Chapter 8

1. Chapter 8 Non-current (fixed) assets

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. Non-current (fixed) Assets and Depreciation

11. 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).

12. 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).

13. 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.

14. 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

15. 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:

16. Straight-line depreciation (Continued) 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: = £200 per annum Accounting policy: Depreciation is charged on a straight-line basis at a rate of 20% of cost per annum.

17. Straight-line depreciation (Continued) ‘Straight line’ – a graph of the net book value of the asset at the end of each year produces a straight line.

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

19. 1200 1000 800 600 net book value 400 200 0 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 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 of depreciation

20. 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

21. Reducing balance depreciation (Continued) The rate of depreciation to be applied under the reducing balance method of depreciation is calculated by the formula: rate = × 100% where n = the number of years of useful life R = the estimated residual value C = the cost of the asset

22. ( ) -5 1 Reducing balance depreciation (Continued) Example calculation 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%). 30 Rate = × 100% = approx 50% 1,000

23. Reducing balance calculation Table 8.2 Calculation of reducing-balance depreciation

24. 1200 1000 800 600 net book value 400 200 0 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 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

25. 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.

26. 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.

27. Income statement (profit and loss account) Balance sheet at 31 Dec

28. 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).

29. 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.

30. 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

31. 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)

32. 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

33. 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)

34. Presentation See text book for more detail on • Spreadsheets • Presentation

35. Chapter 8 Bookkeeping supplement

36. DEBIT ENTRIES CREDIT ENTRIES Left-hand side of the equation Asset Increase Decrease Right-hand side of the equation Liability Decrease Increase Ownership interest Expense Revenue Capital withdrawn Capital contributed Debit and credit entries in ledger accounts Table 8.12 Rules for debit and credit entries in ledger accounts

37. Analysis of transactions for the Removals company, Year 2 Table 8.13 Analysis of transactions for The Removals Company, Year 2

38. Ledger accounts required to record transactions

39. Ledger accounts required to record transactions (Continued) L1 OWNERSHIP INTEREST L2 CASH

40. Ledger accounts required to record transactions (Continued) L3 VAN AT COST L4 ACCUMULATED DEPRECIATION OF VAN

41. Ledger accounts required to record transactions (Continued) L5 SALES L6 RUNNING COSTS

42. Ledger accounts required to record transactions (Continued) L7 DEPRECIATION OF THE YEAR

43. 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