Answers to self-test questions
3.4 Non-current (fixed) assets
3.4.1 Tangible and intangible non-current assets
We have already seen that non-current assets are those assets which are going to be kept and used in the business for several years. If you look at Example plc’s balance sheet you will see that the first two types of non-current asset shown are intangible non-current assets and tangible non-current assets. Tangible non-current assets are those which have a physical identity, for example office equipment and delivery vehicles. Intangible non-current assets are those which do not have a physical identity, but which have some value to the business, for example patents and trademarks.
Another intangible non-current asset that you might come across is goodwill. We will return to discuss goodwill later in the chapter.
49
Accounting in a Nutshell
3.4.2 Depreciation
You should recall that the income statement for the year shows the fair cost of running the business for the year. Think about what happens when a non-current asset, for example a delivery van costing £22,000, is purchased.
The £22,000 is paid out to the supplier, but it would not really be fair to charge the whole of that £22,000 in the income statement for the year. Otherwise the profit for that year would be relatively low and then in later years the business would be using the vehicle without suffering any charge in the income statement for the year.
Profits would be distorted, and managers and others who are using the accounts would not find it easy to monitor the business’s performance.
This problem is resolved by sharing out the original cost of the asset over the years that will benefit from its use. Suppose in our example of the delivery van we assumed that it would last the business for four years, after which time it would be sold for
£2,000. This means that over the years we are using it we will have used up £20,000 of the van’s value (£22,000 cost less £2,000 final sales value). A fair share of the loss of value for each year could therefore be £5,000.
This £5,000 is known as the depreciation charge for the year.
This method of calculating depreciation is called straight-line depreciation. Other methods commonly used charge greater amounts in the earlier years and less in the later years of the asset’s life.
The depreciation charge is applied as follows:
Year 1 In the first year of the van’s life, £5,000 depreciation will be charged to the income statement, as the fair cost of using the van for the year. The remaining £17,000 (£22,000 less
£5,000) will be shown in the balance sheet at the end of Year 1 under tangible non-current assets. This £17,000 is known as the net book value of the non-current asset.
Year 2 In the second year, another £5,000 depreciation will be charged in the income statement for Year 2. The remaining
£22,000£2,000
4 years £5,000 per year
Accounting in a Nutshell
50
£12,000 will be shown in the balance sheet at the end of Year 2 under tangible non-current assets.
The value of the delivery van used up by the business will thus be shared out over the years that receive the benefit.
Net book value shown in Charge to income statement balance sheet at end of year
£ £
Year 1 5,000 17,000
Year 2 5,000 12,000
Year 3 5,000 7,000
Year 4 5,000 2,000
20,000
Notice that the final value shown in the balance sheet at the end of the van’s useful life is £2,000, that is the amount we expect to sell it for.
Exercise
A landscape gardening company has purchased a new fleet of lawnmowers for £5,000. They expect to use the lawnmowers for three years, after which time they will be sold for a total of £500.
Using straight-line depreciation (equal depreciation charges for each year) produce a table which shows, for each of the three years, the depreciation charge in the income statement and the net book value of the lawnmowers to be shown in the balance sheet.
Solution
Depreciation charge to Net book value shown in income statement balance sheet at end of year
£ £
Year 1 1,500 3,500
Year 2 1,500 2,000
Year 3 1,500 500
4,500
Annual depreciation charge £5,000£500
3 £1,500 per annum
51
Accounting in a Nutshell
3.4.3 Cost sharing, not valuation
It is important for you to appreciate that the aim of the depreciation charge is simply to share out the cost of the asset over the years that it is used. In the example of the delivery van, the £17,000 shown in the balance sheet for Year 1 is simply the amount of the delivery van’s cost left in the accounts which has not yet been shared out or charged to the income statement. It is not a valuation of the asset, therefore the term ‘net book value’ can be rather misleading.
We could just as easily, and quite defensibly, have stated that the van would last for five years instead of four. The annual depreciation charge would then be £4,000 [(£22,000£2,000)/5]
and the net book value at the end of Year 1 would be £18,000 (£22,000 less £4,000 depreciation). The same asset, in the same business, is apparently ‘worth’ £1,000 more and the profit for the year is £1,000 more.
In this example the figures involved are relatively small, but imagine what a difference a change in depreciation policy could make in companies with a very large investment in non-current assets, for example aircraft and expensive manufacturing machinery. For this reason companies are required to state their depreciation policy in their published accounts.
To give you an idea of what this statement might say, here is the statement of depreciation policy from the 2004 Annual Report of, Nichols plc, the specialist in soft drinks and beverage systems.
The statement is included in the section headed ‘Accounting policies’.
Fixed assets are stated at cost and are depreciated over their estimated useful lives, having regard to their residual values. The principal depreciation periods, using the straight line method, are:
Freehold and long leasehold 50 years
Plant and machinery 4–10 years
The statement uses the term ‘residual values’ to refer to the forecast value of the asset at the end of its estimated useful life. This is the amount for which it is expected the asset will be sold after four years or after ten years, or after whatever period the company expects to keep the asset for its own use.
Accounting in a Nutshell
52
3.4.4 Amortisation
‘Amortisation’ is similar to depreciation but the term is usually used to describe the ‘depreciation’ of intangible non-current assets.
For example, J Sainsbury plc, a leading UK food retailer, includes in its accounting policy statement for 2005 the following in the section headed ‘Intangible fixed assets’.
Pharmacy licenses are included in intangible assets and amortised on a straight line basis over their useful economic life of 15 years.
You can see that the effect of the amortisation charge is the same as that of a depreciation charge. The cost of acquiring a pharmacy license is spread over the income statements of the years that benefit from the acquisition of the licence. At the end of each year the balance sheet will show the amount of the original cost that has not yet been ‘shared out’ to any of the income statements, that is the licences are stated in the balance sheet at their original cost less the amortisation to date.
3.4.5 Revaluing fixed (non-current) assets
Some non-current assets may increase in value; for example, property values tend to increase over time. In this situation the company can revalue the property, based on the advice of a suitably qualified professional. Depreciation of the property must then be based on the new, higher revalued figure in the balance sheet, using the same principles that you learned about earlier.
For this reason you might see the statement ‘tangible fixed assets are shown at cost or valuation, less accumulated depreciation’.
You might think that it is strange to depreciate properties, but they do not last forever! Most types of property are depreciated over a long time period of, say, 50 years.
The statement of Nichols plc’s depreciation policy in Section 3.4.3 indicates that the company depreciates its properties over 50 years.
Of course a revaluation will not always reveal a significant increase in value. If a company chooses to revalue its non-current assets it must do so on a regular basis. The frequency of the valuation depends on the volatility of the values of the particular assets.
When an item of property, plant and equipment is revalued, the
53
Accounting in a Nutshell
whole of the class of assets to which it belongs must be revalued at the same time. These rules prevent a company from picking out for revaluation only those assets whose updated values might present more favourable results in the financial statements.
The following statement from the 2004 annual report of Thorntons plc, the manufacturer and retailer of confectionery, demonstrates the sort of information that a company might provide concerning its revaluation policy.
Valuations of freehold properties, from which the Group trades, are undertaken annually by a chartered surveyor who is an employee of Thorntons plc. Every third year, the valuations are provided by an external firm of chartered surveyors. These valuations are compared with those already recognised in the financial statements and if not significantly different, then no changes to the carrying values are made.
The term ‘carrying value’ used in this statement means the net amount at which the asset is currently included in the balance sheet. Notice that Thorntons arranges an independent check on the valuations every third year.
3.4.6 Investments
A company may decide to buy shares in another company and hold them on a long-term basis. These shares would be shown under fixed (non-current) assets as investments. If you look at Example plc’s balance sheet you will see that they are holding
£35,000 of non-current asset investments. There are many reasons why one company might decide to buy shares in another, including the following:
◆ To gain some control over the supply of an important material or component.
◆ To spread or reduce their business risk. To give a simplified example of this, a manufacturer of sun hats might purchase shares in a company which manufactures raincoats. Then, come rain or shine, the company should be able to earn a profit!
◆ To engage in a joint venture which is beneficial to both companies.
Accounting in a Nutshell
54
Sometimes you might see investments listed under current assets.
These are shares which the company has bought as a short-term investment and they are usually held for less than one year.