Accounting for Assets

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Learning Objectives

By the end of this chapter, students should be able to:

• Explain what assets are and why they are important in accounting
• Classify assets into current and non-current assets
• Account for cash, receivables, and allowances for doubtful debts
• Apply inventory valuation methods (FIFO, LIFO, Weighted Average)
• Account for Property, Plant and Equipment (PPE)
• Calculate and record depreciation using straight-line and reducing balance methods
• Present assets correctly in financial statements

7.1 Meaning of Assets

An asset is a resource controlled by a business as a result of past events, from which future economic benefits are expected to flow to the business. This definition, based on the IASB Conceptual Framework, contains three essential criteria: control, past event, and future economic benefit.

Examples of Assets

• Cash in hand and at bank
• Inventory (goods held for resale)
• Accounts receivable (trade debtors)
• Buildings, machinery, vehicles
• Furniture and equipment
• Investments in other companies
• Patents and trademarks

Assets are reported on the Statement of Financial Position (Balance Sheet) and represent the economic resources that a business uses to generate revenue.

7.2 Classification of Assets

Assets are classified into current assets and non-current assets based on their expected period of use and conversion to cash. This classification is crucial for assessing a company's liquidity and financial structure.

7.2.1 Current Assets

Current assets are assets expected to be converted into cash, sold, or consumed within one operating cycle or 12 months (whichever is longer) from the reporting date.

Examples:

• Cash and cash equivalents
• Trade and other receivables
• Inventory Prepaid expenses
• Short-term investments

Key Characteristic: High liquidity – can be quickly turned into cash to meet short-term obligations.

7.2.2 Non-Current Assets

Non-current assets are assets expected to be used for more than one accounting period and are not held primarily for resale.

Examples:

• Land and buildings
• Machinery and equipment
• Motor vehicles
• Furniture and fittings
• ·Intangible assets (patents, goodwill)
• Long-term investments

Key Characteristic: Provide long-term benefits and are essential for ongoing operations.

7.3 Accounting for Cash and Receivables

7.3.1 Cash and Cash Equivalents

Cash includes:

• Cash in hand (petty cash)
• Cash at bank (current accounts)
• Cash equivalents (short-term, highly liquid investments with maturities ≤ 3 months)

Internal Control: Strong internal controls over cash are essential to prevent fraud and error. These include segregation of duties, regular reconciliations, and physical security measures.

7.3.2 Trade Receivables

Trade receivables (debtors) are amounts owed to the business by customers who purchased goods or services on credit.

                 Journal Entry for Credit Sale:

Dr Trade Receivables        £X,XXX

   Cr Sales Revenue                £X,XXX

                Subsequent Collection:

Dr Cash/Bank               £X,XXX

   Cr Trade Receivables           £X,XXX

7.3.3 Allowance for Doubtful Debts

Not all credit customers will pay. The prudence concept requires businesses to account for potential losses from uncollectible debts.

Purpose:

• · Apply the matching principle (match bad debt expense with related revenue)
• · Prevent overstatement of assets and profit
• · Present receivables at their estimated realizable value

                Creating/Adjusting the Allowance:

Dr Bad Debts Expense            £XXX

   Cr Allowance for Doubtful Debts    £XXX

            Writing Off a Specific Bad Debt:

Dr Allowance for Doubtful Debts £XXX

   Cr Trade Receivables                £XXX

                      Balance Sheet Presentation:

Trade Receivables                 £XX,XXX

Less: Allowance for Doubtful Debts   (£XXX)

------------------------------------------

Net Trade Receivables             £XX,XXX

7.4 Inventory Valuation Methods

Inventory should be measured at the lower of cost and net realizable value (NRV). NRV = Estimated Selling Price - Estimated Costs to Complete and Sell.

7.4.1 FIFO (First-In, First-Out)

Assumes the earliest goods purchased are the first sold.

Characteristics:

• Ending inventory valued at most recent purchase prices
• Cost of sales based on older costs
• Common for perishable goods (food, pharmaceuticals)
• Permitted under IFRS and most GAAPs

Effect in Inflation: Results in lower cost of sales and higher reported profit compared to other methods.

7.4.2 LIFO (Last-In, First-Out)

Assumes the most recent purchases are sold first.

Characteristics:

• Ending inventory valued at older costs
• Cost of sales reflects recent prices
• Not permitted under IFRS (but allowed under US GAAP)
• Can create distorted balance sheet values during inflation

Effect in Inflation: Results in higher cost of sales and lower reported profit.

7.4.3 Weighted Average Cost

Calculates an average cost per unit for all goods available.

Formula:

Weighted Average Cost = Total Cost of Goods Available ÷ Total Units Available

Characteristics:

• Smooths out price fluctuations
• Simple to apply, especially with computerized systems
• Ending inventory and cost of sales at same average rate
• Permitted under IFRS

Advantages:

• Neutral effect during price changes
• Reduces profit manipulation opportunities
• Easier to apply for homogeneous inventory items

7.5 Accounting for Property, Plant and Equipment (PPE)

Property, Plant and Equipment (PPE) are tangible non-current assets that:

• · Are held for use in production/supply of goods/services
• · Are expected to be used for more than one period
• · Are not intended for sale in the ordinary course of business

Examples of PPE

• Land and buildings
• Machinery and plant
• Vehicles
• Office equipment
• Furniture and fittings

Initial Recognition of PPE

PPE is initially recorded at cost, which includes all expenditures necessary to bring the asset to its intended location and condition for use.

Elements of Cost:

• Purchase price (less trade discounts/rebates)
• Import duties and non-refundable taxes
• Directly attributable costs (installation, assembly, testing)
• Professional fees (architects, engineers)
• Estimated costs of dismantling/removal (if applicable)

                   Journal Entry on Acquisition:

Dr PPE (appropriate asset account)    £XX,XXX

   Cr Cash/Bank/Payables                     £XX,XXX

7.6 Depreciation of Non-Current Assets

Meaning of Depreciation

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. It is a process of cost allocation, not asset valuation.

Reasons for Depreciation:

• Physical wear and tear from use
• Technical/economic obsolescence
• Passage of time
• To apply matching principle (match cost with revenue generated)

Key Depreciation Terms

• Cost: Purchase price plus directly attributable costs
• Residual Value: Estimated amount receivable from disposal at end of useful life
• Useful Life: Period over which asset is expected to be available for use
• Depreciable Amount: Cost minus residual value
• Carrying Amount (Net Book Value): Cost minus accumulated depreciation

7.6.1 Straight-Line Method

Charges equal depreciation expense each year over the asset's useful life.

Formula:

Annual Depreciation = (Cost – Residual Value) ÷ Useful Life

Example:

• Machine cost: £25,000
• Residual value: £5,000
• Useful life: 5 years

Annual depreciation = (£25,000 - £5,000) ÷ 5 = £4,000

                       Journal Entry (annual):

Dr Depreciation Expense           4,000

   Cr Accumulated Depreciation          4,000

Advantages: Simple, easy to calculate, appropriate for assets with uniform benefits.

7.6.2 Reducing Balance Method

Charges higher depreciation in early years, calculated as fixed percentage of carrying amount.

Formula:

Annual Depreciation = Carrying Amount × Depreciation Rate

Example:

• Vehicle cost: £30,000
• Depreciation rate: 40%
• No residual value

Year 1: £30,000 × 40% = £12,000 depreciation

Year 2: (£30,000 - £12,000) × 40% = £7,200 depreciation

Year 3: (£18,000 - £7,200) × 40% = £4,320 depreciation

Appropriate for: Assets that lose more value in early years (vehicles, technology).

Choice of Depreciation Method

The method should reflect the pattern of consumption of the asset's economic benefits. Companies must apply their chosen method consistently and disclose it in their accounting policies.

7.7 Presentation in Financial Statements

Balance Sheet Presentation

STATEMENT OF FINANCIAL POSITION (extract)

As at 31 December 2023

NON-CURRENT ASSETS

Property, Plant and Equipment

   Cost                                            XXX,XXX

   Less: Accumulated depreciation                 (XX,XXX)

   Carrying amount                                            XXX,XXX

CURRENT ASSETS

Inventories                                                     XX,XXX

Trade and other receivables

   Trade receivables                                XX,XXX

   Less: Allowance for doubtful debts               (X,XXX)

   Net trade receivables                                       XX,XXX

Cash and cash equivalents                                       XX,XXX

                                                              --------

TOTAL ASSETS                                                   XXX,XXX

Income Statement Impact

• Depreciation expense appears in the income statement, reducing profit
• Bad debt expense from allowance adjustments reduces profit
• Cost of sales includes cost of inventory sold
• Inventory write-downs to NRV are recognized as expenses

Disclosure Requirements

Notes to financial statements must disclose:

• Measurement bases (e.g., cost model for PPE)
• Depreciation methods, rates, and useful lives
• Inventory valuation methods
• Reconciliation of carrying amounts for each class of PPE
• Details of allowances for doubtful debts

Worked Numerical Examples

Example 1: Inventory Valuation Comparison

ABC Ltd reports the following inventory transactions for March:

• Mar  1: Opening stock - 100 units @ £10 each
• Mar 10: Purchases - 200 units @ £12 each
• Mar 20: Purchases - 150 units @ £14 each
• Mar 31: Sales - 300 units

Calculate closing inventory and cost of sales using:

a) FIFO

b) Weighted Average Cost

Solution:

Total units available = 100 + 200 + 150 = 450 units

Total cost = (100×£10)+(200×£12)+(150×£14) = £1,000+£2,400+£2,100 = £5,500

Closing units = 450 - 300 = 150 units

a) FIFO:

   Closing inventory = 150 units from latest purchase @ £14 = £2,100

   Cost of sales = £5,500 - £2,100 = £3,400

b) Weighted Average:

   Average cost = £5,500 ÷ 450 = £12.22 per unit

   Closing inventory = 150 × £12.22 = £1,833

   Cost of sales = £5,500 - £1,833 = £3,667

Example 2: Depreciation Calculations

A machine costs £48,000, has a residual value of £8,000, and a useful life of 8 years.

Calculate annual depreciation using:

a) Straight-line method

b) Reducing balance method (25% rate)

Solution:

a) Straight-line:

   Depreciable amount = £48,000 - £8,000 = £40,000

   Annual depreciation = £40,000 ÷ 8 = £5,000

b) Reducing Balance (first 3 years only):

   Year 1: £48,000 × 25% = £12,000 depreciation

   Year 2: (£48,000 - £12,000) × 25% = £36,000 × 25% = £9,000

   Year 3: (£36,000 - £9,000) × 25% = £27,000 × 25% = £6,750

Example 3: Allowance for Doubtful Debts

At year-end, Trade Receivables are £85,000. The Allowance for Doubtful Debts has a credit balance of £2,000. Based on an aging analysis, the required allowance is estimated at 5% of receivables.

Calculate:

a) Required allowance

b) Adjustment needed

c) Journal entry

Solution:

a) Required allowance = £85,000 × 5% = £4,250

b) Existing allowance = £2,000 credit

   Additional allowance needed = £4,250 - £2,000 = £2,250

c) Journal Entry:

   Dr Bad Debt Expense        2,250

      Cr Allowance for Doubtful Debts  2,250

Exam-Style Questions and Model Answers

Question 1 (6 marks)

Define an asset according to the IASB Conceptual Framework and give three examples.

Model Answer:

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. (2 marks)

Three examples:

1. Cash at bank (1 mark)

2. Inventory of finished goods (1 mark)

3. Factory machinery (1 mark)

4. Trade receivables from customers (1 mark)

   (Any three appropriate examples)

Question 2 (8 marks)

Differentiate between current and non-current assets, providing two examples of each and explaining why this classification is important.

Model Answer:

Current assets are assets expected to be converted into cash, sold, or consumed within one operating cycle or 12 months (whichever is longer). Examples include inventory and trade receivables. (3 marks)

Non-current assets are assets expected to be used for more than one accounting period and are not held primarily for resale. Examples include land and buildings, and machinery. (3 marks)

This classification is important because it helps users assess the company's liquidity (ability to meet short-term obligations) and financial structure (how the business is financed for long-term operations). (2 marks)

Question 3 (10 marks)

Beta Ltd has the following inventory transactions for April:

• April 1: Opening inventory 200 units @ £15
• April 10: Purchase 300 units @ £16
• April 20: Purchase 400 units @ £17
• April 30: Sales 600 units

Required:

a) Calculate closing inventory using FIFO method (3 marks)

b) Calculate closing inventory using Weighted Average method (4 marks)

c) State which method gives the higher profit when prices are rising, and explain why (3 marks)

Model Answer:

a) FIFO:

Units available = 200+300+400 = 900 units

Units sold = 600 units

Closing units = 300 units

FIFO assumes earliest purchases sold first, so closing inventory = most recent purchases:

300 units from April 20 purchase @ £17 = £5,100 (3 marks)

b) Weighted Average:

Total cost = (200×£15)+(300×£16)+(400×£17) = £3,000+£4,800+£6,800 = £14,600

Average cost = £14,600 ÷ 900 = £16.22 per unit

Closing inventory = 300 × £16.22 = £4,866 (4 marks)

c) FIFO gives higher profit when prices are rising (1 mark). This is because under FIFO, the older (lower) costs are charged to cost of sales (1 mark), leaving the newer (higher) costs in inventory, resulting in lower cost of sales and therefore higher reported profit (1 mark).

Question 4 (12 marks)

A delivery van was purchased on 1 January 2022 for £35,000. It has an estimated useful life of 5 years and a residual value of £5,000.

Required:

a) Calculate annual depreciation using the straight-line method (2 marks)

b) Prepare a depreciation schedule for the first three years using the reducing balance method at 30% (6 marks)

c) Explain two reasons why a business might choose the reducing balance method for vehicles (4 marks)

Model Answer:

a) Straight-line:

Annual depreciation = (£35,000 - £5,000) ÷ 5 = £6,000 (2 marks)

b) Reducing Balance Schedule:

Year 1: £35,000 × 30% = £10,500 depreciation

Carrying amount = £35,000 - £10,500 = £24,500 (2 marks)

Year 2: £24,500 × 30% = £7,350 depreciation

Carrying amount = £24,500 - £7,350 = £17,150 (2 marks)

Year 3: £17,150 × 30% = £5,145 depreciation

Carrying amount = £17,150 - £5,145 = £12,005 (2 marks)

c) Reasons for choosing reducing balance:

1. Matches economic benefits: Vehicles typically lose more value in early years due to rapid depreciation when new and higher maintenance costs as they age. (2 marks)

2. Matches revenue pattern: If the vehicle generates more revenue in early years (e.g., delivery van when newest and most reliable), higher depreciation in early years better matches expenses with revenues. (2 marks)

Question 5 (8 marks)

Explain the purpose of creating an allowance for doubtful debts and describe how it affects:

a) The income statement (3 marks)

b) The statement of financial position (3 marks)

c) State the accounting concept being applied (2 marks)

Model Answer:

The allowance for doubtful debts is created to account for estimated losses from customers who may not pay their debts. It applies the prudence concept by not overstating assets or profit. (2 marks)

a) Income statement effect: The increase in the allowance is recorded as a bad debt expense, which reduces the profit for the period. This matches the potential loss with the revenue earned from the credit sales in the same period. (3 marks)

b) Statement of financial position effect: The allowance is deducted from gross trade receivables to show net trade receivables at their estimated realizable value. This presents a more realistic amount that the business expects to actually collect. (3 marks)

c) The prudence (conservatism) concept is being applied, which requires that losses are recognized as soon as they are anticipated, but profits are only recognized when realized. (2 marks)

Question 6 (6 marks)

A company purchases machinery for £80,000 on 1 January 2023. Installation costs are £5,000 and delivery costs are £2,000. The machinery has a useful life of 10 years and a residual value of £7,000.

Required:

a) Calculate the cost of the machinery for accounting purposes (2 marks)

b) Calculate the annual depreciation using straight-line method (2 marks)

c) Prepare the journal entry to record the depreciation for the first year (2 marks)

Model Answer:

a) Cost of machinery:

Purchase price      £80,000

Installation          £5,000

Delivery              £2,000

Total cost      £87,000 (2 marks)

b) Annual depreciation:

Depreciable amount = £87,000 - £7,000 = £80,000

Annual depreciation = £80,000 ÷ 10 = £8,000 (2 marks)

c) Journal entry:

Dr Depreciation Expense           8,000

   Cr Accumulated Depreciation          8,000

(2 marks)

Key Takeaways

1. Assets are economic resources controlled by a business that provide future benefits
2. Classification into current/non-current helps assess liquidity and financial structure
3. Receivables require allowance for doubtful debts to present realistic values
4. Inventory is valued at lower of cost and NRV using FIFO or weighted average
5. PPE is capitalized at cost and depreciated over useful life
6. Depreciation allocates asset cost; choice of method affects reported profit
7. Presentation in financial statements follows specific formats with required disclosures

                   Common Mistakes to Avoid

✗ Confusing depreciation with asset valuation

✗ Including revenue expenditures in PPE cost

✗ Forgetting to adjust allowance for doubtful debts

✗ Using LIFO for IFRS reporting

✗ Not writing down inventory to NRV when required

✗ Misclassifying current and non-current assets

                  Further Study Recommendations

• IAS 16: Property, Plant and Equipment
• IAS 2: Inventories
• IAS 36: Impairment of Assets
• Practice comprehensive questions combining multiple asset types
• Review published financial statements to see real-world applications

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Accounting for Assets /E-cyclopedia Resources by Kateule Sydney is licensed under CC BY-SA 4.0