Chapter 6 - Adjustments to Monetary Values in Financial Statements: Depreciation of Non-Current Assets Flashcards
Non-Current Assets
Are acquired by firms for the use in the operation of business. They will be use on the course of more than 1 financial year: vehicles, tools, motor equipment, computers, machinery.
Capital Expenditure
The purchase of Non-Current Assets.
Non-current assets are debited as an asset in the nominal ledger.
They appear in the Trial Balance and are then added to the Statement of Financial Position.
Reasons for Depreciation
Wear and Tear
Assets wear out and have to be replaced, because they will no longer be able to do the job they were bought for.
Reasons for Depreciation
Age
As an item becomes older, its value decreases
Reasons for Depreciation
Obsolescence
Machinery, vehicles and computers become out of date and are superseded by more technically advanced models.
Reasons for Depreciation
Depletion
In the case of natural resources, for instance, the reserves diminish and get used up.
Reasons for Depreciation
Amortisation
Example, a lease, which is used over a specific period of time. Specially property, amortisation needs to be taken into account, as it the asset will have no value at all for the company at the end of the lease period.
Reasons for depreciation
- systematic way of calculating value loss and identify a realistic value of an asset at a given date.
- Apportion a proportion of the original cost of the asset to the income statement every year of the asset’s economic use (to match income and expenses)
Choice of depreciation method
Whichever method is picked by a business, it needs to be consistent year to year, and the same method needs to be used year to year.
Different methods can be used for different assets, but it should be kept for that asset throughout that asset’s life.
The explanation for the chosen method needs to be detailed in the accounts’ notes, which can be very long in large businesses.
Non-Current Assets and Depreciation
Requirement of Companies Act is that:
Non-Current Assets should initially be measured at historic cost (value it was bought for). Following that, measurement can be carried at historic cost minus accumulated depreciation or at a revalued amount.
Non-Current Assets and Depreciation in the Statement of Financial Position
Since the non-current asset needs to be shown in the Statement of Financial Position at its original cost, it is necessary to create an additional account in the nominal ledger to record the accumulation of depreciation.
Each class of non-current asset will have it’s own ‘Accumulated Depreciation’ account.
Methods of Depreciation
Straight Line
An equal amount is added and charged to the Income Statement every year based on the initial cost of the asset.
Formula: Original cost of asset - expected residual value / number of years the item is expected to live.
Methods of Depreciation
Straight Line
Example
Example: machine cost £150,000, it is expected to last 10 years and have a residual value of £15,000.
Calculation:
150,000 - 15,000 = 135,000 / 10 = 13,500 annual depreciation charge
- The Income statement is charged £13,500 every year for 10 years (unless asset is disposed before then)
- The Statement of Financial Position, the non-current assets value will be deducted £13,500 every year.
- The Statement of Financial Position will show the original total cost of the asset, less the total accumulation of depreciation to date
Methods of Depreciation
Straight Line
Net Carrying Value
Net Carrying Value (NCV): the yearly new amount after depreciation has been deducted.
It is the remaining cost to be used over the asset’s life, not what the asset could be sold for, or what it is worth.
The provision for depreciation represents the loss in value of the asset that has been written off.
Methods of Depreciation
Straight Line
In the Final Accounts
Income Statement
- The charge to the Income Statement is the same each year
Statement of Financial Position
- Original Cost
- Deduction of total depreciation accumulated up to date
Methods of Depreciation
Diminishing Balance
`The Second and subsequent years, the the same percentage is charged on the depreciated value, of the asset in the preceding year.
That is, on its diminishing net carrying value.
Methods of Depreciation
Diminishing Balance
Example
Example: machine cost £150,000, it is expected to last 10. the residual value is not an important factor in this method. A percentage reduction is deducted each year.
It is decided that depreciation will 20% every year.
Then you calculate the 20% deduction for that year from the net carrying value of the previous year.
Methods of Depreciation
Comparison of both methods
Straight Line
Same amount depreciation added to Income Statement every year.
It is appropriate for assets that remain more or less constant through life: fixtures and fittings, furniture and office equipment. And where the value of the asset is uniform.
Diminishing Balance
The depreciation charge to the Income Statement will decrease every year, as the net carrying value of the asset decreases as well.
Because the charges are higher in the earlier years, the firm will take greater benefit from the asset then, when it will more efficient. In the latter years there will be more costs linked to repairing and maintenance. So this is more suitable for machinery and vehicles.
If the benefit of the asset will be mainly in the first years, then the best will be the diminishing balance; if the benefits are stable throughout the years, then the best will be the straight line.
Methods of Depreciation
Consistency Concept
Firms will use whichever method they will consider suitable for the asset, but they should remain consistent in the method they adopt, as in using it continuously each year, so that the profit figure is not distorted, as it’s needed to make meaningful decisions.
Entering Depreciation into the Financial Statements
Depreciation is an adjustment to the figures in the trial balance, so it needs to be entered twice:
- as an expense in the Income Statement (the expense depreciation for that year)
- as accumulated depreciation to date in the Statement of Financial Position, and it will be deducted from the non-current asset to reduce its value.
Depreciation calculation example
Trial Balance
Trial Balance extract
Machinery £40,000
Motor vehicles £18,000
Fixtures and Fittings £15,000
1st year, so no accumulated depreciation.
Notes to the Trial Balance:
- Machinery: 10% straight line
- Motor vehicles: 20% diminishing balance
- Fixtures and Fittings: 10% straight line
Depreciation calculation example
Calculations from Trial Balance
Year 1 Depreciation Calculation
Machinery £40,000; 10% straight line
£4,000 depreciation
Net Accumulated Value: £36,000
Motor vehicles £18,000; 20% diminishing balance
£3,600 depreciation
Net Accumulated Value: 14,400
Fixtures and Fittings £15,000; 10% straight line
£1,500 depreciation
Net Accumulated Value: £13,500
Depreciation calculation example
Depreciation shown in Income Statement
Income Statement extract
Less Expenses Depreciation Machinery £4,000 Motor Vehicles: £3,600 Fixtures and Fittings 1,500
Depreciation calculation example
Depreciation shown in Statement of Financial Position
Statement of Financial Position extract
Non Current Assets Machinery £40,000 Accumulated depreciation £4,000 Motor Vehicles £18,000 Accumulated depreciation £3,600 Fixtures and Fittings £15,000 Accumulated depreciation £1,500
Depreciation calculation example year 2
Trial Balance
The trial balance (extract):
Accumulated depreciation for:
Machinery £4,000
Motor Vehicles £3,600
Fixtures and Fittings £1,500
Depreciation calculation example year 2
Depreciation calculation
Year 2 Depreciation Calculation
Machinery 10% straight line £4,000 depreciation Net Accumulated Value: £36,000 Year 2 depreciation £4,000 Net Accumulated Value year 2: £32,000
Motor vehicles 20% diminishing balance £3,600 depreciation Net Accumulated Value: 14,400 Year 2 depreciation: 14,400 x 20 / 100 = £2,880 Net Accumulated Value year 2: £11,520
Fixtures and Fittings 10% straight line £1,500 depreciation Net Accumulated Value: £13,500 Year 2 depreciation: £1,500 Net Accumulated Value year 2: £12,000
Depreciation calculation example year 2
Income Statement
Income Statement extract year 2
Less Expenses Depreciation Machinery £4,000 Motor Vehicles: £2,880 Fixtures and Fittings 1,500
Depreciation calculation example year 2
Statement of Financial Position
Statement of Financial Position extract year 2
Non Current Assets Machinery £40,000 Accumulated depreciation £8,000 Motor Vehicles £18,000 Accumulated depreciation £6,480 Fixtures and Fittings £15,000 Accumulated depreciation £3,000
Notes: Net Carrying Value Machinery £32,000 Motor Vehicles £11,520 Fittings and Fixtures £12,000
Impairment of Assets
Sudden decline in the suitability of a non-current asset: plant, machinery, building; or the quality of a current asset, such as receivables.
If a non-current asset is depreciated as usual, but impairment arises, the net carrying value may overstate the real value on the statement of financial position. Therefore when justified, an impairment allowance can be applied.
Impairment of Assets
Factors limiting the non-current assets
Partial unrepairable damage, technological obsolescence earlier than anticipated, changes in law that no longer allow the asset to be used as envisaged (ex. machinery that is no longer compliant with Health and Safety).
After the impairment allowance has been applied, it will continue to be depreciated in the future years.
Impaired assets are not written off, they are merely revalued to the lower amount.
