Chapter 8: Further Fixed Assets - Hire purchase, leasing, grants and intangibles Flashcards
8.1 Hire purchase
Under hire purchase the trader obtains the use of an asset in exchange for a periodic rental payment (usually monthly). At the end of the rental period the trader has the option to purchase the asset, normally for a nominal sum. Thus, the trader is hiring the asset with a subsequent purchase. Where the business acquires an asset under hire purchase, the strict legal position is that title does not pass from seller to buyer until the final hire purchase instalment is paid. In the meantime, the buyer has enjoyed the full use of the asset, just as if they were the legal owner and had purchased the asset outright.
Accounting procedures are designed so accounts reflect the economic reality of this transaction. FRS102 Section 20 – leases and the qualitative characteristic of substance over form should be treated in accordance with the economic substance rather than the strict legal position. In accounts we treat the asset as if it had been purchased outright with a loan being provided by the hire purchase company. The periodic payments are then treated as repayments of this loan.
8.1 Leasing
Leasing – alternatively a business may lease an asset
• Short term leasing – for example the hire of a machine for 6 months, is referred to as an operating lease. This type involves the lessee or hirer paying rental on an asset for a period which is substantially less than its useful life
• Long term leasing – for example when a car is leased for 3 or more years, referred to as a finance lease. Here the lease term is likely to be for a major part of the asset’s economic life
Operating lease – this presents little problem since the business is paying for a service which it is currently using, it is simply the hire of an asset. Thus, the payments are treated as a revenue expense in the accounts. The double-entry to record is as follows:
£ £
Dr Operating lease rental X
expense (P+L account)
Cr Bank Account X
8.1 Finance Leasing
Finance lease – this is different, it is similar to hire purchase and differs only due to the fact that there is normally no option to purchase the asset at the end. Even though the asset is only leased, the total of the rentals payable normally equal the cash purchase price of the asset plus an extra amount for the fact payments are made over a period of years. The distinguishing feature of a finance lease in comparison to an operating lease is that substantially all the risks and rewards of the asset transfers to the lessee (hirer).
The transaction is applied in the same way as hire purchase, the transaction should therefore be accounted for by showing the asset in the balance sheet as its normal cost as if it had been purchased. The main problem is that the payments will exceed the cash price of the asset, this extra interest or finance charge is charged as an expense to the profit and loss account. The double entry way to record an asset acquired under hire purchase or finance lease is:
£ £
a) Dr Fixed asset cost X
Cr Loan creditor account being the cost of X
the asset if purchased for cash outright
b) Dr Loan creditor account X
Cr Bank being the amount X
of any deposit
c) Dr Loan creditor account X
Cr Bank being each monthly X
or periodic payment made to
the finance or loan provider
d) Dr Finance expense X
Cr Loan creditor account being each X
monthly or periodic allocation of interest
It is easiest to call the creditor account a loan creditor, under a finance lease the correct term is obligation under a finance lease account.
The total interest or finance charge that is incurred in a finance lease or HP agreement is calculated as follows:
£
Deposit X
Instalments X
Less: cash price (X)
Total interest/ finance charge x
this is spread evenly over the life of the lease/HP agreement
8.2 Government Grants - Revenue Grant
Businesses can qualify for a government grant in certain categories of expenditure. FRS 102 Section 24 says government grants, requires grants to be recognised using either the performance model or the accrual model. The performance model states that grants should only be recognised when future performance related conditions are met, if there are no conditions the grant is recognised when received.
When applying the accrual model, you classify grants as either a grant relating to revenue or relating to assets.
Revenue grant – this can be as a contribution towards wages and salaries of employing someone who is currently unemployed, then the grant will be recognised in the profit and loss account in the year in which the expenses are incurred, normally the year of receipt. It is credited as a form of sundry income:
£ £
Dr Bank X
Cr Grant income account X
(profit and loss account)
8.2 Government Grants - Asset Grants
Asset grants – if a grant is received in respect of capital expenditure, the grant is not recognised in the P+L account in the year of receipt, since the depreciation charge will be spread over the useful life of the asset. The grant will be held on the balance sheet as deferred income (income received but not earned). Each year a relevant portion will be released to the P+L account, matching it with the related depreciation charge:
£ £
a) Dr Bank X
Cr grant account (deferred X
income balance sheet)
being the initial cash receipt
b) Dr grant account X (deferred income balance sheet) Cr grant income account X (P+L account) being each release of the grant income in line with the associated depreciation expense in the P+L account
8.3 Intangible fixed assets (R+D)
They are assets than cannot be touched but generate future economic benefits for the business. The most common examples of intangible fixed assets are:
• Research and development expenditure
• Goodwill
• Patents, know-how copyrights and trademarks
The reason for treating it as fixed is that it is incurred for the purposes of achieving revenues in future years, rather than like a tangible fixed asset. FRS 102 Section 18 states all intangible assets shall be considered to have a finite useful life. If the useful life cannot be estimated, it shall not exceed 10 years. The intangible is then amortised on a systematic basis over its useful life (same principal as depreciation) starting with the period in which the intangible fixed asset is available for use.
Research and development expenditure – the accounting treatment for R&D is in FRS 102 Section 18, this distinguishes between research and development as follows:
• Research includes original investigations undertaken to gain new scientific or technical knowledge, the search for applications of research findings and searching for alternative materials, devices, products, processes, systems or services.
• Development is the use of scientific or technical knowledge to produce new or substantially improved materials, devices, products, processes, systems or services prior to the commencement of commercial production
FRS102 requires that research expenditure always be written off or expensed as it is incurred, apart from expenditure on tangible fixed assets acquired to provide research facilities. There is no certainty that research expenditure will provide future revenues which is why the costs are written off in the profit and loss account as they are incurred.
For development expenditure, FRS102 requires it too should be written off as incurred, unless it is related to a project which is technically feasible and commercially viable. Development expenditure is only allowed to be capitalised in the balance sheet if the business is certain the development expenditure will result in future economic benefits to the business. If development costs are shown as an asset, amortisation should start in the period of commercial production of the product or process and should be charged on a systematic basis to each accounting period which is expected to benefit from the development expenditure (its useful life).
8.3 Intangible fixed assets - goodwill
Goodwill – this is the reputation of the business; the value of goodwill is the difference between the value of the business as a whole and the sum of the values of individual assets that are shown on the balance sheet. It is difficult to place a value on goodwill since the value of a business is subjective. Any value of goodwill (referred to as inherent or unique goodwill) is unreliable so does not appear on the balance sheet. The only time the value of a business is not subjective is when it is bought. When buying a business, you incur a cost in buying a capital asset know as goodwill (referred to as purchased goodwill).
FRS102 Section 19 suggests that purchased goodwill should be capitalised and classified as an asset on the balance sheet. FRS102 states intangible fixed assets gave a finite useful life and that goodwill should be amortised over this life.
FRS102 Section 27 requires all assets should be reviewed annually for impairments and written down if required. An impairment is where the recoverable amount (the fair value less costs to sell) of an asset has dropped to below the value at which it is carried in the balance sheet. This is relevant for goodwill, which due to its nature is subject to many internal and external influences.
Taxation of goodwill – goodwill is a chargeable business asset for an individual which will become chargeable as a gain on disposal, regardless of whether it was purchased or inherent. The difference being if it was purchased it will have a base cost for the purposes of the calculation of the gain, whereas if it was inherent it is likely to have no base cost.
If a company disposes of goodwill it may either result in a chargeable gain (or loss) or in an income profit (or loss) depending on when the goodwill was purchased or created by the company.
