Ch 11 - Depreciation & reserves Flashcards
Why are depreciation adjustments made?
Because virtually all non-current (NCA) have finite useful economic lives
Depreciation
def: measure of the wearing out, consumption or other reduction in the useful economic life of a NCA, whether arising from:
i) passage of time, or
ii) obsolescence through technological or market changes
How does depreciation vary according to the nature of the asset?
-FINANCIAL asset -> lifespan which is fixed in terms of time (such as property lease)
-PHYSICAL asset -> deteriorate more rapidly when they are used more heavily
- SOME assets -> are more likely to be overtaken by new technology before the end of their physical lives (such as computers)
Straight line method
def: value of assets written off evenly over a number of years
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(cost-estimated RV) / (estimated UL)
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intangible assets suffer depreciation (known as ‘amortisation’)
Reducing balance method
def: charges a fixed % of ‘BV’ (cost-depreciation to date) each year so that the whole cost is charged over the life of the asset.
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1- [(estimate RV)/cost]^(1/n) where n is the estimated UL in years
Give one advantage of the reducing balance method
It tends to charge a heavier proportion of the cost of the assets when they are new. This might make the depreciation charge in the SPL more relevant because most of the charge will be based on the cost of newer, more recent assets.
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str line method weights assets equally which can be a drawback when the cost of assets is rising because of inflation.
3 main ways that equity can arise
1) sale of shares to the SH
2) certain adjustments (such as revaluation of NCA)
3) retention of profit after tax
Are the ‘nominal’ value and market value always the same for shares?
No, it’s possible that the company will be able to find buyers who are willing to pay rather more.
Share premium account
def: difference between the nominal value of shares & the amount paid for them. It’s not permissible to issue shares at a discount
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included in ‘Other reserves’ in SFP
What can the share premium account be used for?
-preliminary expenses of forming a company
-expenses & commission incurred in any issues of shares
-any P/L on issue of loan stock
-any premium paid on the redemption of loan stock
-expenses of issue of loan stock
Revaluation reserve
common practice to revalue L&B (land & buildings) in the SFP
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the amount of the revaluation reserve is included in ‘Other reserves’ in the SFP)
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annual depreciation is based upon the revalued amount. The valuation will be written off over the estimated UL of the asset. It’s acceptable for the co. to revise its expectations as to the expected UL at the time of revaluation.
Advantages of fair value accounting for all assets & liabilities
> READERS of accounting information may want to know the current MV of the co’s assets & liabilities
more REALISTIC valuation of the co’s capital will give a more realistic rate of return
FV are a better basis for DECISION making than historical costs (because they offer a more realistic view of the net worth of the business - would be useful when selling assets, merging or being taken over)
co. would by increased allowance for depreciation, be CONSERVING more funds for replacement of assets
co could obtain more LOAN FINANCE on the basis of the increased value of its assets
if a co’s assets have FALLEN IN VALUE, this indicates poor stewardship of the co’s assets & should be reflected in the SPL
Disadvantages of fair value accounting for all assets & liabilities
> FV are not much better basis for decision making unless all items in the SFP are measured at FV (some are FV & some historical cost) -> INCONSISTENCY
FV increase the RISK OF MISUNDERSTANDING on the part of existing/potential investors (MV & Balance sheet asset values are different)
properly QUALIFIED REGULATED PROFESSIONALS will be required to undertake revaluation if FV are relied on (cost incurred)
the data on FV may NOT be RELIABLE (whereas MV) – need for PV
MODELS used and the ASSUMPTIONS made within those models, will DIFFER across companies, causing problems for auditors
Retained earnings
balance on reserve is the aggregate amount of profits earned during the lifetime of the co less amounts paid out of profits for tax & dividends
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Company law restricts dividends by linking the maximum payout of distributable reserves to protect the interest of creditors. Otherwise, the directors could use all of a failing co’s remaining assets to pay a massive dividend to its SH’s. Doing so would act against the interests of the co’s creditors & lenders.
