinery

2001 - - 2001 -

Dec 31 Balance c/d 2,500 Dec 31 Profit & loss 2,500

2002 - 2002 -

Dec 31 Balance c/d 5,000 Jan 1 Balance b/d 2,500

- - - Dec 31 Profit & loss 2,500

- - 5,000 - - 5,000

2003 - 2003 -



- - 7,500 - - 7,500

2004 - 2004 -



- - 10,000 - - 10,000

Although the charge to the profit and loss account stays thesame at 2,500, the accumulated total on the above'provision' account will increase each year. This is illustratedon the balance sheet where the closing balance is deductedfrom the cost of the asset to give the net book value of theasset at that moment in time:


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account because it is capital income. What we do include isthe profit or loss on the sale of the fixed asset.

The profit or loss on the sale of any fixed asset is calculated

as follows;

Profit on disposal = selling price of asset - net bookvalue of the asset

The net book value represents what the asset is 'worth' at themoment of the sale and it is calculated as follows:

Net book value = cost of asset - accumulated

depreciation

The accumulated depreciation is all the depreciation that hasbeen 'charged' on the asset right up until the moment of thesale.

If an asset is sold during a financial year then calculating theaccumulated deprecation can be completed. Some firms willuse a fractional depreciation policy which means they wouldcharge depreciation for each portion of a year. For example, ifthe asset was sold after three months of a financial year'sstarting date, then one quarter of a full years (3 months is aquarter of one year) depreciation would be charged for. Thisis sometimes referred to as deprecation being charged on 'amonthly basis'.

Some firms prefer to keep it simple and only charge a fullyear's depreciation regardless of when the sale actuallyoccurs. Any examination question will guide you as to what

method will be used.

Therefore, if the net book value is higher than the selling priceof the asset, a loss will be made on the sale. The sale of fixedassets is referred to as the disposal of assets. This will includesituations where the asset is part of a 'trade in' deal, where anew asset is acquired in part exchange for the old asset.

The treatment of the profit or loss on the asset disposal willbe as follows:


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- Profit & lossentry Treated as:

Profit ondisposal Credit

Income - added on toprofits

Loss ondisposal Debit

Expense - deducted fromprofits

There are three main steps in the calculation of the profitsand loss on the disposal of the asset. These are as follows:

1. Calculate the annual deprecation for the asset.2. Calculate the accumulated deprecation on the asset

3. Calculate the net book value of the asset.4. The profit or loss on the disposal can be calculated by

comparing the net book value with the selling price ofthe asset.

Example 1

A machine was bought on 1 January 2001 for 9,000.Depreciation was to be provided for at 20% on cost (straightline method) on a monthly basis. On 30 June 2003 themachine was sold for 5,000 cash.

AnswerThe profit on the disposal is calculated as follows:

1. The annual deprecation provided on this machine is20% of 9,000 = 1,800

2. The accumulated deprecation is the annual deprecation

over a 2 1/2 year period = 1,800 x 2 1/2 = 4,5003. The net book value will be: cost - accumulated

depreciation, i.e. 9,000 - 4,500 = 4,500.

4. The profit on the asset disposal will therefore be:5,000 - 4,500 = 500 profit.

This 500 profit would appear as income in the profit and lossaccount for this period.


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In our example, the ledger accounts would appear as follows:

Machinery

2003 - - 2003 -

Jan 1 Balance b/d 9,000 Jun 30 Machinery disposal 9,000

Provision for depreciation - machinery

2003 - 2003 -

Jun 30 Machinery disposal 4,500 Jun 30 Balance b/d 4,500

Notice how each entry will also appear in a new account -machinery disposal. This asset disposal account is opened todeal with the disposal of any fixed asset. Once the profit orloss on the disposal has been calculated then this account isclosed off.

Machinery disposal

2003 - - 2003 -

Jun30 Machinery 9,000

Jun30

Machinerydeprecation 4,500

Notice that the disposal account is taking the other half of thedouble entry for the entries made in the cost and provisionaccounts. The cash received from the sale is also entered intothe disposal account. This is debited to the cashbook andtherefore is credited to the disposal account. This is shownbelow:

Machinery disposal

2003 - - 2003 -


Jun30



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- - - Jun30 Cash 5,000

This account is now closed off. If there were no outstandingbalance then this would mean that the asset has been sold forexactly the same amount as its net book value. This meansthere is no profit or loss on this sale and no further entries arerequired.

However, in our example, there is an outstanding balance onthe account. This amount represents the profit or loss on thedisposal. We finish off the disposal account as follows:

Machinery disposal

2003 - - 2003 -


Jun30


Jun30

Profit &loss 500

Jun30 Cash 5,000

- - 9.500 - - 9,500

The 500 'balancing figure' represents the profit made on thesale

How do we know it is a profit? Well, this is because if it is onthe debit side of the disposal account, then it must be on thecredit side of the profit and loss account - which means it isadded on to the profit.

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