Accruals Accounting: Tangible Non-Current Assets and Depreciation

Chapter 3: Tangible Non-Current Assets and Depreciation

This chapter covers the distinction between capital and revenue expenditure, the presentation of non-current assets in the balance sheet, the concept of depreciation, methods for calculating depreciation, recording depreciation in the general ledger, and presenting depreciation in financial statements. Depreciation is presented as an extension of the accruals concept.

3.1 Non-Current Assets

Non-current assets are assets purchased for long-term use. Examples include tangible assets like land, buildings, computer equipment, and motor vehicles, and intangible assets like patents and copyrights. Expenditure on non-current assets is called capital expenditure, including the initial cost and any additional expenditure (additions), such as building an extension.

Accounting Concepts

• Historical Cost Concept: Assets should be valued at their acquisition cost.

• Going Concern Concept: Assumes the business will continue operating in the foreseeable future, allowing assets to be valued at historical cost less depreciation, even if this is more than the scrap/disposal value.

Under the going concern concept, assets are valued at historical cost unless the business is known to be closing down (e.g., in June), in which case assets are valued at their disposal price.

3.1.1 The distinction between capital and revenue

• Revenue Expenditure: Expenditure on inputs consumed in the day-to-day running of the business that does not increase the value of a non-current asset (e.g., motor vehicle repair).

• Capital Expenditure: Expenditure on non-current assets or improving the earning capacity of non-current assets (e.g., purchasing equipment).

The classification of an asset as current or non-current depends on the nature of the business. For instance, a car dealership holds motor vehicles as inventory (current assets), while a car rental business holds them as non-current assets.

Misclassifying expenditure impacts profit and balance sheet values.

Activity 3.1: Revenue or capital

Chadwick Joinery:

• Purchasing a computer (Capital)

• Purchasing a docking station for the computer (Capital)

• Purchasing a stapler for £5 (Revenue)

• Buying factory machinery (Capital)

• Electricity cost of running the machinery (Revenue)

• Spending £5,000 on improving the machinery (Capital)

• Spending £700 on repairing machinery (Revenue)

• Buying a van (Capital)

• Expenditure on signwriting on the van giving the name of the firm with its logo (Capital)

• Road tax for the van (Revenue)

• Petrol for the van (Revenue)

• Painting a new building (Capital)

• Painting an existing building (Revenue)

3.1.2 Materiality

Materiality refers to information that, if omitted or misstated, could influence financial statement users' decisions. Businesses must determine what is considered material to avoid wasting time on insignificant items.

Example: Staples are immaterial, but a large supply of staples may be material. An inexpensive stapler would be a revenue expense, while a large industrial stapler would be capitalized as a non-current asset.

Materiality is subjective and varies by business size. Smaller businesses might capitalize items costing £100 or more, while larger businesses might use £500 or £1,000 as the threshold.

3.2 Depreciation

Depreciation is the annual measure of the cost consumed of a non-current asset, charged as an expense in the income statement. It allocates the original cost less residual value to the income statement over the periods that benefit from the asset's use.

To calculate depreciation, the accountant needs to know:

• Purchase cost

• Estimated useful life

• Estimated residual value

3.2.1 Cost

Cost includes the purchase price, import duties (excluding VAT if the business is VAT registered), and costs directly attributable to bringing the asset into working condition. This includes:

• Initial delivery and handling costs

• Site preparation costs

• Installation and assembly costs

• Professional fees (engineers, architects, and legal fees)

• Costs of testing the asset

• Staff costs directly related to constructing or acquiring the asset (excluding training costs).

Also includes any subsequent expenditure that increases the future economic benefits generated by the non-current asset.

3.2.2 The estimated useful life

Non-current assets have both a physical and economic life. The physical life is affected by time and wear, while the economic life is influenced by technological improvements and changes in demand. The economic life may be shorter than the physical life.

The accountant must estimate the useful life of a non-current asset based on past patterns, information from other businesses, expected wear and tear, and obsolescence due to technological advances or new products.

3.2.3 The residual value

The residual value is the estimated amount an asset could be sold for at the end of its useful life, less any disposal costs. Determining residual value is a matter of judgement.

Depreciation is deducted from the depreciable amount over the asset's life. The depreciable amount is calculated as the asset's cost less its residual value.

Example: A van costing £40,000 is expected to be sold for £2,500 after five years. The depreciable amount is £37,500 (£40,000 - £2,500).

Intangible assets are amortized rather than depreciated.

3.3.1 Straight line method of depreciation

The straight line method allocates the same amount of depreciation to each year. It is calculated by dividing the depreciable amount by the expected useful life.

Example: A van with a depreciable amount of £37,500 and a useful life of five years will have a depreciation expense of £7,500 per year (£37,500 / 5).

Activity 3.2 Calculating depreciation using the straight line method

A business buys a pickup truck for £57,000. It is considered to have a residual value of £5,000 at the end of its useful life in the business. The pickup truck is to be depreciated over 5 years using the straight-line method of depreciation.

• Depreciable amount = $57,000 - 5,000 = 52,000$

• Depreciation per year = $52,000 / 5 = 10,400$

The straight line method assumes the asset is consumed evenly over time, which may not be appropriate for all assets, especially those affected by technology or used more in early years.

3.3.2 Reducing balance method of depreciation

The reducing balance method applies a fixed percentage depreciation charge to the cost of the asset after deducting previous depreciation. It does not deduct the residual value from the cost.

Example: A van costing £40,000 is depreciated at 42.56% per year using the reducing balance method.

The depreciation rate calculation formula is: $\sqrt[n]{\frac{s}{c}}$
where:
n = number of years
s = the net realisable value
c = cost of the asset.

The net book value (NBV) can be calculated using the formula: $NBV = Cost × (1 − r)^n$
where r = the depreciation rate as a decimal and n = the number of years. For the example above, the NBV for the example van at the end of year 2 is: $£40,000 × (1 − 0.4256)^2= £40,000 × (0.5744)^2 = £40,000 × (0.3299353) = £13,197$

Activity 3.3 Calculating reducing balance depreciation

A business buys a truck for £57,000. It is considered to have a residual value of approximately £18,700 at the end of its useful life in the business. The truck is to be depreciated over 5 years using the reducing balance method of depreciation. Assume a depreciation rate per year is set at 20%.

The reducing balance method results in a smaller depreciation charge as the asset ages, which is suitable for assets used up quickly in early years. It is commonly used for motor vehicles because repair costs increase as the asset ages, balancing the overall cost.

3.3.3 Comparing the two methods

The straight line method is best if the asset provides equal benefit over its life, while the reducing balance method is better if the benefit is greater in earlier years. The appropriate method may vary by asset class and business. The chosen method should be consistent and reflect how the asset's economic benefits are consumed. Once a method has been chosen and used it should not be changed. This is because of the application of another accounting concept known as consistency.

Depreciation methods chosen for accounting purposes may differ from those allowed for tax purposes. Governments may substitute a figure based upon its own rules.

3.4 Recording depreciation

Depreciation is recorded using double entry, involving the asset account, bank account, depreciation account, and accumulated depreciation account.

• Depreciation account: An expense account appearing in the income statement.

• Accumulated depreciation account: Deducted from the asset's cost in the balance sheet.

3.4.1 Accounting for non-current assets and depreciation in the general ledger

Example: Purchasing a van for £40,000:

Motor vehicles (asset)

Bank (asset)

At the end of year 1, using the straight line method of depreciation, the entries in the general ledger before closing them off would be:

Depreciation (expense)

Accumulated depreciation (balance sheet)

To close the accounts off the entries would be:

Depreciation (expense)

Accumulated depreciation (balance sheet)

Activity 3.4 Recording depreciation in the general ledger

Record the depreciation of Mr Smith's van in the general ledger at the end of its second year of use, using the straight line method of depreciation.

Depreciation (expense)

Accumulated depreciation (balance sheet)

3.4.2 Presenting depreciation in the financial statements

Depreciation is recorded in the income statement as an expense. Accumulated depreciation is deducted from the asset's cost to arrive at the net book value (NBV) in the balance sheet.

The double entry is:

• Dr: Depreciation expense in the income statement

• Cr: Accumulated depreciation in the balance sheet

Accounting entries Mr Smith's van in Section 3.3.1 using the straight line method of depreciation.

Income statement

Balance sheet

Activity 3.5 Completing the depreciation table

Using the reducing balance method of depreciation shown above complete the table below for the business of Mr Smith.

In the individual balance sheet of a business the balance sheet presentation is usually in the following format.

ABC sole trader Extract from the balance sheet as at 31 December 20X5

Activity 3.6 Depreciation – income statement and balance sheet entries

Using the format of the tables in Activity 3.5, show extracts from the balance sheet and income statement for Mr Smith's van at the end of year 5 if the business uses the:

• a. the straight line method of depreciation

• b. the reducing balance method of depreciation.

a. Straight line
Income statement

b. Reducing balance
Income statement

3.4.3 Additions to non-current assets

A full year's depreciation is usually charged on a non-current asset purchased at the beginning of the financial year. If purchased partway through the year, depreciation is charged from the date of acquisition. Some businesses adopt an accounting policy of charging a full year's depreciation in the year the non-current asset was purchased, and none in the year of sale.