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Accounting for fixed assets (Depreciation and the accruals concept…
Accounting for fixed assets
Capital expenditure
Expenditure that is likely to provide a benefit to the organisation for more than one accounting period/financial year
The benefits and period of the benefit provided may be difficult to predict
Such expenditure can be identified as increasing the earning capacity of the business
Incurred on the purchase of fixed assets such as land and buildings, plant and machinery, vehicles and fixtures and fittings. The cost of these fixed assets is accounted for over their anticipated useful life
Usually involves an annual depreciation charge
Concerned with purchasing high-value, long-term and permanent fixed assets for use in the business. These assets are not bought to be resold
Eg. Central government capital grants (capital income). The principle is that capital grants should be recognised in the profit and loss account so as to match with the expenditure to which they are intended to contribute
Revenue expenditure
Expenditure that is necessary for the day-to-day operations of the business
Likely to provide benefit to the organisation for only the current accounting / financial year and so is charged against profits in the period to which it relates
A cost used by the organisation in trading
Eg. running costs such as electricity, business rates, wages and salaries of employees, interest charges, purchase of consumables such as stationery and goods purchased for resale
Revenue income
Includes income from the sale of goods to customers, rents received, dividends received, interest received etc
The distinction between capital and revenue items is critical. If capital and revenue items are not classified accurately, the accounting profit will be incorrectly calculated. For example if a capital expenditure item is included as revenue expenditure, then the annual profit will be understated. Similarly, if a capital grant were included in one year's accounts, then the annual profits would be overstated
The nature of depreciation
Depreciation is 'the measure of the cost or revalued amount of the economic benefits of the tangible fixed asset that have been consumed during the period' (FRS 15)
The consumption of fixed assets includes the wearing out, using up or other reduction in the useful economic life of tangible fixed assets whether arising from use, effluxion (passing) of time or obsolescence through either changes in technology or demand for the goods and services produced by the asset
In referring to the useful economic life, the definition implies that the business will need to repack the fixed assets at some time in the future
The assumption is that the business is a going concern and that the fixed assets will need to be replaced to maintain the operating capability of the business
Depreciation may occur due to
Use or physical deterioration
The continued use of fixed assets such as plant and machinery or motor vehicles, will lead to their need for replacement at some point in the future
The duration of each class of item varies but they will all need to be relocated eventually
Their replacement will occur at the end of the item's economic life
Fixed assets depreciate as a result of the wear and tear from their usage
Obsolescence
Arises when a fixed asset is no longer useful because an enhanced or improved model has become available
Does not necessarily render the existing the existing fixed asset unworkable, it is just the case that a new model or edition has additional attributes or features
The rate of obsolescence with computer technology in the 21st century is a prime example this practice
It may also be the case that the business has outgrown the fixed asset and requires one with grater functionality and the business has grown
Time
Fixed assets depreciation over time is specific to fixed assets that have a legal life, such as a lease on a property
As time passes the lease becomes less valuable to the business, at the end of the life of the lease, its value to the leaseholder is nil
Depreciation and the accruals concept
Fixed assets are normally purchased for payment in cash, however accountants do not charge the total cost of the acquisition to one accounting period. Rather, they spread the capital cost over several accounting periods. This is done by gradually writing off the asset's useful economic life
The asset's useful economic life is normally the period over which the present owner of the asset derives economic benefits from its use
The annual charge to the profit and loss account is called depreciation
The total amount to be depreciated is cost - residual value
The residual value, also known as the scrap value, is what the business expects to realise or received at the end of the assets useful economic life. This represents the sale proceeds or trade in value of the asset. This is in accordance with accruals concept, as it charges the annual depreciation in the profit and loss and matches it with the revenue sales generated during that same accounting period
Charging an annual deprecation charge to the profit and loss avoids the cost of the acquisition being charged to one accounting period and producing a misleading profit figure. It also recognised that capital expenditure is different from revenue expenditure
The capital expenditure on a fixed asset, unlike expenditure on consumables and services should not be written off in one year
Complying with the accruals concept by writing off a fixed asset by an annual depreciation charge is affected by many subjective judgement. There are three key subjective judgments
What is the estimated useful economic life of the fixed asset?
What will be the annual use of the fixed asset in each accounting period?
What is the estimated residual value?
Methods of depreciation
The various methods in use give different arithmetical results in each accounting year but are related to assumptions about the fixed asset concerning the estimated useful economic life; the estimated residual value and the estimated annual use of the fixed asset in each accounting period
There are two main methods
Straight line method
A method of depreciation that remains fixed over the life of the fixed asset
The total depreciable amount is charged in equal instalments in each accounting period over the expected useful life of the asset
The most commonly used method
Cost of asset - Residual value / Expected useful life of the asset
The annual depreciation that is charged is often expressed at the rate of X% per annum on the net cost of the asset
For example spreading the depreciable amount over four years uses a rate of 25% per annum
Reducing balance method
A method of depreciation that reduces annually over the life of the fixed asset
This method calculates the annual depreciation charge as a fixed percentage of the net book value of the asset as at the end of the previous accounting period
Net book value:
The historic cost of an asset less any accumulated depiction or other provision for the diminution in value eg reduction to net realisable value
Accounting for depreciation
Depreciation is an annual charge for the consumption of fixed assets. However the reduction of the asset does not require a credit to the fixed asset account
The charge for depreciation is made to the profit and loss account and a provision for depreciation account is opened
The double entry required for the accounting for depreciation is: Dr Profit and Loss account Cr: Provision for depreciation
The fixed asset account always remains unchanged with the cost of the fixed asset
Deprecation also has an impact on the balance sheet
Tangible fixed assets are always shown at net book value
Accumulated depreciation is the balance on the provision for depreciation account at the end of the accounting period
Impact of depreciation
The two depreciation methods have different effects on the figures that appear in both the profit and loss account and on the balance sheet
Over the same period, the total depreciation charged to the profit and loss account is the same, and the net book value is the same however the way that the depreciation is apportioned is different
The annual depreciation expense charged to the profit and loss account differs for both methods. This will have an impact on the annual profit figure
The value of fixed asset in the accounts as revealed in the balance sheet by the net book value differs in both methods. This will impact on the value of the total assets included in the balance sheet
Straight line method
Assumes that the business enjoys equal benefits form the use of the asset in every accounting period throughout its useful economic life, thus it can be argued that it produces a fair allocation of the total depreciable amount across the different accounting periods
Has the merits of certainty, simplicity and equality of annual charge
Most widely used method of depreciation
Particularly applicable to such assets as buildings, patents and leases where time is the important factor in generating the benefits to be gained from the use of an asset
Does not reflect the fact that normally the greatest loss in the market value of a fixed asset occurs in the first year of its use
Does not reflect that there can be an unevenness of the loss in the market value of a fixed asset
Reducing balance method
Charges larger depreciation in the earlier years of the assets life and smaller amounts in later years
Assumes that the benefits obtained by the business from using a fixed asset reduces over time
Can be used when it is considered appropriate to charge a greater proportion of the total depreciable amount to the earlier years and a lower proportion to the later years
Approximates to reality in respect of certain fixed assets, eg motor vehicles where the depreciation calculated in the first year reflects the great loss in market value at the same time as when repairs are usually low
Choosing a depreciation method
The business should choose the method most appropriate to them
The method should be one that matches depreciation expense to the revenues that the fixed asset helped to generate
The accountancy bodies in their accounting standard on depreciation do not recommend one method over another
The standard says that the method used should be the one most appropriate to the fixed asset and to the assets used in the business
Tangible fixed assets
Depreciation is provided normally on a straight line basis to write off the cost or valuation of tangible fixed assets over their estimated useful economic lives to any estimated residual value using the following rates
Buildings: up to 50 years
Research equipment: 8 years
Computing equipment and motor vehicles: 3-5 years
Other equipment: 10-15 years
No depreciation is provided on freehold land and assets in the course of construction
Revaluation of fixed assets
Whichever method is chosen, depreciation is calculated using the historical cost of the fixed assets
Many fixed assets, particularly some land and buildings, rises over time, largely because of inflation
Some organisations periodically revalue their fixed assets to reflect the current market value, otherwise the total value of the assets might seem unrealistically low
Depreciation is then calculated on the revalued amount
The impact of the revaluation of fixed assets on the accounting equation is reflected in a corresponding increase in the owner's capital funds
Disposal of fixed assets
In the normal course of trading, a business purchases and resells its fixed assets. This maintains the operating capability of the business as a going concern
The asset to be sold is recorded in the balance sheet at its net book value
The net book value does not represent an estimate of its market value
Net book value is an asset's value to the business, the proceeds of the sale are thus likely either to exceed or to be less than the net book value, which will result in either a profit or loss
The accounting for the disposal of a fixed asset can be separated into four stages
Transfer the fixed asset for sale to the disposal account - Dr Disposal account Cr Fixed asset account- Write out the original cost of the fixed asset from the fixed asst account to the disposal account
Transfer the depreciation for the fixed asset being sold to the disposal account - Dr Provision for depreciation Cr Disposal account - Write out the accumulated depreciation for the disposed fixed asset form the provision for depreciation account to the disposal account
Credit any proceeds of the sale to the disposal account - Dr bank Cr Disposal account - Record the proceed of the sale of the fixed asset
Transfer any gain or loss arising from the disposal to the profit and loss account - transfer the loss or profit to the profit and loss account from the disposal account.
Organisations purchase and sell assets at various times throughout the financial year. It is possible to calculate a proportionate amount of depreciation to reflect accurately when an asset was sold or purchased
Calculating a proportionate amount of depreciation reflects the limited amount of use the business has had from the asset in that period. In practice many organisations ignore the part-year depreciation and charge a full year's depreciation on fixed assets in the year of their purchase (regardless of the point in time during the year at which they were acquired) and no depreciation in the year of sale / disposal of the asset
While a failure to apportion depreciation to the months of the year when an asset is only owned for a few months is actually contrary to the matching concept, it may be defended on the grounds of materiality
Intangible fixed assets
There are a number of aspects of a business that may not have a monetary value placed on them
A skilled, loyal and efficient workforce
Excellent relations between management and workforce
The site of the business (eg if this is in a city centre or near a motorway, it may give the business a competitive advantage
A range of well-known and trusted brand names
A range of products or services protected by patents or copyrights
A loyal customer base built up the business's relations with customers
Difficult to identify in monetary terms on a balance sheet but they would nevertheless be valued by a prospective buyer
Frequently created or built up in the course of time by business
Their value is not usually included in the balance sheet as accountants cannot place an objective value on them
Accounting concepts and depreciation
Most managers do not need to be caught up in the technical aspects of depreciation but will need to understand the reasons why depreciation is included and its impact on financial statements
The application of the accounting concepts helps to assist the influence of depreciation
Historic cost concept: Directs that transactions, eg the purchase of fixed assets, are recorded at the value at the time the transaction occurred
Going concern concept: Directs that assets are not recorded at their break up value, as it is assumed the business will continue in existence
Accruals concept: Directs that the main objective of depreciation is to match the cost of the fixed assert against the revenue that the asset is helping to generate
Consistency concept: Directs that the accounting treatment of depreciation should involve a method that is used consistently and gives comparability over accounting periods