Chapter 6 - Adjustments to Monetary Values in Financial Statements: Depreciation of Non-Current Assets

Question 1

Non-Current Assets

Answer 1

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.

Question 2

Capital Expenditure

Answer 2

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.

Question 3

Reasons for Depreciation

Wear and Tear

Answer 3

Assets wear out and have to be replaced, because they will no longer be able to do the job they were bought for.

Question 4

Reasons for Depreciation

Age

Answer 4

As an item becomes older, its value decreases

Question 5

Reasons for Depreciation

Obsolescence

Answer 5

Machinery, vehicles and computers become out of date and are superseded by more technically advanced models.

Question 6

Reasons for Depreciation

Depletion

Answer 6

In the case of natural resources, for instance, the reserves diminish and get used up.

Question 7

Reasons for Depreciation

Amortisation

Answer 7

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.

Question 8

Reasons for depreciation

Answer 8

1. systematic way of calculating value loss and identify a realistic value of an asset at a given date.
2. 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)

Question 9

Choice of depreciation method

Answer 9

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.

Question 10

Non-Current Assets and Depreciation

Answer 10

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.

Question 11

Non-Current Assets and Depreciation in the Statement of Financial Position

Answer 11

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.

Question 12

Methods of Depreciation

Straight Line

Answer 12

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.

Question 13

Methods of Depreciation

Straight Line

Example

Answer 13

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

1. The Income statement is charged £13,500 every year for 10 years (unless asset is disposed before then)
2. The Statement of Financial Position, the non-current assets value will be deducted £13,500 every year.
3. The Statement of Financial Position will show the original total cost of the asset, less the total accumulation of depreciation to date

Question 14

Methods of Depreciation

Straight Line

Net Carrying Value

Answer 14

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.

Question 15

Methods of Depreciation

Straight Line

In the Final Accounts

Answer 15

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

Question 16

Methods of Depreciation

Diminishing Balance

Answer 16

`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.

Question 17

Methods of Depreciation

Diminishing Balance

Example

Answer 17

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.

Question 18

Methods of Depreciation

Comparison of both methods

Answer 18

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.

Question 19

Methods of Depreciation

Consistency Concept

Answer 19

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.

Question 20

Entering Depreciation into the Financial Statements

Answer 20

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.

Question 21

Depreciation calculation example

Trial Balance

Answer 21

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

Question 22

Depreciation calculation example

Calculations from Trial Balance

Answer 22

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

Question 23

Depreciation calculation example

Depreciation shown in Income Statement

Answer 23

Income Statement extract

Less Expenses
Depreciation
Machinery £4,000
Motor Vehicles: £3,600
Fixtures and Fittings 1,500

Question 24

Depreciation calculation example

Depreciation shown in Statement of Financial Position

Answer 24

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

Question 25

Depreciation calculation example year 2

Trial Balance

Answer 25

The trial balance (extract):

Accumulated depreciation for:
Machinery £4,000
Motor Vehicles £3,600
Fixtures and Fittings £1,500

Question 26

Depreciation calculation example year 2

Depreciation calculation

Answer 26

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

Question 27

Depreciation calculation example year 2

Income Statement

Answer 27

Income Statement extract year 2

Less Expenses
Depreciation
Machinery £4,000
Motor Vehicles: £2,880
Fixtures and Fittings 1,500

Question 28

Depreciation calculation example year 2

Statement of Financial Position

Answer 28

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

Question 29

Impairment of Assets

Answer 29

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.

Question 30

Impairment of Assets

Factors limiting the non-current assets

Answer 30

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.