CHAPTER 10: NON-CURRENT ASSETS AND DEPRECIATION

LEARNING OBJECTIVES
 Identify the accounting principles behind accounting for NCAs and
depreciation;

 Specify what is included in the cost of a NCA;

 Use the straight line and reducing balance methods to calculate depreciation;

 Calculate profits and losses on disposal of NCA, including part-exchange

disposals;

 Specify the effects of changing residual values, useful lives and depreciation
methods on amounts in the SOPL and SOFP;

 Identify the situations that may result in the impairment of assets and calculate
an impairment loss;

 Identify how to account for NCAs, depreciation and disposals in the ledger
accounts;

 Calculate the figure in the SOFP for tangible NCAs and the figures that appear
in the PPE note;

 Calculate the depreciation charge and disposals on gross and net profit in the
SOPL;

 Specify the uses of the assets register;

 Identify the accounting treatments of intangible assets, including goodwill and

development expenditure.
CONTENT

1. Tangible NCA and depreciation (IAS 16) (FRS 102 s17)

- NCAs are assets that have a useful life extends beyond one reporting period.
Non-current assets may be tangible or intangible. Tangible non-current assets
are known as property, plant and equipment (PPE).

- The cost of a non-current asset includes: purchase price; delivery costs; taxes
and duties; irrecoverable VAT; installation and assembly costs; professional
fees; testing costs

- Subsequent expenditure may be added to the cost of an item of PPE provided

the expenditure enhances or restores any benefits consumed…

- Part of an asset's cost may be settled by trading in an old asset in part-

exchange.

- All tangible non-current assets except freehold land have a finite useful life

- Many items of PPE have a residual value at the end of useful lives

- Depreciation allocates the asset's cost less its residual value over its useful
life.

- NCAs maybe tangible (which means they have physical substance) or

intangible (which means they do not have physical substance).

1.1. IAS 16 – Property, Plant and Equipment

The objective of IAS 16 is to prescribe in relation to property, plant and equipment
the accounting treatment for:

- The recognition of assets

- The determination of their carrying amounts;

 - The depreciation charges relating to them.

IAS 16 should be followed when accounting for PPE unless another IFRS Standard
requires a different treatment. For example, IFRS 05 – Non-current Assets Held for
Sale and Discontinued Operations.

1.2. Cost of PPE

The cost of PPE includes all amounts incurred to acquire the asset and any amounts
that can be directly attributable to bringing the asset to the location and condition
necessary for being capable of operating in the way intended by management.

Directly attributable costs include:

- purchase price
- delivery costs
- stamp duty and import duties (and irrecoverable VAT on cars)
- costs of preparing the site for installation and assembly of the asset
- professional fees, such as legal and architects' fees
- costs of testing whether the asset is functioning
The cost of subsequent capital expenditure on a non-current asset will be added to
the cost of the asset, provided this expenditure enhances the benefits of the non-
current asset or restores any benefits consumed. It is therefore called enhancement
expenditure. This means that costs of major improvements or a major overhaul may
be capitalised. However, the costs of repairs that are carried out simply to maintain
existing performance may not be capitalised: they will be treated as expenses of the
reporting period in which the work is done, and charged in full as an expense in that
period

Note: CARS are exceptions: VAT is not usually recoverable. Thus, the amount
capitalised will exclude VAT.
1.3. Paying for PPE
A business might purchase a new non-current asset for cash or on credit, or it may
hand over an old asset in part-Exchange (eg. motor vehicles)

The supplier of the new asset agrees to take the old asset, and gives the buyer a
reduction in the purchase price of the new asset. This reduction is the part-exchange
value of the old asset.

WORKED EXAMPLE: PART-EXCHANGE

A business purchases a new delivery van, trading in an old van in part-exchange.
The cost of the new van is £25,000 and the part-exchange value of the old van is
£10,000. Therefore, the business will pay the van dealer £15,000.

1.4. Useful life

Physical life and economic life of an asset

Physical life is the period of time that an asset remains functional. This time period
may be substantially longer than the useful life of an asset, since a functional asset
may still be replaced by a more productive asset. Also, the asset may become too
expensive to operate profitably after a period of time. For example, a machine may
be able to process 100 units per hour, and can theoretically do so for the next 20
years. However, its useful life may be only 5 years, since it can be replaced at that
time by a machine that can process 500 units per hour.

Economic life is the expected period of time during which an asset remains useful
to the average owner. When an asset is no longer useful to its owner, then it is said
to be past its economic life. The economic life of an asset could be different than its
actual physical life. Thus, an asset can be in optimal physical condition but may not
be economically useful. For example, technology products often become obsolete
when their technology becomes obsolete. The obsolescence of flip phones occurred
due to the advent of smartphones and not because they ran out of utility.

Useful life of an asset

The useful life of an asset is an estimate of the number of years it will remain in
profitable service. The purpose of a useful life estimate is to determine how long an
asset will remain in useable condition. From a financial standpoint, this means the
period of time in which an asset will generate an economic benefit for the business.

So the useful life is the estimated economic life (rather than the potential physical
life) of an item of PPE to the business.

The only tangible asset that is deemed to have an unlimited useful life is freehold
land. All other tangible assets have a finite useful life and will be depreciated over
that useful life.

1.5. Depreciation
Depreciation is an accounting convention that allows a company to write off an
asset's value over a period of time, commonly the asset's useful life. Assets such as
machinery and equipment are expensive. Instead of realizing the entire cost of the
asset in year one, depreciating the asset allows companies to spread out that cost and
generate revenue from it.

Depreciation is an accounting method of allocating the cost of a tangible or physical

asset over its useful life or life expectancy. Depreciation represents how much of an
asset's value has been used up. Depreciating assets helps companies earn revenue
from an asset while expensing a portion of its cost each year the asset is in use.

Depreciation is the systematic allocation of cost less residual value, over useful life.
To calculate the depreciation charge for a reporting period, the following factors are
relevant due to the application of Accrual concept:

- Asset cost;

- Useful life;

- Asset residual value.

1.6. Residual value

Residual value is the estimated amount that the entity would obtain from disposing
of the asset, after deducting estimated disposal cost. With residual value, it is
assumed that the asset has reached the end of its useful life and is in the condition
the asset was expected to be in at the end of its life.

The cost of an item of PPE less its residual value represents the total amount to be
depreciated (i.e. depreciable amount) over its useful life.

INTERACTIVE QUESTION: DEPRECIABLE AMOUNT

ABC company purchased a new car for a sales representative. The invoice received
contained the following information: (£)

- List price of the car 18,720

- Deposit paid (6,200)

- Amount due 12,520

It is estimated that the new car will have a useful life of three years and will have a
residual value of £6,360.

Requirement:

Calculate the total amount to be depreciated in respect of the new car.

2. The objective of depreciation

2.1. Accounting concepts and depreciation

Accrual principle: it would be inappropriate to charge cost of an asset to any single
period.

Depreciation: method to spread cost of NCA over its useful life (accrual principle)

2.2. Common depreciation misconceptions:

 Depreciation represents the fall in value of an assets?

 Deprication: to set aside money to replace the asset at the end of its useful
life?

 Depreciation NOT reflects the fall in value of an assets

 Deprication NOT to set aside money to replace the asset at the end of its useful
life

3. Calculating depreciation
When a non-current asset is depreciated:

(a) Depreciation: is an expense of the reporting period in SPL

(b) The NCA is wearing out and being consumed, and so its cost in the statement
of financial position must be reduced by the amount of depreciation charged

The amount of depreciation deducted from the cost of a NCA to arrive at its carrying
amount will build up (or 'accumulate') over time: called accumulated
depreciation.
WORKED EXAMPLE
A non-current asset costing £40,000 has a useful life of four years and an estimated
residual value of nil, it might be depreciated by __________ per annum. And the
accumulated depreciation at the end of the 3rd year is __________ ?

3.1. Methods of depreciation

 Straight line method

 Reducing balance method

A change from one method to another is considered a change in accounting

estimate. There is no change in accounting policy, which remains: to depreciate
tangible non-current assets (see IAS 08 - Accounting Policies, Changes in
Accounting Estimates and Errors).

3.2. Straight line method

 Depreciable amount is charged in equal instalments

 The annual depreciation = (Cost of asset – residual value)/Useful life in years

 The monthly depreciation

= (Cost of asset – residual value)/Useful life in years *12

 Other way of stating straight line method of depreciation: percentage per

annum on the asset’s depreciable amount

WORKED EXAMPLE
A business has a reporting period from 1 January to 31 December and purchases a
non-current asset on 1 April 20X1, at a cost of £24,000. The useful life of the asset
is four years, and its residual value is nil.

Requirement:
What is the depreciation charge for the reporting period to 31 December 20X1?

3.3. The reducing balance method

 Depreciation charge is fixed percentage of the brought foward carrying
amount of NCA

 Not concerned with residual value (nor the percentage)

 Note: yearly depreciation charge

WORKED EXAMPLE
A business purchases a non-current asset at a cost of £10,000 on 1 January 20X1,
which it plans to keep for three years to 31 December 20X3. The business wishes to
use the reducing balance method to depreciate the asset, and calculates that the rate
of depreciation should be 40% of the reducing balance (carrying amount) of the
asset.

Requirement:

Calculate the depreciation charge per annum and the carrying amount of the asset at
the end of each reporting period?

3.4. Applying a depreciation method consistently

A business can choose which method of depreciation to apply to its PPE. Once this
decision has been made, it should be applied consistently from reporting period to
reporting period. A change in the method of depreciations is permitted if there is a
change in the way in which the asset is used.

INTERACTIVE QUESTION: DEPRECIATION

A lorry bought for a business cost £17,000 plus VAT at 20%. It is expected to last
for five years and then to be sold for £2,000 plus VAT.

Requirement:
Work out the depreciation to be charged to each 12-month reporting period under:

a) the straight line method

b) the reducing balance method, using a rate of 35%

3.5. Depreciating subsequent expenditure

Subsequent expenditure is depreciated over remaining useful life of the initial
asset.

WORKED EXAMPLE
Malcom buys a building on 1.1.X0 for £200,000. On 1.1.X2, he adds an extension
that cost £50,000.

Requirement:

Calculate the annual depreciation charge before and after the extension is built, on
the basis of straight line depreciation over 10 years, with no residual value.

3.6. Reviewing and changing depreciation method

Remaining carrying amount is depreciated under new method

WORKED EXAMPLE
Jakob Co. purchased an asset for £100,000 on 1.1.X1. It had an estimated useful life
of five years and it was depreciated using the reducing balance method at a rate of
40%. On 1.1.X3 it was decided to change the depreciation method to straight line.
There was no change to the useful life , and no residual value is anticipated.

Requirement:

Show the depreciation charge for each year (to 31 December) of the asset’s life.
3.7. Reviewing and changing useful life & residual value
The residual value and estimate useful life of a non-current asset should be reviewed
and changed if they are no longer appropriate.

WORKED EXAMPLE: CHANGE IN USEFUL LIFE

A business purchased a non-current asset costing £12,000 with an estimated useful
life of four years and no residual value. The business decided after two years that the
useful life of the asset has been underestimated and it still has five more years to
come making its total useful life seven years.

Requirement:

Calculate the annual depreciation charge for final five years?

INTERACTIVE QUESTION: CHANGE IN RESIDUAL VALUE

An asset had a cost of £10,000, an estimated useful life of 10 years and a residual
value of £200. At the start of Year 3 a review shows its remaining useful life was
unchanged but the residual value was reduced to nil.

Requirement:

Calculate the depreciation charge for each of Year 1 to 3 on the straight line basis.

4. Accounting for depreciation

4.1. Accounting for depreciation

 Set up accumulated depreciation account

 Record depreciation charge for the period:

DEBIT Depreciation expense (SPL) £X

CREDIT Accumulated depreciation (SFP) £X

  The balance on the accumulated depreciation account is the total accumulated
depreciation

 NCA cost accounts are unaffected by depreciation

 In SFP, the balance on the accumulated depreciation account is set against the
NCA cost accounts to derive the carrying amount

WORKED EXAMPLE: ACCOUNTING FOR DEPRECIATION

Brian Box set up his own computer software business on 1.3.20X6. He purchased a
computer system on credit from a manufacturer for £16,000. The system has a useful
life of three years and a residual value of £2,500 and the business applied the straight
line method of depreciation.

Requirement:

Draw out the T accounts for the cost of the asset and accumulated depreciation

4.2. Adjusting TB for depreciation

 Calculate amount of depreciation

 Prepare year-end journal to record depreciation (and impairment loss)

 Enter journal in adjustment column

 Adjust the initial TB

5. Impairment of assets (IAS 36 – Impairment of assets)

IAS 36 Impairment of Assets seeks to ensure that an entity's assets are not carried at
more than their recoverable amount (i.e. the higher of fair value less costs of disposal
and value in use). With the exception of goodwill and certain intangible assets for
which an annual impairment test is required, entities are required to conduct
impairment tests where there is an indication of impairment of an asset, and the test
may be conducted for a 'cash-generating unit' where an asset does not generate cash
inflows that are largely independent of those from other assets.

5.1. Identifying an asset that may be impaired

At the end of each reporting period, an entity is required to assess whether there is
any indication that an asset may be impaired (i.e. its carrying amount may be higher
than its recoverable amount). IAS 36 has a list of external and internal indicators of
impairment. If there is an indication that an asset may be impaired, then the asset's
recoverable amount must be calculated.

The recoverable amounts of the following types of intangible assets are measured
annually whether or not there is any indication that it may be impaired. In some
cases, the most recent detailed calculation of recoverable amount made in a
preceding period may be used in the impairment test for that asset in the current
period:

 an intangible asset with an indefinite useful life

 an intangible asset not yet available for use
 goodwill acquired in a business combination
5.2. Indications of impairment
External sources:
 market value declines
 negative changes in technology, markets, economy, or laws
 increases in market interest rates
 net assets of the company higher than market capitalisation
Internal sources:
 obsolescence or physical damage
 asset is idle, part of a restructuring or held for disposal
 worse economic performance than expected
  for investments in subsidiaries, joint ventures or associates, the carrying
amount is higher than the carrying amount of the investee's assets, or a
dividend exceeds the total comprehensive income of the investee
These lists are not intended to be exhaustive. Further, an indication that an asset may
be impaired may indicate that the asset's useful life, depreciation method, or residual
value may need to be reviewed and adjusted.

5.3. Determining recoverable amount

 If fair value less costs of disposal or value in use is more than carrying amount,
it is not necessary to calculate the other amount. The asset is not impaired.
 If fair value less costs of disposal cannot be determined, then recoverable
amount is value in use.
For assets to be disposed of, recoverable amount is fair value less costs of disposal.

Fair value less costs of disposal

Fair value is determined in accordance with IFRS 13 Fair Value Measurement

Costs of disposal are the direct added costs only (not existing costs or overhead)

Value in use
The calculation of value in use should reflect the following elements:

 an estimate of the future cash flows the entity expects to derive from the asset
 expectations about possible variations in the amount or timing of those future
cash flows
 the time value of money, represented by the current market risk-free rate of
interest
 the price for bearing the uncertainty inherent in the asset
 other factors, such as illiquidity, that market participants would reflect in
pricing the future cash flows the entity expects to derive from the asset
Cash flow projections should be based on reasonable and supportable assumptions,
the most recent budgets and forecasts, and extrapolation for periods beyond
budgeted projections. IAS 36 presumes that budgets and forecasts should not go
beyond five years; for periods after five years, extrapolate from the earlier budgets.
Management should assess the reasonableness of its assumptions by examining the
causes of differences between past cash flow projections and actual cash flows.

Cash flow projections should relate to the asset in its current condition – future
restructurings to which the entity is not committed and expenditures to improve or
enhance the asset's performance should not be anticipated.

Estimates of future cash flows should not include cash inflows or outflows from
financing activities, or income tax receipts or payments.

5.4. Recognition of an impairment loss

 An impairment loss is recognised whenever recoverable amount is below
carrying amount.
 The impairment loss is recognised as an expense (unless it relates to a revalued
asset where the impairment loss is treated as a revaluation decrease).
 Adjust depreciation for future periods.
WORKED EXAMPLE: IMPAIRMENT AND DEPRECIATION
A business purchased a building on 1.1.20X1 at a cost of £100,000. The building
had a 20-year useful life. During 20X5, property prices fell sharply indicating that
the building maybe impaired. On 31 December 20X5, the business undertook an
impairment review and determined that the building had a fair value less costs of
disposal of £60,000 and a value in use of £50,000.

Requirement:

Calculate:

a) The impairment loss of the business at 31 December 20X5.

b) The depreciation charge for the year ended 31 December 20X6
6. Non-current asset disposals
Profit or loss on disposal is capital income or capital expense, not part of gross profit.

6.1. The principles behind calculating profit or loss on disposal

The difference between:

 Carrying amount

 Net disposal proceeds (or part-exchannge value)

6.2. Accounting for NCA disposals

Question: What is our pupose of recording disposal:

Answer: we need to eliminate

 The cost of the asset

 The accumulated depreciation of the asset

 Record the cash received or receivable account

 Calculate profit/loss on disposal

(Note: before conducting this step, remember to record depreciation for the year of
disposal (if applicable))

Open disposals account to record disposal of NCA

(a) The following items appear in the disposals account:

(1) The value of the asset (at cost)

(2) Accumulated depreciation

(3) The disposal proceeds, if any

(b) Profit or loss on disposal is the difference between:

 (1)The disposal proceeds; and

(2) The carrying amount

Let us make journal entries together!

1) Open disposal account

2) Remove the cost of the asset

3) Remove accumulated depreciation

4) Record the disposal proceeds

5) Balance off the disposal account

WORKED EXAMPLE: DISPOSAL OF A NCA

A business purchased a NCA on 1.1.20X1 for £25,000. It has an estimated useful
life of six years and an estimated residual value of £7,000 and is depreciated on the
straight line basis. The asset was sold after three years on 1.1.20X4 to another trader
who paid £17,500 for it.

Requirement:

What was the profit or loss on disposal?

6.3. Disposals of NCA given in part-exchange

 Part-exchange/trade-in value: considered as the NRV (instead of disposal
proceeds) of the old asset

 Now, let us record disposal of NCA in part-exchange!

(Note: instead of recording disposal proceeds (cash/receivable); we will

record a new asset (at cost) and some cash/payable we have to pay or promise to
pay)
WORKED EXAMPLE
Asset A, costing £20,000 is acquired by a business for £12,000 plus its old asset B.
Asset B costs £15,000 and has had £4,000 depreciation charged in respect of it.

What are the relevant ledger account entries?

6.4. The TB and NCA

A typical example of exam long question!

WORKED EXAMPLE: NCA AND THE TRIAL BALANCE

Rodrigo’s initial trial balance as at 31 December 20X0 is as follows:

Trial balance
Debit Credit
£ £
Current assets 87,420
Capital at 1.1.X0 100,000
Freehold land and buildings - cost at 1.1.X0 100,000
Freehold land and buildings - accumulated depreciation at
1.1.X0 15,000
Plant and equipment - cost at 1.1.X0 45,000
Plant and equipment - accumulated depreciation at 1.1.X0 18,750
Motor vehicles - cost at 1.1.X0 25,000
Motor vehicles - accumulated depreciation at 1.1.X0 14,650
Current liabilities 15,420
Expenses 5,830
Purchases 58,740
Sales 205,640
Drawings 47,670
Suspense 200
369,660 369,660
The following matters have now been discovered:

(a) On 1 January 20X0 Rodrigo disposed of an item of plant that had cost £10,000
and on which £1,250 depreciation had been charged. He received payment by bank
transfer for £7,950. The accounting entry made was to the debit cash at bank account
and credit the suspense account.

(b) On 1 January 20X0, he also traded in a car that had cost £8,000 and on which
£4,500 depreciation had been charged for a new car costing £13,300. He also paid
£7,750 by bank transfer. The only entry with regard to this transaction was to credit
the cash at bank account and debit the suspense account.

(c) With regard to the assets held at 31 December 20X0, depreciation on the freehold
building of £5,000, on plant and equipment of £5,290, and on motor vehicles of
£6,900, is to be charged.

Requirement:

Prepare Rodrigo’s year-end journals as at 31 December 20X0 in respect of these

matters and calculate the final trial balance

7. The asset register

7.1. Data kept in asset register

 The internal reference number (physical identification)

 Manufacturer's serial number (for maintenance)

 Description of asset

 Location of asset

 Department which uses the asset

 Purchase date (for calculation of depreciation)

 Cost, enhancement expenditure

 Depreciation method and estimated useful life

  Carrying amount

8. Intangible NCAs
Purchased goodwill may appear as an asset in a company’s SFP. It represents the
amount paid for a business in excess of what its net assets are worth.

Some development costs are capitalised on the SFP.

Intangible non-current assets should be subject to reviews for impairment of their

value.

8.1. Goodwill
 What is good will?

Goodwill is created by good relationships between a business and its customers,

for example:

- by building up a reputation (by word of mouth perhaps) for high quality

products or high standards of service
- by responding promptly and helpfully to queries and complaints from
customers
- through the personality of the staff, their attitudes to customers and their
skills

8.2. Purchased goodwill

 Why purchased goodwill (and not internally generated?)

8.3. Accounting for purchased goodwill

8.4. How is the value of purchased goodwill decided

 Difference between price agreed and value of net assets in the accounting
records of the new business
  Calculation of goodwill precede fixing purchase consideration of the business

8.5. Development costs

 Two ways of treatment of development costs:

 Write off as expense

 Capitalise as asset

 Note: IAS38: development costs MUST be capitalised as asset – if the

criteria are satisfied!

Activity: When development expenditure is carried forward as an asset: what are

the accounting entries?

 Accounting entries are:

DEBIT NCA (Development cost) £X

CREDIT Cash/payables £X

 The cost of this NCA will need to be allocated to the SPL as it is matched
against the income it generates. This process is essentially the same as for
depreciation of tangible non-current assets, but it is called amortisation.

8.6. Other intangible assets

 Licences purchased by a company

 Patents on ideas or designs developed by a company

 Investments held for the long term

9. The NCAs note to the SFP