DESARROLLO DE LAS COMPETENCIAS

L

O

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

STUDY MATERIAL C2 144

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.

145 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.

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.

STUDY MATERIAL C2 146

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 ‘ valunoth-ing ’ the asset, in the sense of estimatnoth-ing 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.