CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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Accounting for

Non-current Assets

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LEARNING OUTCOMES

When you have completed this chapter, you should be able to:

䉴 explain and distinguish capital and revenue;

䉴 identify the basic methods of valuing assets on current cost, fair value and value in use

bases and their impact on proﬁ t measures and statement of ﬁ nancial position values;

䉴 explain and calculate the methods of depreciation including straight line, reducing

balance and revaluation methods, and prepare accounts using each method and

impairment;

䉴 prepare a non-current asset register.

6.1 Introduction

We have already learned that a non-current asset is a resource acquired by an organisation

with the intention of using it to earn revenue for a long period of time. Examples of tangi-

ble non-current assets include land, buildings, motor vehicles, machinery and equipment.

In this chapter we shall look at the important distinction between capital expenditure and

revenue expenditure, where capital expenditure is deﬁ ned as expenditure on non-current

assets. We shall also learn about the concept of depreciation and how this is applied in

practice. The chapter also looks at the sale of non-current assets and how non-current

assets are controlled.

The chapter concludes with a brief discussion on another class of non-current assets

known as ‘ intangible non-current assets ’ .

6.2 Capital and revenue expenditure

Capital expenditure is expenditure likely to increase the future earning capability of the

organisation, whereas revenue expenditure is that associated with maintaining the organi-

sation’s present earning capability.

Accounting for

Non-current Assets

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ACCOUNTING FOR NON-CURRENT ASSETS

Thus, new items of plant and machinery that are bought from external manufacturers,

vehicles, buildings and purchases of land are clearly capital expenditure to be included in a

statement of ﬁ nancial position. However, when assets are internally manufactured or when

existing assets are modiﬁ ed or repaired, it is sometimes difﬁ cult to determine whether the

expenditure is of a capital or revenue nature. The general principle to be followed is that if

the expenditure signiﬁ cantly improves earnings capability, then it is to be treated as capital

expenditure. When making this comparison in the context of expenditure on repairs, it is

necessary to consider the effects in relation to the position prior to the need for repair.

Example 6.A

Consider the situation where a computer is repaired by replacing a faulty ﬂ oppy disk drive and a faulty hard

drive. The replacement ﬂ oppy disk drive is identical to that which it replaced. The faulty hard drive had a stor-

age capacity of 500 megabytes, its replacement is a 5 gigabyte (i.e. 5,000 megabyte) unit. At the same time

a CD-ROM drive is ﬁ tted. How should these ‘repair’ costs be classiﬁ ed?

Solution

The replacement of the faulty ﬂ oppy disk drive with an identical unit is clearly a repair, and as such will be

treated as an expense.

The ﬁ tting of the CD-ROM drive is clearly not a repair because the computer did not have a CD-ROM drive

previously. This is an addition to the asset, which should be capitalised.

It is the cost of the hard disk drive that presents the classiﬁ cation problem. To the extent that it replaced the

original hard drive it is a repair, but the new drive has ten times the capacity of the original. As it enhances the

storage capacity of the computer it is capital expenditure. Thus this cost must be divided, part of it is treated as

an expense and the remainder as capital expenditure.

The distinction between capital and revenue expenditure is important because of the implications for the ﬁ nan-

cial statements. Revenue expenditure will be reﬂ ected in full in the measurement of proﬁ t in the period in which

it is incurred. In contrast, capital expenditure will be reﬂ ected in an increase in asset values in the statement of

ﬁ nancial position. This will diminish over the life of the asset as it is depreciated (see later), with a corresponding

reduction in the proﬁ t reported.

Exercise 6.1

Explain brieﬂ y the difference between capital and revenue transactions.

Solution

Capital transactions are those affecting the long-term operations of the organisation. They

might affect non-current assets, non-current borrowing and so on. Revenue transactions

are those affecting the immediate future of the organisation. They might include the

purchase or sale of inventories, the incurring of expenses such as wages, heat and light,

and so on.

Revenue transactions would also include the repair and maintenance of non-current

assets, even though the initial purchase of those assets was a capital transaction.

Expenditure that does not provide any additional beneﬁ t is classed as revenue.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

ACCOUNTING FOR NON-CURRENT ASSETS

Capital transactions would also include the cost of acquisition of non-current assets,

such as legal fees, carriage and delivery, and installation costs. If the equipment needs to be

tested prior to use, these costs can also be included.

Exercise 6.2

Classify each of the following transactions into capital or revenue transactions:

●

Complete repaint of existing building.

●

Installation of a new central heating system.

●

Repainting of a delivery van.

●

Providing drainage for a new piece of water-extraction equipment.

●

Legal fees on the acquisition of land.

●

Carriage costs on a replacement part for a piece of machinery.

Solution

●

Complete repaint: revenue.

●

Installation of new heating system: capital.

●

Repainting van: revenue.

●

Drainage for new equipment: capital.

●

Legal fees on acquisition of land: capital.

●

Carriage costs on replacement part: revenue.

6.3 Depreciation

The cost of the non-current asset will contribute to the organisation’s ability to earn rev-

enue for a number of accounting periods. It would be unfair if the whole cost were treated

as an expense in the income statement in the year of acquisition. Instead, the cost is spread

over all of the accounting periods in which the asset is expected to be making a contri-

bution to earnings (this is known as the asset’s useful life). The process by which this is

achieved is called depreciation.

We shall look at the calculation of depreciation in detail in the next section. For now,

we shall just focus on the main principles.

●

When we acquire a non-current asset, we credit cash (or creditors), and debit an account

called ‘non-current assets ’ or ‘ plant and machinery ’ or another suitable description.

●

If we were to prepare a set of ﬁ nancial statements immediately afterwards we would dis-

play the balance on the asset account – the cost of the asset – on the statement of ﬁ nancial

position. It would not appear as an expense in the income statement at all, because we

have not yet begun to ‘ consume ’ it in earning revenue.

●

During the periods that the asset is in use – its useful life – we must allocate its orig-

inal cost on some fair basis. An appropriate proportion of the cost must be recorded

as an expense – called depreciation charge – in the income statement of each period

concerned.

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ACCOUNTING FOR NON-CURRENT ASSETS

●

We achieve this by, in effect, changing the balance in the asset account. Each year we

decide that some proportion of the original cost has now been ‘ consumed ’ in operating the

business. This proportion is transferred to the income statement, where it is shown as an

expense, and the amount remaining on the statement of ﬁ nancial position is correspond-

ingly reduced. (This remaining balance is referred to as the carrying amount of the asset.)

●

Eventually we reach a point where the whole of the original cost has been consumed and

the carrying amount for the asset on the statement of ﬁ nancial position has declined to

zero (or perhaps to some small residual value that it may realise on disposal).

It is extremely important to understand this basic notion of depreciation as a means of

allocating the cost of a non-current asset over a number of accounting periods. It has noth-

ing whatever to do with ‘ valuing ’ the asset, in the sense of estimating what its fair value

might be at the end of each accounting period. (Fair value is the estimated amount for

which an asset could be sold.) Indeed, it is not likely, in general, that the carrying amount

of a non-current asset is anything like an approximation to its fair value. Nor does depreci-

ation have anything to do with providing a fund for replacing the non-current asset when

it is consumed. The process of transferring amounts from statement of ﬁ nancial position to

income statement each year does not in any sense generate funds for the business. It may

indeed be desirable to plan ahead for asset replacement by setting aside cash for the pur-

pose, but this is an exercise quite separate from the process of charging depreciation.

Exercise 6.3

Explain what you understand by the term ‘ depreciation ’ .

Solution

Depreciation is the systematic allocation of the cost of an asset, less its residual value, over

its useful life. In practice, it is usually taken as being the original cost of the asset spread

over its estimated useful life. The cost is reduced by any expected residual value, which is

the estimated amount that may be received if the asset is sold at the end of its useful life.

The depreciation might be an equal amount every year (the straight-line basis) or might

be a percentage of its opening value each year (the reducing-balance basis). There are other

methods, including revaluation for small items.

The amount of depreciation each year is charged against the proﬁ ts, and reduces the

asset’s carrying amount. Depreciation is not a method of providing for the replacement of

the asset, and no cash movement is involved.

6.4 Calculating depreciation

There are a number of methods that accountants use to depreciate a non-current asset.

The two most common methods that are used will each be examined in this section of the

chapter using the same basic information about a single non-current asset:

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

ACCOUNTING FOR NON-CURRENT ASSETS

Cost – 1 January 20X5 $50,000

Estimated useful life 10 years

Estimated residual value at the end of its life (residual value) $1,280

6.4.1 The straight-line method

This method allows an equal amount to be charged as depreciation to each account-

ing period over the expected useful life of the asset. If the depreciation charge were to

be shown on a graph it would be a straight line parallel to the horizontal axis (hence

the name of the method). The amount to be charged to each accounting period is given

by the formula:

Depreciation per annum

iginal cost estimated residual va





llue

Estimated useful life

sing the data above, the annual depreciation charge would be

£, £,

£,

50 000 1 280

4 872





The effect of the abov

e would be that the carrying amount of the asset shown in the

organisation’s statement of ﬁ nancial position would be reduced by $4,872 each year. The

corresponding effect would be to reduce proﬁ ts in the income statement by charging

depreciation as an expense.

The ledger entries to record the depreciation are

●

credit an accumulated depreciation account;

●

debit the income statement with the annual depreciation.

As each year passes, the balance on the accumulated depreciation account will increase as

follows:

Accumulated depreciation

31 Dec. X5 Income statement 4,872

31 Dec. X6 Income statement balance 4,872

9,744

31 Dec. X7 Income statement balance 4,872

14,616

and the asset would be shown on the statement of ﬁ nancial position as follows:

Cost ($) Accumulated depreciation ($) Carrying amount ($)

(31 Dec. 20X5) non-current assets 50,000 (4,872) 45,128

(31 Dec. 20X6) non-current assets 50,000 (9,744) 40,256

(31 Dec. 20X7) non-current assets 50,000 (14,616) 35,384

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ACCOUNTING FOR NON-CURRENT ASSETS

The example above shows the depreciation account in respect of the single asset used

in the example; however, each asset would not normally have a separate ledger account.

While it is necessary to calculate the depreciation of each asset separately, it is usual for the

ledger accounts to summarise the depreciation charge and the accumulated depreciation

in respect of different categories of assets such as buildings, motor vehicles, and plant and

equipment.

6.4.2 The reducing-balance method

Some assets give a greater service – and therefore depreciate more – in their early years

than they do in later years. For this reason, it is considered sensible to charge a higher

amount of depreciation in the earlier years. This method of depreciation is known as the

reducing-balance method. With this method a constant percentage is applied to the cost

not yet treated as an expense at the end of the previous accounting period. This results in

the depreciation charged as an expense being greater in the earlier years of an asset’s life

than in the later years.

This can be illustrated using the data from the previous example. In this case the annual

depreciation rate works out as 30.7 per cent. For the purposes of illustration this will be

rounded up to 31 per cent.

Original cost 50,000

Year 1 depreciation 15,500 (31% of 50,000)

34,500

Year 2 depreciation 10,695 (31% of 34,500)

23,805

Year 3 depreciation 7,380 (31% of 23,805)

16,425

At the end of the asset’s useful life the remaining amount should equal its estimated resid-

ual value of $1,280 subject to any difference caused by rounding the percentage to be used

for the amounts of annual depreciation.

The double-entry bookkeeping will be the same in principle as that illustrated earlier for

the straight-line method. Clearly, though, the amount charged as an expense and the cor-

responding reduction in the value of the asset will be different depending on the method

of depreciation used, until the end of the asset’s useful life.

Exercise 6.4

A machine is purchased on 1 May 2000 for $1,000 cash. The ﬁ nancial year ends on 30

April each year.

Show the account or accounts in the ledger for the ﬁ rst 3 years assuming that the machine

is depreciated by 20 per cent per annum on the reducing-balance method.

Income statement and statement of ﬁ nancial position entries are not required.

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FUNDAMENTALS OF FINANCIAL ACCOUNTING

ACCOUNTING FOR NON-CURRENT ASSETS

Solution

Machine at cost

2000 $

1 May Cash 1,000

Accumulated depreciation for machinery

2001 $ 2001 $

30 Apr. Balance c/f 200 30 Apr. Income statement 200

1 May Balance b/f 200

2002 2002

30 Apr. Balance c/f 360 30 Apr. Income statement 160

360 360

1 May Balance b/f 360

2003 2003

30 Apr. Balance c/f 488 30 Apr. Income statement 128

488 488

6.4.3 The machine-hour method/units of

production method

Some non-current assets depreciate according to their usage. If the asset has a measurable

‘ life ’ in terms of the number of hours it is likely to be used, or the number of units of out-

put it is likely to produce, it can be depreciated according to that rate.

For example, a computer printer might have an expected total output of 50,000 sheets.

If it produces 10,000 sheets in a year, it can be said to have used up one-ﬁ fth of its cost in

that year.

6.4.4 The revaluation method

This method of calculating depreciation differs from the straight-line and reducing-

balance methods explained above by not being a calculation based on the original cost of

an individual asset. Instead, the method relies on an estimated cost being made in respect

of a group of similar small-value assets when preparing the ﬁ nancial statements. The

following example illustrates the principles involved.