Week 5 - Non-current assets Flashcards
What are the two types of assets?
Non-current and Current assets
What are the characteristics of non-current assets?
- Long term in nature (more than one year)
Subcategories:
1. Intangible
2. Tangible
3. Financial (long term, investments held)
eg machines, buildings
What does long term in nature for non-current assets contribute to?
Expected to contribute to income generation for more than one year
Indirect relationship with trading activities (you dont trade the machines or buildings)
What are the characteristics of current assets?
- Short term in nature (less than a year)
Subcategories:
1. Inventories
2. Trade receivables
3. Cash
What does short term in nature for current assets mean?
Convertible into cash in less than one year
Usually relate directly to trading activities
What are tangible assets?
physically assessable, we can see and touch it
What are examples of tangible non-current assets?
- land and buildings
- plant and machinery
- fixtures and fittings
- motor vehicles
What are examples of intangible assets?
- Brands
- Research and development
- Goodwill
- Patents and trade marks
What are financial assets?
another type of non-current asset which is also intangible
they are not directly/related to the core business
Where do we put assets?
balance sheet/ SOFP
What is the initial value of the non-current assets in the SOFP known as?
the Historical Cost of the asset
What is a historical cost?
this is the cost of acquiring the asset, plus costs of bringing it to its working condition and location
(eg delivery fees)
What does the historical cost include?
- Purchase price
- Costs of site preparation
- Delivery and installation costs
- Professional fees related to the above
What do we exclude from the historical cost?
- Costs of extended warranty
- Maintenance agreement
- Replacements and spare parts (for future use)
-> expense them (Income statement)
How is the initial value of the non-current assets included in the SOFP/ Balance sheet?
Dr: Non-current asset £xxx
Cr: Cash/ payables £xxx
What will each different type of non-current asset have?
a separate non-current asset T account
eg different T account for buildings and cars
What do we need to change in the Balance sheet since non-current assets are used for more than one year?
need to record/ adjust the value of non-current assets in the following years
What are two methods to adjust non-current assets value in the following years?
- Revaluation model
- Cost model
What is the revaluation model?
record the fair value (market value) of the assets in the year when making the balance sheet (eg Land)
What is the cost model?
Depreciate the assets in the subsequent years, and reduce the value of the assets in the balance sheet (eg machinery, motor vehicles etc)
What do we use the revaluation model on?
Inflation, inflation results in the cost of non-current assets acquired several years ago being out-of-date
A particular concern for long-term non-current assets such as land and investment properties
When do the IAS16 allow the revaluation of non-current assets to fair value?
- if a business chooses to revalue an asset, it has to revalue all assets of that type
- and it has to go regularly keep fair values up to date
- we normally apply the revaluation model on land and investment properties
What is the bookkeeping for upward revaluation?
Dr: non-current assets £xxx
Cr: Revaluation reserve (as part of owners equity) £xxx
Where is the revaluation reserve?
a separate line in the equity section in the balance sheet
What do we have to apply in the cost model?
application of the matching concept to non-current assets
What are expenses?
costs consumed in delivering goods or services to customers
What is the matching part of the accruals concept?
all expenses must be matched against the revenue (or income) earned in an accounting period
What is the depreciation process for tangible assets (within cost model)?
as non-current assets will contribute to generation of income for more than one year, the complexity in heir accounting is matching their costs to the income they help generate
also called amortisation for intangible assets
What is depreciation?
the systematic allocation of the depreciable amount of (ie the cost of using) an asset over its useful economic life
What does depreciation reflect during a period?
depreciation reflects the amount of economic benefits of the tangible non-current assets that have been consumed during the period
What do the IAS16 require to be depreciated?
all tangible non-current assets except land and investment properties to be depreciated, even where their market value is greater than their historical cost or net book value
this includes buildings because they have a finite life
What is the annual amount of depreciation equal to?
the amount of the total cost of a non-current assets used up during the year
What is the net value of the non-current assets in the balance sheet reduced by?
the annual amount of depreciation (= the amount of the total cost of a non-current assets used up during the year)
What is the net book value (NBV) in the balance sheet?
NBV = the historical cost - the total accumulated depreciation
What do we use NBV as?
the value to calculate total assets
What accounts do we use for the historical cost and total accumulated depreciation?
keep separate accounts for the historical cos and the total accumulated depreciation for each type of asset
What is the annual amount of depreciated charged as?
an expense in the income statement
thus matching the cost of using the asset against the income its use helps to generate
An asset costing £300,000 is acquired in Year 1 and expected to last for 3 years with no residual value. Profits are £250,000 per year
With depreciation, the cost is allocated over 3 years:
Year 1
Profit before depreciation: £250,000
Depreciation: (£100,000)
Net profit: £150,000
Year 2
Profit before depreciation: £250,000
Depreciation: (£100,000)
Net profit: £150,000
Year 3
Profit before depreciation: £250,0000
Depreciation: (£100,000)
Net profit: £150,000
An asset costing £300,000 is acquired in Year 1 and expected to last for 3 years with no residual value. Profits are £250,000 per year
Without depreciation, the cost is all allocated to Y1 (means financial statements in future years dont reflect that the asset is still used by the business):
doesnt meet matching concept
Year 1
Profit before depreciation: £250,000
Depreciation: (£300,000)
Net profit: (£50,000)
Year 2
Profit before depreciation: £250,000
Depreciation:
Net profit: £250,000
Year 3
Profit before depreciation: £250,0000
Depreciation:
Net profit: £250,000
What is the depreciable amount?
the cost of an asset less its expected residual value
What is residual value?
the estimated disposal proceeds at the end of the assets useful life
What does economic life determine?
the expected useful life for calculating depreciation
What is the economic life of an asset?
time for which the asset is expected to generate economic benefits for the firm
this period needs to be estimated when the non-current asset is acquired
What does economic life depend on?
number possible factors such as:
- Physical life (limited through wear and tear etc)
- Technological obsolescence
What are not revalued each year as a result of depreciation?
assets
What is depreciation but has no cash effect?
an expense
What data do you need to calculate depreciation?
- Historical cost (or valuation) (C)
- The length of the asset’s expected useful economic life to the business (N)
- The estimated residual value of the asset at the end of its useful economic life (RV)
- Method of calculating each year’s depreciation
(straight line, reducing balance, sum of digits)
What are the three methods to calculate depreciation?
straight line, reducing balance and sum of digits
What does the straight line method assume (annual charge to income statement)?
assumes that the amount of the asset used up remains constant each year
to reflect this, the depreciation charge must be the same each year, which equals
Depreciation =
(Original cost (C) - estimated residual value (RV)) / Estimated useful life (years) (N)
What is the straight line method equation?
Depreciation =
(Original cost (C) - estimated residual value (RV)) / Estimated useful life (years) (N)
What is the depreciable amount in the straight line equation?
Original cost (C) - estimated residual value (RV)
Example of the straight line method
ABC ltd purchased a machine at cost of £40,000 on 1st Nov 2021. The machine is expected to use for 4 years. At the end of the useful life, the residual value of the machine is estimated to be £1024. The financial year end of ABC ltd is 31st October
Demonstrate the annual depreciation charge in the income statement and the net book value (NBV) of the machine at the end of the financial year
Annual depreciation expense = (40,000 - 1024) / 4
= 9744 into income statement
Example of the straight line method
ABC ltd purchased a machine at cost of £40,000 on 1st Nov 2021. The machine is expected to use for 4 years. At the end of the useful life, the residual value of the machine is estimated to be £1024. The financial year end of ABC ltd is 31st October
Demonstrate the annual depreciation charge in the balance sheet in 2022, 2023 and 2024, and the net book value (NBV) of the machine at the end of the financial year
Balance sheet 31/10/2022
Machine at cost: £40,000
Less Accumulated depreciation: (9,744)
Net book value (NBV): 30,256
take the difference of the two to get NBV which goes to the balance sheet
Balance sheet 31/10/2023
Machine at cost: £40,000
Less Accumulated depreciation: (19,448)
Net book value (NBV): 20,512
19448 = 9744 +9744
Balance sheet 31/10/2024
Machine at cost: £40,000
Less Accumulated depreciation: (29,232)
Net book value (NBV): 20,512
29,232 = 19448 +9744
What does the depreciation expense (I/S) for the straight line method look like on a graph?
it is a horizontal line, across eg 4 years it is the same
What does the NBV at the end of the year (B/S) for the straight line method look like on a graph?
downward sloping across eg 4 years
What are arguments for the straight line method?
- it is most appropriate for assets that are depleted as a result of the passage of time (eg buildings, leases, patents)
- it may be suitable where an asset’s utilisation is the same in each year (eg plant and machinery, vehicles)
What are arguments against the straight line method?
- it may not give an accurate measure of the loss in value or reduction in useful life (eg the large decrease in resale value of vehicles in the first year of their life)
What is the reducing balance method?
it applies a constant/ fixed percentage depreciation rate each period to the asset’s net book value at the end of the previous period (opening balance of NBV at the current period)
How do you derive the fixed percentage of the reducing balance method?
r = 1 - (RV / C)^1/n
r is the annual depreciation rate (as a decimal)
n is the number of years of depreciation
C cost of non-current asset
What is the reducing balance method formula?
Annual depreciation expense = Opening balance NBV x r
r is the annual depreciation rate
Example of the reducing balance method
ABC ltd purchased a machine at cost of £40,000 on 1st Nov 2021. The machine is expected to use for 4 years. At the end of the useful life, the residual value of the machine is estimated to be £1024. The financial year end of ABC ltd is 31st October
Demonstrate the annual depreciation charge in the income statement and the net book value (NBV) of the machine at the end of the financial year
Calculate the rate:
RV = £1024
C = £40,000
n = 4
r = 1 - (RV / C)^1/n
r = 1 - (1024/40,000)^1/4
= 0.6
Annual depreciation expense for the year end 31/10/2022:
Depreciation expense = 40,000 x 0.6
= 24,000
NBV at the end of the year (B/S) = 40,000 - 24,000 = 16,000
Accumulated depreciation at the end of the year (B/S) = 40,000 - 16,000 = 24,000
Annual depreciation expense for the year end 31/10/2023:
Depreciation expense = 16,000 x 0.6
= 9,600
NBV at the of the year (B/S) = 16,000 - 9,600 = 6,400
Accumulated depreciation at the end of the year (B/S) = 40,000 - 6400 = 33,600
Annual depreciation expense for the year end 31/10/2024:
Depreciation expense = 6,400 x 0.6
= 3,840
NBV at the of the year (B/S) = 6,400 - 3840 = 2,560
Accumulated depreciation at the end of the year (B/S) = 40,000 - 2,560 = 37,440
What does the Depreciation expense at the end of the year (I/S) for the reducing balance method look like on a graph?
downward sloping
first two years steeper, 2-3 years less steep, 4 less steep (gradually becomes smaller and smaller)
What does the NBV at the end of the year (B/S) for the reducing balance method look like on a graph?
downward sloping
first two years steeper, 2-3 years less steep, 4 less steep (reduction gradually becomes slower and slower)
What are arguments for the reducing balance method?
- it is most appropriate for assets that deteriorate as a result of usage where this is greater in earlier years (eg motor vehicles)
- it may also be suitable where the utilisation is the same in each year - the decreasing annual depreciation combined with increasing repair costs give a relatively constant combined annual charge
- it gives a more realistic approximation of the reduction in resale value, although this is not really a purpose of depreciation
What are arguments against the reducing balance method?
- it contains an arbitrary assumption about the rate of declining value
- it is relatively complex
When does the sum of the digits method (or sum of the years’ digits method) depreciate more?
will depreciate more in the earlier stage than the later stage
How do you calculate the depreciate rate in the sum of the digits method?
Through the following:
- Denominator: Digits of the year numbers (N) are summed as
n x (N+1) / 2
- Numerator for each year: the number of the year in reverse order
eg N = 4
- Denominator = 4 x (4+1) / 2
= 10
- Numerator Year 1 = 4
Year 2 = 3 etc..
Depreciation rate for year 1 = 4/10
How to calculate the annual depreciation expense for the sum of the digits method?
Annual depreciation expense = (Cost - Residual Value) x rate
What is the depreciable amount in the sum of the digits method?
Cost - residual value
Eg Sum of the digits method
Cost = 40,000
Residual value = 1024
Depreciable amount = 40,000 - 1024 = 38,976
Annual depreciation expense for the year end 31/10/2022:
Depreciation expense = 38,976 x 4/10
= 15,590
NBV at the end of the year (B/S) = 40,000 - 15,590 = 24,410
Accumulated depreciation at the end of the year (B/S) = 40,000 - 24,410 = 15,590
Annual depreciation expense for the year end 31/10/2023:
Depreciation expense = 38,976 x 3/10
= 11,693
NBV at the end of the year (B/S) = 24,410 - 12,717 = 11,693
Accumulated depreciation at the end of the year (B/S) = 40,000 - 12717 = 27283
Annual depreciation expense for the year end 31/10/2023:
Depreciation expense = 38,976 x 2/10
= 7,795
NBV at the end of the year (B/S) = 12717 - 7,795 = 4922
Accumulated depreciation at the end of the year (B/S) = 40,000 - 4,922 = 35,078
In the 4th year the accumulated depreciation at the end of the (B/S) is the same as the depreciable amount 38,976
What does the depreciation expense (I/S) graph look like for the sum of the digits method?
downward sloping
What does the NBV at the end of the year (B/S) graph look like for the sum of the digits method?
downward sloping, less steep each year
Impacts of different depreciation methods on net profits
with eg
Assume the business generates £20,000 profit before depreciation for all 4 years which the asset is held (ie net profit = £20,000 - depreciation)
Profit after deducting depreciation:
- Straight line eg £10,256 each year, investors like this because it is less volatile
- Reducing balance, end up with negative number in the first year, but gets better and better in the following years
- Sum of digits, the first year it is positive but still less profit than the straight line method
What are the two effects depreciation has on bookkeeping?
- It reduces the amount the asset is recorded at in the balance sheet by the amount that has been used up (depreciated historical cost)
- The amount of depreciation charged in the year is an expense in the income statement (allocating/ matching the cost against the revenues generated)
How does depreciation affect the value of an asset shown on the balance sheet?
Depreciation reduces an asset’s value over time, so it is shown on the balance sheet at its net book value, calculated as the original cost less accumulated depreciation since acquisition.
Do we debit/ credit the depreciation expense in the income statement?
debit
Do we debit/ credit the accumulated depreciation in the balance sheet?
credit
What is accumulated depreciation also called?
provision for depreciation account (acontra asset account)
What is a contra asset account?
the account we use to reduce the assets account
(behaves in the opposite way to a real asset account)
What do we debit and credit in the straight line method?
same every year
debit - depreciation expense: 9744
credit - accumulated depreciation: 9744
What do we debit and credit in the reducing balance method?
(numbers for eg)
year 1:
debit - depreciation expense: 24,000
credit - accumulated depreciation: 24,000
year 2:
debit - depreciation expense: 9,600
credit - accumulated depreciation: 9,600
year 3:
debit - depreciation expense: 3,860
credit - accumulated depreciation: 3,860
year 4:
debit - depreciation expense: 1,536
credit - accumulated depreciation: 1,536
How is depreciation shown in the Income Statement?
Gross profit X
Less expenses:
Depreciation (X)
Net profit X
How is depreciation shown in the balance sheet?
Asset at cost XX
Less: Accumulated depreciation (XX)
Net book value/ Written down value XX
The NBV shows the asset’s value at that date and goes to the accounting equation (assets = liabilities + equity)
(Before disposal) What has depreciation been charged each year based on?
- Knowledge of original historical costs
- Original estimates of residual value and economic life of asset
What happens when we dispose of a non-current asset?
We will have actual knowledge of the residual value and economic life.
As these are likely to be different from our original estimates several years earlier, the disposal proceeds will probably be different to the net book value at the date of disposal
When we sell the non current asset the selling price may be different to the net book value of this machine shown in the balance sheet, what does this cause?
either profit on disposal or loss on disposal
What is profit on disposal?
amount by which proceeds are larger than net book value at date of disposal
What is loss on disposal?
amount by which net book value is larger than disposal proceeds
Disposal of machinery example:
A machine cost £10m and has accumulated depreciation of £6m. It is disposed off for £5m. How is this recorded in financial statements?
Before disposal:
Net book value of the machine -> £10m - £6m = £4m
After disposal:
Cash -> £5m
Profit on sale -> £1m
Cash (proceeds) received less Net book value at the date of disposal (5m - 4m = 1m)
profit 1m to income statement
Disposal of machinery example 2:
A machine cost £10m and has accumulated depreciation of £6m. It is disposed off for £3m. How is this recorded in financial statements?
Before disposal:
Net book value of the machine -> £10m - £6m = £4m
After disposal:
Cash -> £3m
Loss on sale -> £1m
Cash (proceeds) received less Net book value at the date of disposal (3m - 4m = -1m)
loss 1m to income statement
How should we account for the disposal of non-current assets in terms of bookkeeping?
- Set up a new ‘disposal of non-current asset’ T account for the asset that we disposed of
- Move original historical cost of the disposed asset to the new T account:
Debit: Disposal of non-current asset £xxx
Credit: Non-current asset at cost £xxx
eg
Debit: Disposal of non-current asset £10m
Credit: Non-current asset at cost £10m - Move the accumulated depreciation on disposed asset from the original account to the new T account:
Debit: Accumulated depreciation £xx
Credit Disposal of non-current asset £xx
eg
Debit: Accumulated depreciation £6m
Credit Disposal of non-current asset £6m - For disposal proceeds:
Debit: Cash (or trade receivables) £xx
Credit: Disposal of non-current asset £xx
eg
Debit: Cash (or trade receivables) £5m
Credit: Disposal of non-current asset £5 m - The balance on the ‘Disposal of non-current asset’ account will be the loss on disposal (debit) or profit on disposal (credit balance)
How should we account for the disposal of non-current assets in terms of bookkeeping?
ALL TOGETHER what it looks like
-Debit: Disposal of non-current asset £10m
Credit: Non-current asset at cost £10m
Debit: Accumulated depreciation £6m
-Credit Disposal of non-current asset £6m
Debit: Cash (or trade receivables) £5m
-Credit: Disposal of non-current asset £5 m
T account: Disposal of non-current asset
Debit = £10
Total = £10
Credit = £6
= £5
Total = £11
Balance is on the credit side, then we have a profit on disposal, which is 11m - 10m = 1m
What is an alternative way to work out profit/ loss on disposal?
Using two major equations:
1. OB of NBV - Disposed NBV = CB of NBV
2. Profit/ loss on disposal = Proceeds - Disposed NBV
And one supporting equation:
NBV = Cost - Accumulated Depreciation
Eg
Cost of disposed machine: £10m
Accumulated depreciation of disposed machine: £6m
NBV disposed machine = 10m - 6m = 4m
Profit/ loss on disposal = 5m - 4m = 1m profit
Profit/ loss on disposal is shown on a separate line in the income statement, doesnt belong to core business
In balance sheet:
Machine at cost: Cost -10m
Less Accumulated depreciation: OB Accumulated Depreciation -6m + Depreciation expense
What is a partial year depreciation?
When a non-current asset is bought or sold part way through an accounting year, the depreciation expense is computed either:
1. on a strict time basis
2. As might be indicated in a question:
- Full years charge in the year of purchase (eg only in company for 3 months but still consider as a whole year)
- None in the year of sale
What is the strict time basis?
calculating the exact time the machine has stayed in the company
What is a strict time basis in the year of acquisition?
In the year of acquisition, from the date of purchase to the end of the accounting year
What is a strict time basis in the year of disposal?
In the year of disposal, from the start of the accounting year to the date of sale
