slide 8.1 pauline weetman, financial and management accounting, 5 th edition © pearson education...

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Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Chapter 8

Non-current (fixed) assets

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Definitions

Asset

• Resource… from which future economic benefits are expected to flow.

Non-current (fixed) assets

• Held for use in profit generating process.

• On a continuing basis.

• Not for sale in ordinary course of business.

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Classification

• Property, plant and equipment, also called tangible non-current (fixed) assets.

• Intangible non-current (fixed) assets.• Investments held long term.

Intangible: No physical substance• Patents• Trade marks• Development costs• Goodwill

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Valuation

Normally at • Cost less accumulated depreciation equals• NET BOOK VALUE (NBV) or• depreciated cost.Revaluation of non-current (fixed) assets• Asset is given a valuation above cost.• Usually applied to land and buildings.• Revaluation is a choice for the company.• If used, revaluations must be updated regularly.

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Cost of non-current (fixed) assets

At acquisition

• Purchase price of an asset plus the cost of preparing it for use.– Legal costs of acquisition and installation and

commissioning costs.

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Improvements after purchase

Improvement expenditure may extend the asset’s annual output capacity

• increasing its economic life.• reducing associated running costs.• improving the quality of its output.Costs incurred to improve on the asset’s original

condition: for example• extension to a building.• rebuilding shop fittings to attract new type of

customer.These costs should be added to the original cost of

the asset and depreciated over the remainder of its useful life.

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Repairs, restoration

Costs incurred to maintain, repair or restore the asset to its original condition– treated as an expense and charged to the profit and loss account: for example,

• replacing roof damaged in storm.

• replacing engine in bus.

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Depreciation

• Non-current (fixed) assets are gradually used up in providing goods and services over time.

• Purpose of accounting depreciation is to spread the cost of a non-current (fixed) asset over its expected useful life.

• Depreciation is a method of allocating cost. • Achieves a matching of costs against the

related revenues.

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Depreciation (Continued)

In historical cost (traditional) accounting:

• the Net Book Value (NBV) is the result of a calculation.

(Original cost – Accumulated depreciation)

• it is not intended to represent the asset’s market value.

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Non-current (fixed) Assets and Depreciation

Year Assets – Liabilities = Ownership interest

1 ↓ ↓

2 ↓ ↓

3 ↓ ↓

etc.

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Yearly depreciation, Accumulated depreciation

• Each year that a non-current (fixed) asset is in use, a portion of its cost is deducted from the balance sheet value. That portion of cost is ‘matched’ against the revenues of that year. This gives the depreciation charge of the year. (Income statement profit and loss account).

• The depreciation of the non-current (fixed) asset in each year is added to the depreciation of earlier years to arrive at the Accumulated depreciation. (Balance sheet).

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Calculation of depreciation

Requires three items of information:

• the cost of the non-current (fixed) asset.

• the estimated useful life.

• the estimated residual value (the value remaining at the end of the useful life).

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Total depreciation

Total depreciation of the non-current (fixed) asset is equal to the cost of the non-current (fixed) asset minus the estimated residual value.

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Purpose and methods

The purpose of the depreciation calculation is to spread the total depreciation over the estimated useful life.

Methods of depreciation

(a) Straight-line method

(b) Reducing value

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Straight-line depreciation

• Those who believe that a non-current (fixed) asset is used evenly over time apply a method of calculation called straight-line depreciation.

The formula is:

lifeExpected

valueresidualExpectedCost –

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Non-current (fixed) asset, which has a cost of £1,000 and an expected life of 5 years. The expected residual value is nil. The calculation of the annual depreciation charge is:

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–000,1£ nil= £200 per annum

Accounting policy:Depreciation is charged on a straight-line basis at a rate of 20% of cost per annum.

Straight-line depreciation (Continued)

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‘Straight line’ – a graph of the net book value of the asset at the end of each year produces a straight line.

Straight-line depreciation (Continued)

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End of year

Depn of the year Total depn Net book value of the asset

(b) (c) (£1,000 – c)

£ £ £

1 200 200 800

2 200 400 600

3 200 600 400

4 200 800 200

5 200 1,000 nil

Pattern of depreciation and net book value

Table 8.1 Pattern of depreciation and net book value over the life of an asset

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Straight-line depreciation – graph of net book value

Figure 8.1 Graph of net book value over Years 1 to 5, for the straight-line method ofdepreciation

0

200

400

600

800

1000

1200

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

ne

t b

oo

k v

alu

e

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Reducing-balance depreciation

• Those who believe that the non-current (fixed) asset depreciates faster in the earlier years of its life would calculate the depreciation. Formula:

Fixed percentage × the net book value at the start of the year

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rate = )( n

C

R1 × 100%

The rate of depreciation to be applied under the reducing balance method of depreciation is calculated by the formula:

where n = the number of years of useful life R = the estimated residual value C = the cost of the asset

Reducing balance depreciation (Continued)

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n = 5 years

C = £1,000

R = £30 (The residual value must be of reasonable magnitude. To use an amount of nil for the residual value would result in a rate of 100%).

× 100% = approx 50%Rate =

Example calculation

Reducing balance depreciation (Continued)

)(1

1,000

30

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Year Net book value at start of year

Annual depreciation Net book value at end of year

(a) (b) = 50% of (a) (a–b)

£ £ £

1 1,000 500 500

2 500 250 250

3 250 125 125

4 125 63 62

5 62 31 31

Reducing balance calculation

Table 8.2 Calculation of reducing-balance depreciation

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Reducing balance depreciation – graph of net book value

Figure 8.2 Graph of net book value over Years 1 to 5, for the reducing-balance method of depreciation

0

200

400

600

800

1000

1200

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

net

bo

ok

valu

e

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Retaining cash in the business

• Fee income £120,000. Pay wages and other costs £58,000. Depreciation calculated as £10,000.

• How much may the owner take in drawings?• Cash available is £62,000.• But if that is taken for personal use there is nothing

left in the bank to put towards asset replacement.• Take cash of £52,000 leaves £10,000 towards

asset replacement.• Problem – business may spend the £10,000 on

other aspects of business, such as buying current assets or repaying loans.

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Presentation in financial statements

Example:

On 1 January Year 2 Electrical Instruments purchased a three-year lease of a shop for £60,000. The accounts over the next three years would include the following items related to the lease.

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Income statement (profit and loss account)

Year ended 31 Dec Yr 2 Yr 3 Yr 4

£000’s £000’s £000’s

Depreciation expense 20 20 20

Balance sheet at 31 Dec

Lease at cost60 60 60

Less: Accumulated depreciation

20 40 60

Net book value 40 20 0

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Straight-line with residual value

The Removals Company was set up on 1 January Year 2, purchased van for £60,000, and started to trade.

The manager estimates that:

1. The van will be used for 3 years; and

2. Estimated residual value of £6,000 (second hand or scrap value).

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Calculation

• Net cost of the van

= (£60,000 – £6,000) = £54,000.• Net cost has to be depreciated over 3 years.

i.e. (54,000/3) = £18,000 per year.

Assume:• During the year cash receipts from sales were

£120,000• and cash expenses were £58,000 for wages,

petrol and running costs.

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£000’s

Van at cost 60

Less: Accumulated depreciation (18)

Net book value 42

Cash 62

104

Ownership interest at start 60

Profit for the year 44

104

Balance sheet – end Year 2

Table 8.4 The Removals Company: Statement of financial position (balance sheet) at end of Year 2 and Income statement (profit and loss account) for Year 2

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£000’s

Fees for removal work 120

Cash expenses (58)

Depreciation (18)

(76)

Profit for the year 44

Income statement (profit and loss account) Year 2

Table 8.4 The Removals Company: Statement of financial position (balance sheet) at end of Year 2 and Income statement (profit and loss account) for Year 2 (Continued)

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Year 2 Year 3

£000’s £000’s

Van at cost 60 60

Less: Accumulated depreciation 18 36

Net book value 42 24

Cash 62 124

104 148

Ownership interest

OI at start 60 104

Profit and loss account 44 44

104 148

Balance sheet

Table 8.6 The Removals Company statement of financial position (balance sheet) at end of Year 3 and Income statement (profit and loss account) for Year 3

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Year 2 Year 3

£000’s £000’s

Turnover 120 120

Cash expenses (58) (58)

Depreciation (18) (18)

76 76

Profit for the year 44 44

Income statement (profit and loss account)

Table 8.6 The Removals Company statement of financial position (balance sheet) at end of Year 3 and Income statement (profit and loss account) for Year 3 (Continued)

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Presentation

See text book for more detail on

• Spreadsheets

• Presentation

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Chapter 8

Bookkeeping supplement

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Capital contributedCapital withdrawn

RevenueExpenseOwnership interest

IncreaseDecreaseLiability

Right-hand side of the equation

DecreaseIncrease Asset

Left-hand side of the equation

CREDIT ENTRIES DEBIT ENTRIES

Debit and credit entries in ledger accounts

Table 8.12 Rules for debit and credit entries in ledger accounts

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Date Transaction or event Amount Dr Cr

Year 2 £

1 Jan Owner contributes cash 60,000 Cash Ownership interest

1 Jan Purchase furniture van 60,000 Van at cost Cash

All year Collected cash from customers

120,000 Cash Sales

All year Paid for running costs 58,000 Running costs

Cash

31 Dec Calculate annual depreciation

18,000 Depreciationexpense

Accumulated depreciation

Analysis of transactions for the Removals company, Year 2

Table 8.13 Analysis of transactions for The Removals Company, Year 2

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L1 Ownership interest L4 Accumulated depreciation of van

L2 Cash L5 Sales

L3 Van at cost L6 Running costs

L7 Depreciation of the year

Ledger accounts required to record transactions

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L1 OWNERSHIP INTEREST

DATE PARTICULARS PAGE DEBIT CREDIT BALANCE

Year 2 £ £ £

Jan 1 Cash L2 60,000 (60,000)

L2 CASH


Year 2 £ £ £

Jan 1 Owner’s capital L1 60,000 60,000

Jan 1 Van L3 60,000 nil

Jan–Dec

Sales L5 120,000 120,000

Jan–Dec

Running costs L6 58,000 62,000

Ledger accounts required to record transactions (Continued)

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L3 VAN AT COST


Year 2 £ £ £

Jan 1 Cash L2 60,000 (60,000)

L4 ACCUMULATED DEPRECIATION OF VAN


Year 2 £ £ £

Dec 31

Depreciation for the year

L7 18,000 (18,000)


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L5 SALES


Year 2 £ £ £

Jan–Dec

Cash L2 120,000 (120,000)

L6 RUNNING COSTS


£ £ £

Jan–Dec

Cash L2 58,000 58,000


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L7 DEPRECIATION OF THE YEAR


£ £ £

Dec 31

Accumulated depreciation

L4 18,000 18,000


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Ledger account title £ £

L1 Ownership interest 60,000

L2 Cash 62,000

L3 Van at cost 60,000

L4 Accumulated depreciation of van 18,000

L5 Sales 120,000

L6 Running costs 58,000

L7 Depreciation 18,000 _______

Totals 198,000 198,000

Trial balance at the end of Year 2 for the Removals company

Table 8.14 Trial balance at the end of Year 2 for The Removals Company

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noncurrent fixed assets

management accounting

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pauline weetman

depreciated cost

assets original condition

restoration costs

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