Adjustments to the final accounts of business organisations

In this section we cover the following topics:

Capital and revenue expenditure Accounting for accruals and prepayments Bad debts, recovered bad debts and provision for doubtful debts

Bad debts Provisions for doubtful debts Bad debts recovered

Depreciation Meaning of depreciation Calculation of straight-line and reducing balance methods of

depreciation Deprecation adjustments for profits and balance sheets Calculation of profits and losses on asset disposal

Classification of expenditure

All firms spend money in their business operations. However, not all this expenditure will appear immediately in the profit and loss account as an expense. The reason this happens is due to the classification of all expenditure into one of two kinds either capital expenditure or revenue expenditure.

Capital expenditure

Money spent on fixed assets or any other long term projects is likely to be classified as capital expenditure. The purchase of a fixed asset involves money being spent on an item which is going to be (hopefully) used for more than one period of time. Therefore, including it as an expense in the current profit and loss account would be misleading and would violate the idea of the accruals concept (where expenses are matched to the period in which they 'belong'). The accruals concept is covered in more detail on 3.2

As a result, capital expenditure appears on the balance sheet. For example, the purchase of new equipment would be capitalised and listed as a fixed asset. Money has been spent on this asset and the bank or cash figure would be reduced, but it initially appears as though the cost of the asset does not appear as an expense. However, the asset does appear as an expense but this is done over time and will appear as depreciation (a provision, not an expense - don't worry, both provisions and expenses are deducted as though they are expenses in the profit and loss account).

Capital expenditure would also include costs involved in getting the asset

into working condition. For example, these costs would all be classified as capital expenditure:

1. Delivery costs for asset

2. Installation costs

3. Legal fees involved with the purchase of an asset

Revenue expenditure

Money spent on day-to-day running costs would be classified as revenue expenditure. This is because the expense can be linked to belonging to a specific period of time. The expense is 'used up' during that period of time and will not be carried forward into the next period of time. Any items of revenue expenditure will appear as an expense in that period's profit and loss account

If the expenditure does not add value to the firm or have any long-lasting impact then it is likely to be revenue expenditure.

The following table illustrates examples of capital and revenue expenditure:

Capital expenditure Revenue Expenditure

Installation of heating system, Annual costs of heating system

Upgrades to computer system Power cost of computing system

New premises Repairs to premises

Painting new premises Repainting existing premises

Carriage inwards on new equipment

Carriage inwards on stocks for resale

Installation costs of machinery Running costs of machinery

One-off license fee Annual road tax

Differences between the two types of expenditureCapital expenditure is capitalised. This means that it does not appear in the profit and loss account as an expense but goes straight on to the balance sheet. However, the cost of a fixed asset will appear in the profit and loss account as an expense, but this will be on the form of 'depreciation' which we will cover in this module. Revenue expenditure

will appear in the profit and loss account in the period in which it is incurred:

Type of expenditure Where it should appear

Revenue expenditure

Profit and loss account - expense

Capital expenditure Balance sheet item - asset

Capital and revenue income

Similarly, incomes for the firm will be classified as either capital income or revenue income.

Revenue incomeThis usually includes the revenue from the sale of stocks, but may also include money received from items such as commissions received, or interest received. Revenue incomes will all be included in the profit and loss account (sales revenue appears in the trading account section of the overall account). Any other forms of income would be credited to the profit and loss account normally added on to the gross profit before the expenses are deducted.

Capital incomeThis refers to one-off sources of income. The sale of a fixed asset would be treated as capital income. This means that the revenue from the sale of a fixed asset, the money raised through the issue of shares, or money obtained in the form of a loan would not be included as income in the profit and loss account.

Implications in classification of expenditure

If any item is incorrectly classified as capital expenditure then there will fewer expenses included with the other revenue expenses in that year's profit and loss account. In other words, profits will be higher this year as a result. However, once the expenditure has been capitalised on the balance sheet, it will require depreciation over time. Hence, future profits will be lower (maybe not by much - this will depend on how long a period the asset is written off over).

Although the distinction between 'revenue' and 'capital' appears straightforward, it is not always easy to classify items as one or the other and the classification will partly depend on whether or not a firm regards an expenditure as a significant amount of expenditure or not. For example, when a firm buys a set of chairs, for example, then technically

these should be regarded as an asset which will provide a benefit over the next few years i.e. it is a capital expenditure which should be put on the balance sheet and depreciated. However, if the cost of the chairs is only a few hundred pounds the firm may write them off in one go i.e. treat them as revenue expenditure and put the total expenditure on the profit and loss this year (this is the concept of materiality, covered in 3.2)

In the case of items such as research and development some firms will treat this as a revenue expenditure on the basis that the benefits of this have been used up this period. Other firms will treat research and development as capital expenditure on the basis that it will hopefully provides a benefit in the future if the research is fruitful. This lack of clarity about what is and what is not a capital expenditure gives some firms increased scope for 'window dressing' their accounts so as to present the firm in a particularly flattering way. For example, by deciding to classify an item as a capital expenditure rather than as revenue expenditure this year's costs will be reduced and profits increased simply because of a change in accounting policy.

As a result, the accounting profession has developed a series of regulations which state which items of expenditure can and which cannot be capitalised on the balance sheet. These regulations are covered in module 6. For example, in the case of Research and Development costs 'SSAP 13' states that R & D expenditure can only be capitalized if certain conditions are met".

Exam tips - capital and revenue expenditure

Examination questions do not normally focus solely on the distinction between capital and revenue expenditure. This topic is likely to be tested in the context of some other topic - such as the effect on profits of the purchase of a fixed asset.

The distinction between capital and revenue expenditure (and incomes) may be tested in terms of their effect on cash flow and profits at the same time.

Accruals and prepayments

The profit and loss account for any firm should show the income and expenses belonging to the time period in which account claims to represent. In most cases, the profit and loss account is drawn up for a year - this means that it should show all the income earned and all the expenses incurred for that year even if they have not all been paid and received.

This idea is contained within the accruals (or matching) concept - that we should account for income and expenses when they are incurred (i.e. used up), not when they are paid and received. In other words, if an item of income or an expense belongs to a period of time (e.g., car insurance for a year) then it would appear as an income or expense for that period - regardless of the amounts actually paid or received.

So far, we have only applied this concept to sales and purchases - sales are included as income and purchases are included as an expense even though they are usually on credit terms and the money from these transactions may not be paid or received until the next accounting period. For example, credit sales made on 20th December 2001 would count towards the profits of the year ended 31 December 2001, but the cash generated by this sale is unlikely to be received until 2002. The accruals concept must also be applied for any expenses and any incomes. This leads to some new definitions:

The implications of these for the profit and loss account is that this account should show the income that should have been received and the expenses that should have been paid when the transaction was originally made, even if this does not correspond with the money paid in or received.

If expenses are paid immediately when they are incurred and income is received immediately when it is also earned, then we have no need for accrual and prepayments. For example, if we assume the annual electricity bill was £750 and commission received for the year of 2001 was £500, then the ledger accounts would appear as follows:

Electricity

2001 - £ 2001 - £

Dec 31

Bank 750 Dec 31

Profit & loss 750

Electricity appears on the debit side of the profit and loss account (as an expense).

Commission Received

2001 - £ 2001 - £

Dec 31

Profit & loss 500 Dec 31

Bank 500

Commission received appears on the credit side of the profit and loss account (as income).

If you are not using bookkeeping, then you should be aware of the following:

Expenses - Debit balances

Incomes - Credit balances

In the above example, Rent would appear as a debit (expense) and commission received would appear as a credit (income) in the profit and loss account.

If we allow for accrued expenses and prepayments then this will involve discrepancies between the amount that appears in the profit and loss account and the amount that was actually paid or received. The following examples include situations taking this into account.

Concepts covered

1. Accrued expenses (or accruals) are expenses incurred during a

financial period but not yet paid for, i.e. expenses owing

2. Prepayments are expenses paid in advance of the current financial

period (i.e. paid now for the next period).

3. Accrued revenue refers to income which is still owing to firm (similar

to debtors)

4. Prepaid revenue refers to income which the firm has received in

advance of when it was due

Adjustments without bookkeeping

The same examples as above are now explained without the use of bookkeeping.

Remember the profit and loss account has to deal with the amounts that were due to be either paid or received. Therefore the adjustments needed for accruals and prepayments in expenses will be as follows:

Profit and loss entry = amount paid + accrued expenses still owing

Profit and loss entry = amount paid - prepayment for next period

For incomes and revenues received by the firm, the treatment will be as follows:

Profit and loss entry = amount received + accrued revenue (amount still owing to us)

Profit and loss entry = amount received - prepaid revenue (received in advance for next period)

Dealing with more than one year

So far we have considered examples where the outstanding balance only occurs at the end of the year, It is perfectly possible to carry these forward and to have outstanding balances at the start and at the end of the year.

We can use our knowledge to determine how much should actually be entered in the profit and loss account for the particular period.

Consider the following examples (as before, follow the links to the examples):

Balance sheets

On the balance sheet, only the amount that is either an accrual or a prepayment should be included in current assets and current liabilities. Normally, prepayments should appear in current assets after bank and cash. Accruals should appear in current liabilities after creditors and bank overdrafts.

Accrued expenses or prepaid revenue

Prepaid expenses or accrued revenue

Credit balances Debit balances

Current liabilities Current assets

In questions where the data is presented in the form of a trial balance, the amount actually paid or received will appear within the trial balance.

Information relating to accruals and prepayments will be given at the bottom of the trial balance with the closing stock and other information

Exam tips - accruals and prepayments

To calculate the amount to be included in the profit and loss account, think about the amounts that belong to that period - irrespective of whether they have been paid or not.

Be careful in case there are outstanding balances from both the start and the end of the period - the amounts will need adjusting for both.

Accruals and prepayments will always generate an item for the balance sheets

Bad debts

Credit sales and credit purchases are normal business transactions, where goods are exchanged between supplier and customer, but the money for the transaction is exchanged at a later date. These credit terms offered gives firms valuable 'breathing space' where they can pay for the goods at a time when the firm may have more money available (most credit terms expect payment within one month).

The business offering credit terms is taking the risk that some customers may never pay for the goods sold to them on credit. Any debtor's balances that remain unpaid (after a specified period of time has elapsed) are classified as a bad debt.. The process of cancelling a debt because payment is not expected to be received is known as 'writing off' the bad debt. Bad debts are an unfortunate, but not unusual business expense, and must be charged as an expense to the profit and loss account in the period when the firm decides to cancel the debt from ledger accounts

Bad debts are a profit and loss expense in the period in which they are written off

Firms would not offer credit to any firm they know would not pay, but many firms will experience financial difficulty - and may have to close down - thus making bad debts an inevitable part of the business world.

When a debt is found to be bad, the balance on the debtor's account ceases to have any real value and must be closed down as an asset account (here we are trying to show a realistic value of the assets of the firm - the prudence concept - covered in 3.2). This is done by crediting the

debtor's account to cancel the asset and increasing the expenses account of bad debts by debiting it there.

Sometimes the debtor will have paid part of the debt, leaving the remainder to be written off as a bad debt. Alternatively, the firm may receive part of the outstanding debt in full settlement. At the end of the accounting period, the total of the bad debts account is later transferred to the profit and loss account as an expense.

The double entry for bad debts is as follows:

Debit Credit

Bad debts

Debtor

During 2005, the following sales were made all on a credit basis.

January 15, sales of £750 were made to G Flitcroft

March 11, sales of £490 were made to G Elliot

April 27, sales of £160 were made to P Krugman

The entries for these sales would appear as follows:

G Flitcroft

2005 - £ 2005 - £

Jan 15 Sales 750

- - -

G Elliot

2005 - £ 2005

- £

Mar 11 Sales 490 - - -

P Krugman

2005 - £ 2005 - £

Apr 27 Sales 160 - - -

(N.B. The sales account would receive the credit entry for each of these sales)

On the 31 December of that year it was decided that the following accounts would be written off as bad debts:

G Flitcroft

G Elliot

At 31 December, P Krugman had been declared bankrupt during the year and a payment of 25p in the £ was received by cheque in full settlement of this account.

The debtor's account would now appear as:

G Flitcroft

2005 - £ 2005 - £

Jan 15 Sales 750 Dec 31

Bad debts

750

G Elliot

2005 - £ 2005 - £

Mar 11 Sales 490 Dec 31

Bad debts

490

P Krugman

2005 - £ 2005 - £

Apr 27 Sales 160

Dec 31

Bank 40

- - - Dec 31

Bad debts

120

- - 160

- - 160

With the P Krugman account, a settlement of 25p in the £ means that we

have received 25p for every £1 owing to us - the other 75p in the £ is rewritten off as a bad debt.

To complete the entries, the amounts are transferred to the debit side of the bad debts account. This account is then transferred to the debit side of the profit and loss account - as an expense.

Bad debts

2005 - £ 2005 - £

Dec 31

G Flitcroft 750 Dec 31

Profit and loss 1360

Dec 31

G Elliot 490 - - -

Dec 31

P Krugman 120 - - -

- - 1360 - - 1360

In a trial balance, the entries for bad debts will always be in the debit column.

This means that the bad debts have already been deducted from the debtors figure in the trial balance and therefore you should not deduct the bad debt from he debtors figure. Only if the bad debt has not been recorded in the books would the debtors figure need to be reduced because of bad debts.

Provisions for doubtful debts

The profit and loss account and the balance sheet are the final accounts of the firm. One of the main aims of producing these statements is to show a true and fair view of the firm's financial position. One way in which we achieve this is by showing realistic values for any assets that the firm has. Any debtor balance which is unlikely to be collected should be written off as a bad debt and the overall total for debtors will therefore not contain amounts that we have given up hope of collecting.

However there is a problem with the debtors figure as it appears on the balance sheet. Although the debtors figure contains the total amount that we aim to collect from our customers, the firm will probably recognise that, over the course of the next year, some of these debtors will become bad debts and have to be written off.

The firm will have no idea (although it may suspect) which of the firm's debtors will become bad debts (surely it would not have given credit terms to any customer who is unlikely to pay), but it will have to face up the fact that bad debts are a common business occurrence. In most cases, the debtors would be wiling to pay, but simply cannot (maybe because the customer's firm has had to close). As a result, the debtors figure on the balance sheet does not show a 'true and fair view' of the actual amounts that will be collected by the firm from the customers.

Therefore to be prudent, the firm should try to aim to show a more realistic figure for the amounts likely to be collected over the near future - in other words, it should try to estimate the size of any future bad debts, before they actually occur. This can be done by creating a provision for doubtful debts.

This provision is supposed to reflect the likely size of the future bad debts which means that this can be deducted form the debtors figure on the balance sheet so to give a more realistic figure for the amounts likely to be collected.

The provision for doubtful debts is not the same as the amount of bad debts. Bad debts are actual sums of money that have been written off. The provision for doubtful debts is an estimate of the size of future bad debts - it has not happened. The firm may actually over or underestimate the size of the future bad debts when creating this provision. This does not matter, as long as the estimate is a reasonably realistic prediction of what will happen then it does not matter if the actual bad debts in the future are not exactly the same as the provision for doubtful debts.

Calculating the size of the provision for doubtful

debts

When trying to estimate a figure for doubtful debts, a firm would want to take into account the following:

1. The amounts of debts outstanding from each customer

2. How long each debt has been outstanding

3. Economic climate - incidences of business failure

Firms will have different experience when it comes to bad debts. Some firms will operate in industries where bad debts are more frequent than others. Therefore the estimates will differ between firms.

Generally, the longer a debt is owing the more likely it is that it will

become a bad debt. This can be seen in an aged debtors schedule which ranks and classify amounts owing to the firm by the length of time that they have been outstanding.

Example: Ageing Schedule for Doubtful Debts

Period debt owing

Amount

Estimated percentage doubtful

Provision for doubtful debts

- £  % £

30 days or less 10,000 1 100

1 month to 2 months

6,000 2 120

2 months to 6 months

800 5 40

6 months to 1 year

300 10 30

Over 1 year 180 50 90

Total debtors amounts

17,280 - 380

This balance of £380 for the provision would then be deducted from the value of the debtors figure on the balance sheet - giving us a more realistic value of the amount that we will collect from the debtors.

As far, as most examination questions go, the provision for doubtful debts is likely to be a percentage of the overall debtors figure. For example, some firms may always maintain a provision for doubtful debts of 2 or 3% of their outstanding debtors totals.

Accounting for provisionsA provision is an amount charged against profit (i.e. treated as an expense) to record a reduction in the value of an asset - even if the exact fall in value is uncertain. Whether you have studied bookkeeping or not, the accounting entries for provisions are unlike any other types of entries that you will make in terms of their effect on the profit and loss account, as well as on the balance sheet.

There are three main types of provisions that are studied:

1. Provisions for doubtful debts

2. Provisions for depreciation

3. Provision for unrealised profit on stock

If a firm's asset has lost, or is expected to lose value, then we would want to show this loss in the accounts. The balance sheet value can be reduced, but we also want to show the effect of this loss on the profits as well. Therefore a provision will appear in the profit and loss account as an expense - even though no money has been spent. If you imagine that you'd lost some money - you would treat this as a loss for yourself, even though you haven't actually spent any money.

Although a provision will appear as an expense in the profit and loss account, it is only the adjustment to the provision that appears as an expense. Therefore, if the provision is kept at he same level over a few years then, apart from when the provision is created, there will be no further expense in the profit and loss account - only when it was first created.

It may help if you think of it as money you put aside. If last year you had put aside £200 out of profits, and this year you want the same amount to be 'aside' then you don't need to deduct anything from this years profits. The £200 is still there - it was on last years balance sheet and it will be on this years' too, unless it is adjusted.

Provisions are always credit balances and they are kept in the firm's books until the firm decides to eliminate them from the entries. If a provision is to be increased then a further credit entry will need to be 'added' on the existing balance. If the provision were to be reduced then there would need to be a debit entry to reduce the overall balance.

If the provision were actually reduced between one year and the next, then this reduction in the provision would actually be treated as income and would be added on the year's gross profit.

The rules for provisions are as follows:

Profit & loss account Balance sheet

Show change in provision onlyIncreases = expensesDecreases = revenues

Deduct full provision from relevant asset

Accounting entries for provisions for doubtful

debts

When the decision has been taken as to the amount of the provision to be made, then the accounting entries needed for the provision are:

Debit Credit

Profit & loss Provision for bad debts

Increasing the provisionThis provision that was created will be kept on the firm's books and can be adjusted both upwards and downwards to meet changing circumstances.

If we assume that as at 31 December 2002 the debtors figure had risen to £16,000 (see example 1 link above) then the provision may well be adjusted upwards to take into account the increased likelihood of bad debts.

If we maintain the provisions at 3% of debtors, then the provision would be increased to 3% x £16,000 = £480. However, because there is already a provision in existence of the £450, we simply need to add on another £30 to the credit side of the provision for doubtful debts account.

Provision for doubtful debts

2001 - £ 2001 - £

Dec 31

Balance c/d 450 Dec 31

Profit & loss 450

2002 - - 2002 - -

Dec 31

Balance c/d 480 Jan 1 Balance b/d 450

- - - Dec 31

Profit & loss 30

- - 480 - - 480

Therefore the rule for increasing the provision is as follows:

Debit Credit

Profit & loss Provision for bad debts

with the increase in the provision with the increase in the provision

Profit and Loss Account (extract) for the year ended 31 December 2002

-

- £

Gross profit xxx

Less Expenses: -

Provision for doubtful debts 30

Balance sheet (extract) as at 31 December 2002 - -

Current assets £ £

Debtors 16,000 -

Less Provision for doubtful debts 480 15,520

Reducing the provisionThe provision is always shown as a credit balance. Therefore, to reduce it we would need a debit entry in the provision account. If the firm's debtors figure was lower than in the provision year, or the firm had decided that there was a reduced risk of bad debts then the firm may wish to reduce the overall provision.

In our example, on 31 December 2003, the debtors figure was £14,000, and the provision was to be maintained at 3% of debtors. This means that the provision would be reduced down to £14,000 x 3% = £420.

As the outstanding credit balance on the provision for doubtful debts account is £480, we will need to debit that account in order to reduce the provision. This is completed as follows:

Provision for doubtful debts

2001 - - 2001 - £

Dec 31

Balance c/d 450 Dec 31

Profit & loss 450

2002 - - 2002 - -

Dec Balance c/d 480 Jan 1 Balance b/d 450

31

- - - Dec 31

Profit & loss 30

- - 480 - - 480

2003 - - 2003 - -

Dec 31

Profit & loss 60 Jan 1 Balance b/d 480

Dec 31

Balance c/d 420 - - -

- - 480 - - 480

- - - 2004 - -

- - - Jan 1 Balance b/d 420

The entries needed for when the provision is to be reduced are as follows:

Debit Credit

Provision for bad debts

with the decrease in the provision

Profit & loss

with the decrease in the provision

Profit and Loss Account (extract) for the year ended 31 December 2003

-

- £

Gross profit xxx

Add -

Reduction in provision for doubtful debts 60

Balance sheet (extract) as at 31 December 2002 - -

Current assets £ £

Debtors 14,000 -

Less Provision for doubtful debts 420 13,580

For non-bookkeeping students...Even if you are not using the bookkeeping entries in this module, the rules for accounting for the provisions for doubtful debts can still confuse. As long as you remember then distinction between the entries in the profit & loss account and the entry for the balance sheet than you should be alright.

Profit & loss account Balance sheet

Show change in provision for doubtful debts only:

Increases = expense Decreases = revenue

Deduct full provision from debtors figure - show workings in current assets

Bad debts recovered

It is not uncommon for a debt written off in previous years to be recovered in later years. The entries needed to record this can be split into two stages:

First reinstate the balance on the debtors account in the sales ledgerThis may appear odd, but the main reason for restoring the balance on the debtor's account is to give a more detailed record of the debtor's 'history'. The fact that the bad debt has been recovered may influence the decision in the future as to whether the firm offers credit terms to this same customer again.

Entry to reinstate the balance on the debtor's account

Debit Credit

Debtor's account

Bad debts recovered account

Show the effect of the payment being received in the cashbook and in the debtors accountPayment received from debtors

Debit Credit

Cash/bank Debtor's

account

At the end of the financial year, the credit balance in the bad debts recovered account will normally be transferred to the credit side of the profit and loss account (as income)- it would be added on to the gross profit

Normally, we try to match income to the period in which it was generated, or the expense to when it was incurred. However, with bad debts recovered this procedure is ignored. Rather than add the bad debt recovered as income for the period in which the sale was made, we include the income in the period in when it was recovered instead.

To summarise: Bad debts recovered

Trial balance entry

Effect on net profit

Credit Added as income

Exam tips - bad debts and provision for bad debts

Remember, it is the change in the provision that will appear in the profit and loss account.

The full provision will be deducted on the balance sheet.

Although related, it will be easier if you treat the bad debts and the provision for any bad debts as completely separate items when making calculations.

This topic can be integrated into the construction of the final accounts.

Meaning of depreciation

Fixed assets are those assets, which are:

1. of long life, and

2. to be used in the business, and

3. not bought with the main purpose of resale.

Although they represent an expense when they are purchased in the sense that they cost money, purchases of fixed assets are items of capital expenditure and therefore will not appear directly in the profit and loss account during the period in which they are acquired. However, we still need to show the effect of a fixed asset purchased in the final accounts and this is achieved through the use of depreciation.

The main reason for charging depreciation to the profit and loss account is to satisfy the accruals concept - that the profit and loss account should reflect the expense incurred in that period of time. Therefore if an asset is used over a period of time then there should be a charge in the profit and loss account to reflect this usage. However, depreciation is not really a 'true' expense because it does not involve any cash being paid out by the firm. Depreciation is actually a provision not an expense. This means that it is supposed to represent an amount equal to the loss in value of the asset.

Therefore, when a fixed asset is purchased we will not enter the full purchase price of the asset as a profit and loss account expense. We will, however, enter a proportion of the asset's charge as a depreciation provision, for each year that we make use of the asset. This provision will appear as an expense and will also be deducted from the value of the asset on the balance sheet - in order to show the reduced value

Causes of depreciation

Why do assets lose value over time? The main reasons to explain a loss in value are as follows:

1. Wear & tear

2. Obsolescence

3. Passage of time

4. Depletion Wear and tearMost fixed assets will deteriorate over time (i.e. they wear out). This is especially true for vehicles, machinery and equipment. Property does not wear out as quickly and land may never wear out. Freehold land - land that is owned outright - does not have to be depreciated).

ObsolescenceAdvances in technology will mean that assets will lose value. This is because, as new innovations are launched into an industry, assets using older technology will become out of date and therefore will have less value. This does not mean that the equipment is worthless, some firms

may buy the older assets and use them because they cannot afford to buy new up-to-date equipment.

Passage of timeIntangible assets are those which do not exist in a physical sense. Leasehold property and goodwill are examples of intangible fixed assets. These assets may have a legal life fixed in terms of years. For instance, you may agree to rent some buildings for 20 years. This is normally called a lease. After twenty years has elapsed the lease is worth nothing to you, as it has finished. Whatever you paid for the lease is now of no value.

A patent allows the holder to exploit an innovation or invention for a fixed period time (usually 16 years) without any threat of others copying. This could also be considered a fixed asset - if it is purchased, as it is likely to help the firm to generate more income in the future. Here though, instead of using the term depreciation, the term amortisation is often used for these intangible assets.

DepletionSome assets, especially land, will lose value as they are used more and more. For example, a mine will lose value the more the resources are extracted from beneath the surface. Therefore it is the rate at which the resources are depleted which will determine how quickly the asset loses its value.

What happens if the depreciation is wrong?

No one can accurately determine the value of a tangible fixed asset in a number of years time. Depreciation is based on estimated values. Estimates are made for the expected lifespan and any scrap value that might be received for the asset when it has reached ht end of its useful life. Neither of these is likely to be known with certainty. Does this matter?

It would be ideal if the asset did last as long as was estimated. However, this is not a crucial issue. As long as the estimate that is made is realistic then it does not matter. If the asset does not last as long as was expected then when the asset is disposed of, the firm would include, the loss of the value as an expense (the loss would be based on what the asset was worth at that moment in time - the net book value).

Similarly, if the asset last longer than was expected then the asset would appear to have no value according to the firm's accounts. This is not a problem. For many years, the entire fleet of Concorde (the supersonic jet) was valued on British Airways' balance sheet as having zero value.

If the lifespan of an asset is estimated to be longer then the annual depreciation expense will be smaller - as the value of the asset is 'spread'

over a longer period of time. This means that a smaller amount will appear in more years than if a shorter lifespan had been estimated. Some firms have been accused of using this as a means of 'window dressing' their accounts - by exaggerating the lifespan of an asset, the profits can be higher by only charging a smaller amount of deprecation against the annual profits. Auditors are supposed to check this and question any unusually long estimates for expected lifespan.

If the depreciation policy (the method, the lifespan, and so on) is suspected to be highly misleading then it is possible for the firm to change methods. However, the concept of consistency means that the change should be a one-off change, and the change should be disclosed in the 'notes to the accounts' in the annual report and accounts of the company (only for limited companies).

Depreciation and accounting concepts

According to the historical cost concept. All fixed assets should be shown at cost value. However, all fixed assets, with the exception of land, should be subject to depreciation.

The prudence concept states that we should not overstate the value of our assets and therefore depreciation is the method by which we show a more realistic value for asset. Some students are under the impression that the depreciation of assets is undertaken purely to show realistic value for fixed assets. This is not the case. The main reason for providing for depreciation is concerned with the matching concept.

The matching concept (also known as the accruals concept) implies that business costs and revenues should always be accounted for in the period in which they are incurred. If a firm has to pay annual rent, then this expense will appear in that year's profit and loss account - even if not all of it has yet been paid. Likewise, we include sales as income for a period - even if the debtors have not yet sent us the money for the sales.

Similarly, the cost of a fixed asset should only be included as an expense for the period in which we benefit from he use of the asset. However, if we benefit for many years then we should spread the cost of the asset over this longer lifespan - i.e. through the use of annual depreciation. All items of capital expenditure will not appear as an expense in the period in which they are purchased but will be 'written off' over their useful life.

Finally, once a depreciation method is selected, the policy should not be changed. This is an application of the concept of consistency. This states that changing methods would make comparisons with previous year's

account much harder and could be subject to distortions. Therefore changes should only take place in unusual circumstances.

Appreciation

What about the assets that increase (appreciate) in value? It is normal accounting procedure to ignore any such appreciation, as to bring appreciation into account would be to contravene both the historical cost concept and the prudence. Nevertheless, in certain circumstances appreciation is taken into account in partnership and limited company accounts, but this is left until partnerships and limited companies are considered.

There is an intense and lasting debate on this issue within the accounting profession. The profession appears generally to have accepted the use of 'current values' on the basis that this gives more meaningful information to the users of the statements. The system used in the UK at present can best be described as a 'hybrid' one which uses a mixture of historical cost and revaluations. At present the choice is left to the preparers of the statements.

Methods of calculating depreciation

There are a variety of different methods used by firms when calculating the depreciation for fixed assets. However, the two main methods in use are:

1. Straight line method

2. Reducing balance method

We will consider how each of these two methods is calculated

Straight-line method

This method, also known as the fixed instalment method, is the most commonly used method of depreciation. It is also the easiest method to account for.

Once the annual depreciation provision has been calculated, this will remain the same for each year the asset is in use. The formula for calculating the annual rate of depreciation is as follows:

The scrap value (sometimes known as either residual value or disposal value) will, in most cases be an estimate. It is common, keeping in line with prudence to have a zero scrap value - due to the uncertainty of any estimate.

Example 1A delivery vehicle was bought for £25,000 and we thought we would keep it for five years and then trade it in for £3,000 (in effect the trade in value becomes the scrap value).

Once you have had a go at this, check your answer against ours. If you have made some mistakes, make sure you work out carefully where you have gone wrong.

Straight-line as a percentageIt is fairly common to express straight-line depreciation as a percentage. This simply means that a percentage of the original cost of the asset will be charged as the deprecation. For example, if an asset cost £10,000 and depreciation is to be calculated at 10% on cost - this would mean that we should charge 10% x £10,000 (£1,000) as the annual deprecation for each year that we have the asset.

The percentage quoted under the straight-line method will also tell us how long we expect the asset to last, for example:

10% - 10 years

25% - 4 years

20% - 5 years

Reducing balance method

In this method, the annual deprecation is based on a percentage of the asset's net book value (i.e. what the asset is worth in the firm's accounts). The net book value of an asset is calculated as follows:

Net book value = original cost - accumulated depreciation

As the deprecation charged against an asset builds up over time, the net book value of an asset would decrease. Therefore, although the percentage used in this method remains constant, the depreciation charge (in £) will become smaller, the longer we have the asset.

This method is also known as the diminishing or declining balance method.

The percentage rates chosen for reducing balance may seem as if they are chose randomly, without any real explanation. There is a formula which takes into account the cost, the scrap value, the expected lifespan of the assets. This formula calculates the percentage that should be used. We do not include it here because it is not a requirement of the course for you to know the formula and it is, without any doubt, one of the most complicated formulas you would be likely to see.

With both methods, there may be variations used. Some firms will charge depreciation for each month that the asset is owned. In this case, an asset bought half way through the year would only have half of one year's depreciation charged for it. Some firms may charge a full year's depreciation for any assets, regardless of whether it was owned for the full year. Some firms will not charge depreciation in the year of sale, or in the year of purchase. Each question should tell you which of these rules the firm is applying - keep on the look out!

Example 2Equipment is bought for £15,000 and depreciation is to be charged at 20 per cent per annum using the reducing balance method

Remember, both methods can be quoted using percentages for the depreciation.

Straight line is a percentage of the cost of the asset

Reducing balance is a percentage of the net book value of the asset.

Choice of method

Notice that with the reducing balance method, the depreciation provision per year will start off relatively large and will gradually get smaller. It has been commented that this method of depreciation is superior to the straight-line method because it is more realistic with asset valuations - assets do lose more of their value in the earlier rather than the later years. However, the counterargument is that calculating annual amounts for depreciation should not be primarily concerned with providing realistic values for asset

values - it is simply a way of 'spreading' the cost of the asset over its useful life.

Example 3A firm has just bought a machine for £30,000. It will be kept in use for four years, and then it will be disposed of for an estimated amount of £2,000. They ask for a comparison of the amounts charged as depreciation using both methods.

Straight-line method: (£30,000 - £2,000) ( 4 = £7,000 per annum Reducing balance method: 50 per cent will be used.

Have a go at calculating the figures for both methods and then follow the answer link below to see how you got on.

Depreciation adjustments for profits and

balance sheets

Once you have mastered the ability to calculate depreciation, you will then need to enter this into the double entry accounts. As with other provisions, depreciation will always be a credit balance.

All provisions are credit balances

Unlike the provision for doubtful debts, the total depreciation provision is never reduced (unless a mistake has been made) and therefore, we will only credit the depreciation account, while we have the asset.

The double entry record for annual depreciation is as follows:

Debit Credit

Profit & loss Provision for depreciation

No entry is ever made in the actual asset account - unless we decide to purchase more of the same type of asset, or decide the sell some of this type of asset.

The double entry tells us that the depreciation charge will appear on the debit side of the profit and loss account as though we were paying an expense. However, the credit

balance on the provision for depreciation account will be kept and maintained, and added to, as long as the firm still has the relevant asset.

Example 1

On 1 January 2001, a firm purchases a machine for £10,000, paying by cheque. It chooses to depreciate the machine at 25% on cost using the straight-line method.

Show the asset, the provision for depreciation account and the extracts from the balance sheet for each of the four years, the firm has the asset for.

AnswerThe annual depreciation will be 25% x £10,000 = £2,500 (i.e. the machine is expected to last for four years).

The entry in the asset account is easy, it will look as follows:

Machinery

2001 - - 2001 - £

Jan 1 Bank 10,000 Dec 31

Balance c/d 10,000

This balance will be carried forward in this account until the firm either sells the machine or buys more machinery.

The first entry in the provision for depreciation account would appear as follows:

Provision for depreciation

2001 - - 2001 - £

Dec 31

Balance c/d 2,500 Dec 31

Profit & loss 2,500

The profit and loss account is therefore 'charged' with £2,500. We know it is a 'charge' because given the credit entry in the provision for depreciation account, the other half of the entry will be on the debit side of the profit and loss account

The balance on this account is carried forward (unlike expense accounts which are normally 'emptied' at the end of each year and transferred in full to the profit and loss account) and added to in each of the next three years. The full account for the four-year period would appear as follows:

Provision for depreciation - machinery

2001 - - 2001 - £

Dec 31

Balance c/d 2,500 Dec 31

Profit & loss 2,500

2002 - 2002 -

Dec 31

Balance c/d 5,000 Jan 1 Balance b/d 2,500

- - - Dec 31

Profit & loss 2,500

- - 5,000 - - 5,000

2003 - 2003 -

Dec 31

Balance c/d 7,500 Jan 1 Balance b/d 5,000

- - - Dec 31

Profit & loss 2,500

- - 7,500 - - 7,500

2004 - 2004 -

Dec 31

Balance c/d 10,000 Jan 1 Balance b/d 7,500

- - - Dec 31

Profit & loss 2,500

- - 10,000 - - 10,000

Although the charge to the profit and loss account stays the same at £2,500, the accumulated total on the above 'provision' account will increase each year. This is illustrated on the balance sheet where the closing balance is deducted from the cost of the asset to give the net book value of the asset at that moment in time:

Balance sheet (extract) as at 31 December 2001

- -

Fixed assets £ £

Machinery 10,000 -

Less Provision for depreciation 2,500 7,500

Balance sheet (extract) as at 31 December 2002

- -

Fixed assets £ £

Machinery 10,000 -

Less Provision for depreciation 5,000 5,000

Balance sheet (extract) as at 31 December 2003

- -

Fixed assets £ £

Machinery 10,000 - Less Provision for depreciation

7,500 2,500

Balance sheet (extract) as at 31 December 2004

- -

Fixed assets £ £

Machinery 10,000 -

Less Provision for depreciation 10,000 0

Calculation of profits and losses on asset

disposal

Purchases of fixed assets do not appear as expenses in the profit and loss account because they are items of capital expenditure. The 'cost' of the asset will appear over a number of years as provisions made for the depreciation of the fixed assets. Similarly, when a fixed asset is sold, we do not include the income form the sale of the asset in the profit and loss

account because it is capital income. What we do include is the profit or loss on the sale of the fixed asset.

The profit or loss on the sale of any fixed asset is calculated as follows;

Profit on disposal = selling price of asset - net book value of the asset

The net book value represents what the asset is 'worth' at the moment of the sale and it is calculated as follows:

Net book value = cost of asset - accumulated depreciation

The accumulated depreciation is all the depreciation that has been 'charged' on the asset right up until the moment of the sale.

If an asset is sold during a financial year then calculating the accumulated deprecation can be completed. Some firms will use a fractional depreciation policy which means they would charge depreciation for each portion of a year. For example, if the asset was sold after three months of a financial year's starting date, then one quarter of a full years (3 months is a quarter of one year) depreciation would be charged for. This is sometimes referred to as deprecation being charged on 'a monthly basis'.

Some firms prefer to keep it simple and only charge a full year's depreciation regardless of when the sale actually occurs. Any examination question will guide you as to what method will be used.

Therefore, if the net book value is higher than the selling price of the asset, a loss will be made on the sale. The sale of fixed assets is referred to as the disposal of assets. This will include situations where the asset is part of a 'trade in' deal, where a new asset is acquired in part exchange for the old asset.

The treatment of the profit or loss on the asset disposal will be as follows:

- Profit & loss Treated as:

entry

Profit on disposal

Credit Income - added on to profits

Loss on disposal

Debit Expense - deducted from profits

There are three main steps in the calculation of the profits and loss on the disposal of the asset. These are as follows:

1. Calculate the annual deprecation for the asset.

2. Calculate the accumulated deprecation on the asset

3. Calculate the net book value of the asset.

4. The profit or loss on the disposal can be calculated by

comparing the net book value with the selling price of

the asset.

Example 1

A machine was bought on 1 January 2001 for £9,000. Depreciation was to be provided for at 20% on cost (straight line method) on a monthly basis. On 30 June 2003 the machine was sold for £5,000 cash.

AnswerThe profit on the disposal is calculated as follows:

1. The annual deprecation provided on this machine is

20% of £9,000 = £1,800

2. The accumulated deprecation is the annual deprecation

over a 2 1/2 year period = £1,800 x 2 1/2 = £4,500

3. The net book value will be: cost - accumulated

depreciation, i.e. £9,000 - £4,500 = £4,500.

4. The profit on the asset disposal will therefore be:

£5,000 - £4,500 = £500 profit.

This £500 profit would appear as income in the profit and loss account for this period.

Bookkeeping entries for asset disposal

As far as any examination goes, whether you use the non-bookkeeping method or the bookkeeping method it does not matter. It is the final answer, and the workings that support that answer which will gain marks.

The profit or loss on disposal can be calculated thorough the use of an asset disposal account. This uses double-entry transactions to work out if a profit or loss has been made on the disposal.

Example 1

A machine was bought on 1 January 2001 for £9,000. Depreciation was to be provided for at 20% on cost (straight line method) on a monthly basis. On 30 June 2003 the machine was sold for £5,000 cash.

If we use bookkeeping, then we would need to see the state of the relevant accounts at the moment of sale. These would be as follows:

Machinery

2003 - - 2003 - £

Jan 1 Balance b/d 9,000 - - -

Provision for depreciation - machinery

2003 - - 2003 - £

- - - Jun 30 Balance b/d 4,500

To record the disposal of a fixed asset, we need to eliminate all the entries relating to this asset in the ledger accounts. This can be achieved as follows:

1. Credit the relevant asset account

2. Debit the depreciation account (with the amount

provided on this asset)

In our example, the ledger accounts would appear as follows:

Machinery

2003 - - 2003 - £

Jan 1 Balance b/d 9,000 Jun 30 Machinery disposal

9,000

Provision for depreciation - machinery

2003 - £ 2003 - £

Jun 30 Machinery disposal

4,500 Jun 30 Balance b/d 4,500

Notice how each entry will also appear in a new account - machinery disposal. This asset disposal account is opened to deal with the disposal of any fixed asset. Once the profit or loss on the disposal has been calculated then this account is closed off.

Machinery disposal

2003 - - 2003 - £

Jun 30 Machinery

9,000 Jun 30 Machinery deprecation

4,500

Notice that the disposal account is taking the other half of the double entry for the entries made in the cost and provision accounts. The cash received from the sale is also entered into the disposal account. This is debited to the cashbook and therefore is credited to the disposal account. This is shown below:

Machinery disposal

2003 - - 2003 - £

Jun 30 Machinery

9,000 Jun 30 Machinery deprecation

4,500

- - - Jun 30 Cash 5,000

This account is now closed off. If there were no outstanding balance then this would mean that the asset has been sold for exactly the same amount as its net book value. This means there is no profit or loss on this sale and no further entries are required.

However, in our example, there is an outstanding balance on the account. This amount represents the profit or loss on the disposal. We finish off the disposal account as follows:

Machinery disposal

2003 - - 2003 - £

Jun 30 Machinery 9,000 Jun 30 Machinery deprecation

4,500

Jun 30 Profit & loss

500 Jun 30 Cash 5,000

- - 9.500 - - 9,500

The £500 'balancing figure' represents the profit made on the sale

How do we know it is a profit? Well, this is because if it is on the debit side of the disposal account, then it must be on the credit side of the profit and loss account - which means it is added on to the profit.