10.0 Learning Objectives………………………………………………………………
10.1 Introduction………………………………………………………………………
10.2 The Determination of the Cost of Non-Current Assets………………………….
10.2.1 Land……………………………………………………………………………
10.2.2 Cost of Building………………………………………………………………
10.2.3 Cost of Equipment……………………………………………………………
10.3 Capital Expenditure Versus Revenue Expenditure……………………………
10.3.1 Differences Between Capital and Revenue Expenditure……………………
10.4 Depreciation……………………………………………………………………
10.4.1 Causes of Depreciation………………………………………………………
10.5 Methods of Calculating Depreciation…………………………………………
10.5.1 Straight Line Method…………………………………………………………
10.5.2 Reducing Balance Method……………………………………………………
10.6 Double Entry Records for Depreciation…………………………………………
10.7 Disposition of Non-Current Assets………………………………………………
10.8 Summary…………………………………………………………………………
CHAPTER TEN
ACCOUNTING FOR NON-CURRENT ASSETS
10.0 Learning objectives
After you have studied this chapter, you should be able to:
• State the types and characteristics of non-current assets
• Differentiate between capital and revenue expenditure
• Define depreciation and explain why accountants provide for depreciation in final accounts
• Calculate depreciation using the straight line and the reducing balance methods
• Calculate any profit or loss made on the sale of non-current assets
• Explain the significance of maintaining non-current assets register
10.1 Introduction
In this chapter we are going to learn how non-current assets are recorded and valued in the books of accounts of a business organisation. We are also going to learn why depreciation should be provided for and also calculate depreciation using the two most popular methods. Finally we shall learn how to compute any profit or loss that may arise from the sale of non-current assets.
The Ghana National Accounting Standards (GNAS 9) defines Property, Plant and Equipment as tangible assets that:
(a) are held by an enterprise for use in the production or supply of goods or services for rental to others or for administrative purposes and (b) are expected to be used during more than one accounting period.
The statement of Accounting Standard (SAS) No. 3 issued by the Nigerian Accounting Standard Board (NASB) defines Property, Plant and Equipment as tangible assets that:
(c) have been acquired or constructed and held for use in the production or supply of goods and services and may include those held for maintenance or repair of such assets and;
(d) are not intended for sale in the ordinary course of business.
From the above definition you must understand that an asset is classified as a non-current asset by its function rather than by its type. Generally speaking a non-current asset is held for use in the production and supply of goods and services. The asset should have been bought for use on a continuing basis rather than for sale in the ordinary course of business. Any asset, which does not satisfy these general criteria, would be classified as a current asset. Therefore it is not possible to state whether an asset is current or non-current until we know its function. The classification of an asset as fixed or current has to be done with care; this is because an asset may indeed change with changing circumstances. For instance, a company that manufactures and sells cars would normally expect to see such cars classified as current assets. If, however, the company were to use one of their manufactured cars within their own business, then the classification would change from “current” to “non-current”
Examples of non-current assets include land, building structures (offices, factories, warehouses), and equipment (machinery, furniture, tools).
10.2 The determination of the cost of non-current assets
Almost every business enterprise of any size or activity uses assets of a durable nature in its operations. Such assets are not acquired for resale but rather they are used in the business to increase the earning capacity or productivity in the organization.
An item of expenditure, which qualifies for recognition as a non-current asset, should be initially recorded at its historical cost. Historical cost is measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use. The purchase price, freight costs, and installation costs of a productive asset are considered as part of the assets cost. You must remember that any trade discount and rebates are deducted in arriving at the historical cost of the noncurrent asset.
The concept of including all incidental expenses necessary to put the asset in use is illustrated by the following examples:
Illustration 10.1
Slopworks (Ghana) Ltd. Orders a machine from a Nigerian tool manufacturer at an invoice price of ¢100,000,000. Payment will be made in 48 monthly instalment of ¢2,500,000 which include ¢20,000,000 interest charges. Value Added Tax of ¢12, 500,000 must be paid, as well as freight charges of ¢10,250,000. Installation and other start-up costs amount to ¢4,000,000. The cost of this machine to be debited to the machinery Account is ¢126,750,000. It is computed as follows:
¢
Invoice Price * 100,000,000
VAT 12,500,000
Transportation charges 10,250,000
Cost of Installation 4,000,000
Total 126,750,000
• The ¢20,000,000 interest charges on the instalment purchase will be recognised as interest expense over the next 48 months and written-off in the statement of comprehensive income.
10.2.1 Land
When land is purchased, certain incidental costs are generally incurred, in addition to the purchase price. These incidental costs may include commissions to real estate brokers, legal fees for examining and insuring the title and fees for surveying, draining, clearing and grading the property. All these expenditures are part of the cost of the land since they are intended to get the assets ready for use. Any proceeds obtained in the process of getting the land ready for its intended use, such as the sale of cleared timber, are treated as reduction in the price of the land.
Special case is made for the treatment of local improvements, such as pavements, streetlights, sewers, drainage system and land-scaping. These are usually charged to the land account because they are relatively permanent in nature. However expenditures on land such as private driveways, fences, and car parks are recorded separately as land improvements. These expenditures should be recorded as land improvements and depreciated over their estimated useful lives because they have limited useful lives.
10.2.2 Cost of building
The cost of building should include all expenditures related directly to their acquisition or construction. These costs include materials, labour, overheads costs incurred during construction, professional fees and building permit. An organisation may engage the services of contractors to have its building constructed. All costs incurred by the contractors from excavation to completion, are considered part of the building costs.
There are occasions where land purchased as a building site has on it an old building which is not suitable for the buyer‟s use. In this case, the only useful “asset” being acquired, is the land. Where this happens, any cost incurred in demolishing the old building should be debited to the land account together with the purchase price of the land. This is because the cost of demolition less its salvage value is a cost of getting the land ready for its intended use.
10.2.3 Cost of equipment
The term “equipment” in accounting includes delivery equipment, office equipment, machinery, furniture and fittings, factory equipment and similar assets. The costs of these assets include the purchase price, freight and handling charges incurred, insurance on the equipment while in transit and costs of conducting trial runs. Costs therefore include all expenditures incurred in acquiring the equipment and preparing it for use.
10.3 Capital expenditure versus Revenue Expenditure
Capital expenditure may be defined as the cost of acquiring a non-current asset for use in an organization. The earning potential or capacity of such assets will certainly last for more than one accounting period. In addition capital expenditure includes such costs that are incurred in adding value to existing non-current assets in order to improve their earning capacity.
Examples of capital expenditure are:
a) Purchase price of non-current assets such as motor vehicles, buildings, furniture and fittings, plant and machinery
b) Extension or any improvement of a permanent nature made to any structure
c) Legal fees of acquiring land or buildings
d) The cost incurred in bringing any non-current asset to its present location
e) Any other cost that must be incurred in getting the non-current assets ready for its intended use.
Revenue expenditure on the other hand is incurring of any cost in which its earning potential is exhausted within one accounting period. Such expenditures are not made to increase or improve the value of non-current assets but rather, are made for the maintenance and day-today running of the business.
Examples of revenue expenditure are:
1) The cost incurred in acquiring trading inventories for sale
2) Cost of repairing any non-current assets
3) Discount allowed on credit sales
4) Expenses in connection with rent, insurance, telephone and electricity.
10.3.1 Differences between capital and revenue expenditure
Differences due to time:
Where the benefit that is derived from an item of expenditure is used up or exhausted within one accounting period, then such expenditure is revenue expenditure. However if the benefit derived from an item of expenditure extends to more than one period of account, it should be referred to as capital expenditure.
Differences due to type of account:
An increase in capital expenditure is recorded or debited to a non-current asset account, which eventually finds its resting place in the statement of financial position.
All revenue expenditures are charged to the Statement of comprehensive income.
You should be careful not to incorrectly classify capital and revenue expenditure. As you can see from the above, the classification of capital and revenue expenditure has a direct impact on the resulting profit figure in the Trading and Statements of Comprehensive Income and also the assets values in the Statement of Financial Position. This is true because if you wrongly classify revenue expenditure as a capital expenditure, the total expenses figure in the income statement will be understated. This will result in overstating the net profit of the business. Should the owner appropriate the profit for his personal use, it might lead to the collapse of the business since the owner is spending his capital instead of the profits or gains from the business.
10.4 Depreciation
Capital expenditure like building, plant, fixtures and fittings do normally last for more than one year. It is obviously possible that these assets may deteriorate with the passage of time due to its usage. There is therefore the need to recognise the loss in the value of non-current assets in the books of accounts. If this is not done, the value of non-current assets in the statement of financial position will be mis-stated.
The process of recognising the loss in the value of non-current assets as a result of using such assets is called depreciation. The Ghana National Accounting Standards
(GNAS 10) defines depreciation as: “the allocation of the depreciable amount of an asset over its estimated useful life.” The Nigerian SAS No. 9 states that depreciation “represents an estimate of the portion of the historical cost or re-valued amount of a non-current asset chargeable to operations during an accounting period”. The standard also recognises the fact that depreciation for the accounting period is charged to income either directly or indirectly. This definition implies that depreciation is effectively an accrual technique, which matches the cost of a non-current asset with the benefits, which are derivable from the asset.
Non-current Assets produce revenue through use rather than through resale. They can be viewed as quantities of economic service potential to be consumed over time in the earning of revenues. Depreciation recognition transfers a portion of acquisition cost and capitalised post-acquisition cost of non-current to an expense account called depreciation expense. The corresponding credit is the provision for depreciation, a contra non-current assets account that reduces gross assets to net book value. This expense is recorded as an adjusting entry at the end of each accounting period. Depreciation expense could be classified as a selling or administrative expense, depending on the assets function. Manufacturing firms include depreciation of plant and machinery or factory building in the cost of goods produced. When the goods are sold, depreciation becomes part of cost of goods sold.
Certain types of non-current assets have unlimited useful economic lives, and so do not require depreciation. This is usually true of land unless the land is an agricultural land or land acquired for extractive purposes. By contrast, buildings will normally have limited useful economic life, and therefore, will normally be subjected to depreciation.
You must note that the Provision for Depreciation account does not represent cash set aside for replacement of non-current assets; nor does its recognition imply the creation of reserves for asset replacement.
10.4.1 Causes of depreciation
There are several factors that contribute to depreciation of non-current assets. These factors or causes can be classified as follows:
1) Physical deterioration
This is where the fall in value of a non-current asset is due to wear and tear as a result of its constant use. Natural occurrences such as erosion, rust and decay will certainly reduce the value of any non-current asset.
2) Economic factors
This is where an asset is put out of use even though it is in good working condition. This occurs where an asset becomes out of date as a result of new inventions or technological advancement. For example bakers use claymolded oven in baking bread. The invention of gas-molded oven will certainly render the former out of date. This factor of depreciation is known as obsolescence.
Another situation closely linked with economic factors is where a noncurrent asset is rendered useless as a result of the growth and changes in the size of business. A fisherman who uses canoe may have to acquire a large fishing boat when the demand for fish increases beyond the capacity that the canoe can cope with. In this situation you can clearly deduce that it would be more efficient and economical to operate a large fishing boat than the canoe, and as a result the canoe will be put out of use, though it is in good working condition. This factor of depreciation is known as inadequacy.
3) Depletion
Natural resources such as mines, quarries, oil, coal and gas deposits become worthless when the deposits or resources are depleted. These assets are called wasting assets. The process of providing for the consumption of such assets is called depletion.
4) Time factor
There are certain assets that have specific period of legitimate life span. Assets such as patent, copyrights, finance leases have a legal life fixed in terms of years. As and when the years elapse, the value of these assets reduces. The cost of these assets must be spread over their legal lives. The term used in recognising the fall in value of these assets is termed amortisation.
10.5 Methods of calculating depreciation
Depreciation is an attempt to allocate the cost of a non-current asset to each accounting period that the asset is used to generate income or earnings. Depreciation may be calculated simply by deducting the amount receivable when the asset is either sold or put out of use by the business from the cost of the non-current asset. The amount that will be received when the asset is sold or put out of use is technically termed the salvage value or the residual value of an asset. The cost less the salvage value is called depreciable value or amount. It is this depreciable value that the accountant seeks to spread over the useful life of a non-current asset.
There are several methods of calculating depreciation. These include:
1) Straight Line Method
2) Reducing Balance Method
3) Sum-of- the-Years‟-Digits Method
4) Units-of-Output Method
5) Revaluation Method
6) Machine Hour Method
7) Depletion of Unit Method
The purpose of this manual is to explain into details only two of the methods mentioned above. The straight Line or fixed instalment method and the reducing balance or diminishing balance method will be discussed; the remaining methods will be treated in the next stage of the course.
In order to calculate the depreciation charge for a period, we need to know four factors:
• The cost of (or revalued amount) of the non-current asset.
• The estimated residual value of the non-current asset.
• The estimated useful economic life of the non-current asset.
• The method of depreciation that is appropriate for the business.
All the factors mentioned above involve a certain amount of subjectivity. As a result of the subjective nature of the depreciation computation, GNAS 10 requires that the estimates that are used in the depreciation calculation should be kept under constant review and, where appropriate, revised. Where the estimate is revised during the period of depreciation, then the existing net book value should be written down over the remaining estimated useful economic life of the asset in question. The depreciation method should be reviewed periodically. When a change in depreciation method materially changes the annual depreciation charge, then the effect of the change should be accounted for as a change in accounting policy which will necessitate the restatement of the beginning balance of the income surplus account. It must be noted that the revision of the useful life of a non-current asset does not constitute a change in accounting policy but rather a change in accounting estimate. This type of change will not have retroactive effect on the income statement.
10.5.1 Straight Line Method
The straight line method is the most widely used method of computing depreciation charge for financial statement purposes. Under this method, an equal amount of depreciation is recorded for each accounting period over the useful life of the noncurrent asset. The depreciation amount is computed by dividing the original cost of the non-current asset less estimated salvage value by the useful life of the asset. A mathematical formula can be deduced as follows:
Annual Depreciation = Original cost of Asset – Salvage Value
Useful Life of Asset
Illustration 10.2
On January 1, 2000 Hyde Limited purchased a motor vehicle for ¢250,000,000. The motor vehicle has an estimated useful life of five years with a salvage value of ¢5,000,000.
You are required to calculate the depreciation charge and accumulated depreciation for each of the years and show the net book value as at the end of 2004 accounting period using the straight-line method.
Solution to Illustration 10.2
Annual Depreciation = ¢250,000,000 – ¢5,000,000
5
= ¢49,000,000
Beginning Depreciation Accumulated Closing
Year Book value for the year Depreciation Book value
¢ ¢ ¢ ¢
2000 250,000,000 49,000,000 49,000,000 201,000,000
2001 201,000,000 49,000,000 98,000,000 152,000,000
2002 152,000,000 49,000,000 147,000,000 103,000,000
2003 103,000,000 49,000,000 196,000,000 54,000,000
2004 54,000,000 49,000,000 245,000,000 5,000,000
10.5.2 Reducing Balance Method
Under this method of depreciation, the book value of a non-current asset at the beginning of the year is multiplied by a fixed percentage to determine the depreciation for the accounting year. This procedure is repeated in subsequent accounting periods so as to reduce the depreciable value of the non-current asset to zero (i.e. reduce its cost to its residual value).
Illustration 10.3
On January 1, 2000 John Kay Limited purchased plant for ¢250,000,000. It is the policy of John Kay to depreciate Plant at 20%. You are required to calculate the net book value as at the end of 2004 accounting period using the reducing balance method.
Solution to Illustration 10.3
Beginning Depreciation Depreciation Accumulated Closing
Year Book value Rate for the year Depreciation Book value
¢ ¢ ¢ ¢
2000 250,000,000 20% 50,000,000 50,000,000 200,000,000
2001 200,000,000 20% 40,000,000 90,000,000 160,000,000
2002 160,000,000 20% 32,000,000 122,000,000 128,000,000
2003 128,000,000 20% 25,600,000 147,600,000 102,400,000
2004 102,400,000 20% 20,480,000 168,080,000 81,920,000
When a non-current asset is purchased during the year, depreciation is calculated to the nearest month. In some organisations, a full year’s depreciation charge is provided on noncurrent assets acquired during the year irrespective of the period in which they were purchased. Where this is the case any asset sold in the year will also not attract depreciation in the year of sale irrespective of the time of sale within the accounting period.
10.6 Double Entry Records For Depreciation
After calculating the depreciation charge for the accounting year, you must record the amount in the books of account. It is important for you to remember that the process of providing for depreciation is recording for the use of non-current assets during the accounting period. This therefore means that depreciation is revenue expenditure and as such must be recorded in the same manner that accountants record normal business expenses.
There are two main ways of recording depreciation in the books of account of a business organisation. The old method and the modern method of recording depreciation. In the case of the former, depreciation charges are recorded in the noncurrent asset account. It is important to note that this method is no longer used in practice. The double entry of depreciation is as follows under the old method:
Dr. Depreciation Expense Account
Cr. The non-current asset Account in question
Dr. Income statement
Cr. Depreciation Expense Account
Illustration 10.4
On January 1,2000 Brown Kay Limited purchased Equipment for ¢450,000. It is the policy of John Kay to depreciate Plant at 20%. You are required to show the Equipment account in the books of Brown Kay Limited as at the end of 2004 accounting period using the reducing balance method.
Solution to Illustration 10.4
Equipment account
¢ ¢
01/01/2000 Bank 450,000 31/12/2000 Depreciation expense 90,000
31/12/2000 Balance c/f 360,000
450,000 450.000
01/01/2001 Balance b/d 360,000 31/12/2001 Depreciation expense 72,000
31/12/2001 Balance c/f 288,000
360,000 360,000
01/01/2002 Balance b/d 288,000 31/12/2002 Depreciation expense 57,600
31/12/2002 Balance c/f 230,400
288,000 288,000
01/01/2003 Balance b/d 230,400 31/12/2003 Depreciation expense 46,080
31/12/2003 Balance c/f 184,320
230,400 230,400
01/01/2004 Balance b/d 184,320 31/12/2004 Depreciation expense 36,864
31/12/2004 Balance c/f 147,456
184,320 184,320
Balance b/d 147,456
Depreciation Expense Account
¢ ¢
31/12/2000 Equipment account 90,000 31/12/2000 Profit and loss 90,000
31/12/2001 Equipment account 72,000 31/12/2001 Profit and loss 72,000
31/12/2002 Equipment account 57,600 31/12/2002 Profit and loss 57,600
31/12/2003 Equipment account 46,080 31/12/2003 Profit and loss 46,080
31/12/2004 Equipment account 36,864 31/12/2003 Profit and loss 36,864
The modern practice of recording depreciation treats depreciation as a contra to the noncurrent asset account. The non-current asset account is maintained at its original cost. A ledger account called “Accumulated Provision for Depreciation account” is opened and all depreciation calculations are credited to that account, the corresponding entry being passed into the Depreciation charge Account as a debit. The double entry is as follows:
Dr. Depreciation charge Account
Cr. Accumulated Provision for Depreciation Account
Illustration 10.5
On January 1, 2000 Amoroso Limited purchased Equipment for ¢800,000. It is the policy of the Company to depreciate all equipment at 20% per annum. You are required to show the Equipment account in the books of Amoroso Limited as at the end of 2004 accounting period using the reducing balance method.
Solution to Illustration 10.5
31/12/2000 Balance c/f 160,000 31/12/2000 Deprecitioin expense 160,000
31/12/2001 Balance c/f 288,000 01/01/2001 Balance b/d 160,000
31/12/2001 Deprecitioin expense 128,000
288,000 288,000
31/12/2002 Balance c/f 390,400 01/01/2002 Balance b/d 288,000
31/12/2002 Deprecitioin expense 102,400
390,400 390,400
31/12/2003 Balance c/f 472,320 01/01/2003 Balance b/d 390,400
31/12/2003 Deprecitioin expense 81,920
472,320 472,320
31/12/2004 Balance c/f 537,856 01/01/2004 Balance b/d 472,320
31/12/2004 Deprecitioin expense 65,536
537,856 537,856
01/01/2005 Balance b/d 537,856
Depreciation Expense A ccount
¢ ¢
31/12/2000 Equipment account 160,000 31/12/2000 Profit and loss 160,000
31/12/2001 Equipment account 128,000 31/12/2001 Profit and loss 128,000
31/12/2002 Equipment account 102,400 31/12/2002 Profit and loss 102,400 31/12/2003 Equipment account 81,920 31/12/2003 Profit and loss 81,920
31/12/2004 Equipment account 65,536 31/12/2004 Profit and loss 65,536
The balance on the equipment account will be shown on the statement of financial position at the end of the accounting year less the balance on the Accumulated Provision for Depreciation Account as follows:
10.7 Disposition of non-current assets
An organisation can dispose of its non-current assets by either selling it for cash, exchanging it for a similar asset or a different one, or merely by discarding the asset. In all these three situations you must remember to take out the disposed asset from the main non-current asset account. This is done by opening an account for the purpose of the disposal. Into this account is entered the cost of the non-current asset and its associated accumulated depreciation provision. A profit or loss may arise from the disposal of the non-current asset depending on the outcome of the non-current asset disposal account.
On the disposal of non-current asset, the following entries must be passed:
1) Transfer the cost of the non-current asset sold to a named non-current asset disposal account as follows:
Dr. Non-current asset disposal Account
Cr. Non-current asset Account
2) Transfer the accumulated depreciation on the asset sold to the non-current asset disposal account as follows:
Dr. Accumulated provision for depreciation Account
Cr. Non-current asset disposal Account
3) The amount realized from the sale of the non-current asset must be recorded as follows:
Dr. Cash, Bank or Sundry receivables Account
Cr. Non-current asset disposal Account
Where the balance on the non-current asset disposal account is credit, it means that the amount received from the sale is more than the net book value of the non-current asset, hence a profit is the resulting figure.
Dr. Non-current asset disposal Account
Cr. Income statement
Where the balance on the non-current asset disposal account is debited, it means that the amount received from the sale is less than the net book value of the non-current asset sold, hence, the loss must be recorded.
Dr. Income statement
Cr. Non-current asset disposal Account
The entries above can be illustrated by assuming that the equipment purchased by Amoroso in Illustration 10.5 was sold for cash amounting to ¢295,000 at 2nd January 2005. The cost of the equipment as at January, 2 2005 was ¢800,000, its associated accumulated depreciation amounted to ¢537,856 leaving a net book value of ¢262,144 (¢800,000-¢537,856). Since the equipment was sold for ¢295,000 it means that a profit amounting to ¢32,856 will be calculated as follows:
If one again assumes that the equipment purchased by Amoroso in Illustration 10.5 was sold for cash amounting to ¢200,000 on January2 2005. The balance on the equipment account as at January, 2 2005 will show cost of ¢800,000, with its associated accumulated depreciation recording ¢537,856 leaving a net book value of ¢262,144 (¢800,000-¢537,856). Since the equipment was sold for ¢200,000 it means that a loss amounting to ¢62,144 will be calculated as follows:
Calculation of loss on sale of equipment ¢
cost of equipment 800,000
Less Accumulated depreciation 537,856
Net book value 262,144
Proceeds from sale of equipment 200,000
Less Net book value 262,144
Loss on disposalof equipment (62,144)
The transaction involving the sale of assets at a profit as per Illustration .5 will be recorded as:
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