Chapter 7: Fixed Assets and Depreciation Flashcards
7.1 Capital expenditure versus revenue expenditure
Capital expenditure is expenditure incurred in:
• The acquisition of assets required for the continuing use in the business. These assets are known as fixed assets in Companies Act 2006, or property, plant and equipment in FRS102 Section 17. Examples are buildings, motor vehicles, fixtures, fittings, equipment, computers and machinery.
• The alteration or improvement of assets for the purpose of increasing their revenue earning capacity
It is intended that the expenditure will benefit the entity for more than one period and so capital expenditure is not immediately expensed or charged to the profit and loss account
Revenue expenditure on assets – this is expenditure which is expensed or charged to the profit and loss account, this is incurred in:
• The purchase of assets required for conversion into cash (goods for resale)
• The manufacturing, selling and distribution of goods and day-to-day administration of the business
• The maintenance of fixed assets (for example repairs), which just maintains their revenue earning capacity rather than increasing it
7.2 Classification
Fixed assets can be classified into tangible fixed assets and intangible fixed assets.
Tangible fixed assets – assets that can be physically seen and touched (buildings and motor vehicles). They have physical substance and are held for use in the production or supply of goods and services, or for administrative purposes on a continuing basis in the reporting entity’s activities.
Intangible fixed assets – assets which cannot be physically seen or touched, such as goodwill, copyrights or patents. They are non-monetary fixed assets that do not have physical substance but are identifiable as they are capable of being sold separately by the entity or are controlled by the entity through custody or legal rights.
7.3 The Accounting treatment of fixed assets
When an asset is acquired it is recorded as follows:
£ £
Dr Asset cost account X
Cr Bank Account or creditor X
with the cost of the purchase of the fixed asset
Use of the fixed asset – it is necessary to make a charge or expense for the cost of the asset against the profit and loss account for the use of the asset. As the fixed asset is used for a number of years, the cost of the asset should be charged or expensed to the profit and loss account over these same years as an expense. This is known as depreciation.
7.4 Concept of depreciation
FRS102 defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount is effectively the cost to the entity of using the fixed asset over its useful life. The aim of depreciation is to spread the cost of the fixed asset over the period over which the entity expects to benefit from the use of the asset.
There are three factors to consider when attempting to determine the amount of the depreciation expense:
• The carrying amount of the asset
• The length of the asset’s expected useful life to the entity
• The estimated residual value of the asset at the end of its useful life to the entity
The carrying amount of the asset – the asset is valued to the business as:
• The historic cost of the asset (its original purchase price), or
• The asset’s revalued amount. It is becoming increasingly common for businesses to revalue their fixed assets to fair value (particularly freehold and leasehold property) and to incorporate these revalued amounts in their financial statements instead of including the assets at their historic cost. Fair value is the amount that the asset could be sold for in an arm’s length transaction between willing parties
The assets useful life – this is the period over which the present owner will derive economic benefit. It may become useful to another entity when it is no longer useful to the first owner, but this is irrelevant as useful life is determined on a business by business basis. An asset’s useful life may be:
• Predetermined – in the case of lease of property, or affected by
• Depletion – extraction of resources from the asset itself (for example oil fields, gravel quarries)
• Physical deterioration – erosion though use or passing of time primarily due to the processes of rust, rot and general decay through exposure to the elements
• Time – some assets have a flow of benefits directly related to time, such as patents and copyrights
• Economic obsolescence – regardless of good physical condition, the useful life of the asset may be reduced by economic or technological obsolescence (for example computers)
The estimated residual value – this is the estimated amount the entity could currently obtain for the asset at the end of its useful life, considering the age and expected condition of the asset at the end of its useful life.
7.4 Concept of depreciation - methods of calculating depreciation
Methods of calculating depreciation -
• Straight line method – identifies an equal amount of depreciation over the useful lifetime. Annual charge is the cost less any residual value (if any) divided by its useful life. If the asset is likely to give an even and consistent use, this is an appropriate method
• Reducing balance method – applies a fixed percentage to the asset’s net book value. The net book value is the asset’s cost less the accumulated depreciation. The depreciation charge will decrease each year. If the asset is likely to depreciate more quickly in its early life (like a motor vehicle), this is an appropriate method.
7.5 Depreciation and taxation
The accounting methods for depreciation are not acceptable for tax purposes, since it could lead to the manipulation of profits on which tax would be levied. Tax legislation dictates that depreciation is not allowed to reduce profits for tax purposes. Depreciation is replaced by capital allowances which represent the tax equivalent of depreciation but are charged at rates set by government.
7.6 Recording depreciation
Depreciation is an expense in the profit and loss account and so there has to be a depreciation expense account in the records. This is a profit and loss ledger account. Whilst it is charged as an expense to the profit and loss account, it has no impact on the cash in the business. The ongoing charge to the profit and loss account is simply designed to reduce the cost of an asset recorded in the accounts over its useful life. Depreciation reduces the value of the asset in the balance sheet since the original cost is being written down. This is achieved by creating a separate account called the provision for depreciation account, this is a balance sheet ledger account. The balance on this account is set against the debit balance on the asset cost account in the balance sheet to produce the net book value.
The double entry to record the depreciation charge –
£ £
Dr Depreciation account (P+L) X
Cr Provision for depreciation X
account (balance sheet)
The depreciation account records the expense for the year and is closed off to the profit and loss account. The provision for depreciation account records the total (accumulated) depreciation to date and appears on the balance sheet as a reduction in the value of fixed assets.
Assets owned for only part of the year –
Technically when the asset is owned for only part of the year, a business should appropriately apportion the depreciation charge for the number of months the asset is owned. However, an accepted practice has evolved which is to charge a full year’s depreciation in the year of purchase and no charge in the year of disposal.
7.6 Recording depreciation - disposal of fixed assets
Disposal of a fixed asset –
If a fixed asset is disposed of or sold, it is likely that the proceeds will differ from the net book value. Since we will be replacing the net book value of the asset in the balance sheet with the cash received, the difference will represent a profit or loss on disposal.
It is also necessary to remove the asset and its associated depreciation from the books of the business. All of the information regarding the particular asset which is being disposed of is collected into an asset disposal account specifically set up for the purpose. The approach to record the disposal of a fixed asset is as follows:
• Transfer the cost of the asset disposed of from the fixed asset account to the disposal account
£ £ Dr Disposal Account X Cr Fixed asset cost account X with the original cost when the asset was acquired
• Transfer the accumulated depreciation of the asset sold from the provision for depreciation account to the disposal account
£ £
Dr provision for depreciation account X
Cr disposal account with the accumulated X
depreciation on the asset being disposed of
• Record the cash receipt of the sale
£ £
Dr Bank disposal X
Cr disposal account with the X
proceeds of sale
• Close off the disposal account. The balance on the disposal account represents the profit or loss on sale which should be transferred to the profit and loss account
Where a profit on sale is made:
£ £
Dr Disposal account X
Cr Profit and loss account X
Where a loss on sale is made:
£ £
Dr Profit and loss account X
Cr Disposal account X
7.6 Recording depreciation - profit and loss on disposal for tax purposes
Profit and loss on disposal for tax purposes – for tax purposes the profit and loss on the disposal will not represent income which is taxable or an expense that is allowable. The profit and loss are disallowed for tax purposes and an adjustment is made to remove the entry. The only impact on cash within the business will be the actual cash received. These cash proceeds may then be the starting point for calculating a taxable gain on the disposal in accordance with tax legislation.
7.7 Part exchange of a fixed asset
When an asset is disposed of partly in exchange for a new one, with the balance being made up in cash. The accounting treatment is similar to the disposal of fixed assets, but the proceeds are not cash but instead a part exchange allowance against the purchase price of the new asset
Double entry to record the part exchange of a fixed asset –
£ £
Dr Disposal Account X
Cr Fixed asset cost account with the X
original cost of the asset disposed of in part exchange
£ £
Dr Provision for depreciation amount X
Cr Disposal account with the X
accumulated depreciation of the asset disposed of in part exchange
£ £ Dr Fixed asset cost account X Cr Disposal account with the X part exchange allowance £ £ Dr Fixed asset cost account X Cr bank account with payment of X balance for the new fixed asset
Then transfer profit or loss on disposal account to the profit and loss account
