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Depreciation and reserves
Syllabus objectives

4.1 Describe the basic construction of accounts of different types and the role and
principal features of the accounts of a company.

12. Explain how depreciation is treated in company accounts.

13. Explain the function of the following accounts:
 share capital
 other reserves
 retained earnings.

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0 Introduction

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This is a short chapter containing a more detailed discussion of depreciation and reserves.

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The examination is likely test understanding of the purpose of depreciation and the nature of
reserves, ability to calculate depreciation and reserves and to evaluate a company’s policy on
depreciation or reserves.

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1 Depreciation

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1.1 What is the purpose of depreciation?

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Depreciation adjustments are required because virtually all non-current assets have finite
useful economic lives.

Land is an exception and is usually revalued rather than depreciated over time.

The statement of profit or loss needs to show the cost of using non-current assets – not the value
of non-current assets purchased during the year. There are two reasons for this:

1. If a company buys an asset which it still owns at the end of the year, the company has not
lost the whole amount spent. The real loss is the difference between the value of the
asset at the start of the year (or the cash the company used for its purchase) and the
value of the asset at the end of the year.

2. The amount spent on non-current assets can vary considerably from year to year. The
statement of profit or loss would not therefore give a true picture of a company’s
underlying long-term profitability if expenditure on non-current assets was allowed to
distort profits from year to year.

So instead of showing expenditure on non-current assets, companies show the amount by which
their assets have depreciated over the year. Depreciation measures the amount of the capital
stock that has been used up during the year.

Depreciation is defined as the measure of the wearing out, consumption or other reduction
in the useful economic life of a non-current asset, whether arising from:
 the passage of time, or
 obsolescence through technological or market changes.

The first, and most important, aspect of this definition is that depreciation adjustments are
not attempts to reflect the value of non-current assets in the statement of financial position.
Rather, the purpose is to charge the purchase price of the company’s non-current assets in
the statement of profit or loss in a systematic way. Depreciation is, therefore, an application
of the matching concept referred to earlier.

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The definition of depreciation also makes it reasonably clear that the manner in which an

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asset’s life diminishes varies according to the nature of the asset.

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

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A financial asset, such as a lease on some property, has a life span which is fixed in

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terms of time.

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 Physical assets are likely to wear out through use and are likely to deteriorate more
rapidly when they are used more heavily.

 Some assets, such as computers, are more likely to be overtaken by new technology
long before the end of their physical lives.

Ideally, these differences should be reflected by having different bases for depreciation
which reflect the nature of the assets. In practice, the cost of calculating depreciation in
this way would involve such detailed record keeping of usage and output that the charge is
usually based on the passage of time.

For example, a new asset might be purchased for £1,000. Management might estimate that
it will have a useful life of five years (or that normal wear and tear will bring it to the end of
its useful physical life in five years’ time), at which time it will be sold for scrap for, perhaps,
£100. This raises the question of the most appropriate way to spread that £900 loss of value
over the next five statements of profit or loss.

The simplest method is called the straight line basis.

1.2 The straight line basis

This charges equal amounts every year as follows:

Cost  Estimated residual value

Estimated useful life

That would give a charge of

1,000  100
5

= £180 per annum.

The straight line basis can also be expressed by charging a percentage of cost. If it was
assumed that the estimated residual value was immaterial then the charge could be
calculated as 20% of cost per annum

The cost is the original cost of the asset.

Intangible assets may also suffer depreciation (often called ‘amortisation’ of value when referring
to intangibles). Depreciation or amortisation of intangible assets can be calculated in the same
ways as depreciation of tangible assets. For example, a company’s purchase for £60,000 of the
right to use a particular brand name for the next 20 years will suffer depreciation of £3,000 each
year (ie based on the straight line method with no residual value).

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1.3 The reducing balance method

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The reducing balance method is the other common method of charging depreciation. This

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charges a fixed percentage of ‘book value’ (ie cost less depreciation to date) each year so

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that the whole cost is charged over the life of the asset.

The depreciation rate is calculated as follows:

n
Estimated residual value
1
Cost

where n is the estimated useful life in years.

Thus, the rate to be applied to our example would be:

5
100
1
1,000

= 37% (rounded and expressed as a percentage)

The depreciation charged for a particular year under this method will be the value of the asset at
the beginning of the year multiplied by the rate of depreciation. The charge to the statement of
profit or loss of depreciation on a particular non-current asset will therefore fall each year under
the reducing balance method.

That means that the first year’s depreciation will be £1,000  37% = £370, leaving a book
value of £630. The second year’s depreciation will be £630  37% = £233 and so on.

Over the life of the asset, the following pattern would emerge:

Year Book value at Depreciation Book value at end of

start of year year
1 1,000 370 630
2 630 233 397
3 397 147 250
4 250 92 158
5 158 58 100

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Question

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Consider the following non-current assets:

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 factory, initial cost £250,000, estimated useful life 25 years, no residual value
 two vans, initial cost £15,000 each, estimated useful life six years, no residual value
 machinery, initial cost £122,000, estimated useful life eleven years, estimated residual
value £13,750.

The factory was bought seven years ago. The vans and the machinery were all bought at the
beginning of Year Z. The factory and the vans are depreciated using the straight line method.
Depreciation on the machinery is worked out using the reducing balance method.

Calculate the company’s total depreciation charge for Year Z.

Solution

250,000
Factory: annual depreciation charge (using the straight line method) =  10,000
25

2  15,000
Vans: annual depreciation charge (using the straight line method) =  5,000
6

Machinery: using the reducing balance method, we first need to calculate the rate of depreciation
r which is 122,000  (1  r )11  13,750 .

So r = 0.18 and the depreciation for the first year = 0.18  122,000 = 21,960

Total depreciation charge for the year = 10,000 + 5,000 + 21,960 = £36,960

One advantage of the reducing balance method is that it tends to charge a heavier
proportion of the cost of the assets when they are new. This might make the depreciation
charge in the statement of profit or loss more relevant because most of the charge will be
based on the cost of newer, more recent assets. The straight line method weights assets
equally, regardless of their age, which can be a drawback when the cost of assets is rising
because of inflation.

In practice, it is common for companies to assume that all assets of a particular class will
last a ‘standard’ life (eg four years for vehicles and ten years for manufacturing plant).
These rates will be based on experience and will reflect the general patterns observed by
that company. The errors which creep in because some assets are depreciated too slowly
will tend to cancel those which arise because others are depreciated too rapidly.

Clearly, management has a considerable amount of discretion over the amount to be

charged for depreciation in any given year. The estimates of useful life and residual value
will affect both the statement of profit or loss charge and the valuation in the statement of
financial position. The selection of either straight line or reducing balance depreciation will
also have an impact.

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A company cannot however change its depreciation policy from year to year without good cause.

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Companies also disclose a great deal of information concerning their depreciation policies which

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gives the reader a lot of information about the non-current assets and their book values over the

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accounting period.

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Thus, companies are required to provide a considerable amount of detail about their non-
current asset balances:

Freehold Leasehold Plant and Total

Land and Land and Machinery
buildings buildings

£000 £000 £000 £000

Cost or Valuation
1 January 20X0 200 100 50 350
Additions 10 2 4 16
Disposals 7) 6) 8) 21)
31 December 20X0 203 96 46 345

Depreciation
1 January 20X0 30 20 16 66
Charge for year 4 8 5 17
Disposals 3) 2) 4) 9)
31 December 20X0 31 26 17 74

Net Book Value

31 December 20X0 172 70 29 271

1 January 20X0 170 80 34 284

Question

Explain why disposals represent a negative in the depreciation calculation table above.

Solution

A non-current asset that has been in the company’s books for some time will be valued at cost
(ie the full purchase cost) less some amount of depreciation. When that asset is sold, the full
purchase cost of the asset is deducted from the non-current asset account, and the amount of the
depreciation to date-of-sale is deducted from the depreciation account – ie negative depreciation.

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This information would be supplemented by a detailed statement of the accounting policies

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used in deriving the figures. Anyone reading this note will, therefore, be able to make some

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rough estimates of the effects of using a particular accounting policy and might, therefore,

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be able to change the figures to make them comparable with those of another company. It

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also permits some rough estimates of the proportion of the assets’ useful lives which have
been consumed to date. That might make it possible to predict major events such as the
issue of fresh share capital or the raising of a loan with which to invest in non-current
assets.

Question

Given the following information about a company, calculate the amount it received from the sale
of non-current assets in the year to 31 July 20X1.
31 July 20X1 31 July 20X0
£000s £000s
Non-current assets:
Cost 3,976 3,465
Depreciation 1,245 1,033
2,731 2,432

During the year, the company paid £900,000 for new equipment and also made a loss on the
disposal of non-current assets of £50,000. The depreciation allowance for the year is £432,000.

Solution

Firstly, work out the value at cost of the assets that were sold. The non-current assets at cost
were £3,465,000 in 20X0 and £3,976,000 in 20X1. During this year, £900,000 was spent on non-
current assets and an unknown value of non-current assets at cost (x) were disposed of. So:
£3,465,000  £900,000  x  £3,976,000

x  £389,000

Secondly, find the depreciation attached to the assets that were sold. The accumulated
depreciation to 31 July 20X0 was £1,033,000, and the accumulated depreciation to 31 July 20X1
was £1,245,000. During the year, the company’s assets depreciated by £432,000, but some assets
with accumulated depreciation attached to them (y) were sold. So:
£1,033,000  £432,000  y  £1,245,000

y  £220,000

Thirdly, find the book value of the assets that were sold. This amounts to:

x  y  £389,000  £220,000  £169,000

Finally, we find the amount received from the sale of these assets. We are told that these assets
were sold at a loss of £50,000. Thus, the assets were sold at £50,000 less than their book value, ie
they were sold at £119,000.

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2 Capital and reserves

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The statement of financial position lists the assets owned by the company and the liabilities

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which are owed to third parties. The residual amount is called capital or equity and belongs

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to the shareholders.

Equity can arise in three main ways:

 the sale of shares to the shareholders

 certain adjustments, such as the revaluation of non-current assets

 the retention of profit after tax.

2.1 Share capital and share premium

Question

State how the nominal value of a company’s issued share capital is calculated.

Solution

The nominal amount of issued share capital = number of shares issued  par value of shares.

Shares carry a ‘nominal’ value for bookkeeping purposes. This does not, however,
necessarily reflect the market value of the company and it is possible that the company will
be able to find buyers who would be willing to pay rather more.

Ordinary shares are always issued at or above their par value. Any excess money raised over their
nominal value is shown under the heading ‘share premium account’, which is part of ‘other
reserves’.

Question

A US company issued half a million fully paid $0.25 shares at a price of $0.37 each. Determine the
amount of share capital and the share premium account.

Solution

The nominal amount of $125,000 ($0.25  500,000) is shown under the heading ‘called up share
capital’ and the extra $60,000 raised ($0.12  500,000) under the heading ‘share premium
account’.

The difference between the nominal value of the shares and the amount paid for them is
called the ‘share premium account’. It is not permissible to issue shares at a discount.

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The share premium account can also be used for:

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 the preliminary expenses of forming a company

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 the expenses and commissions incurred in any issue of shares

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 any profit or loss on the issue of loan stock
 any premium paid on the redemption of loan stock
 the expenses of issue of loan stock.

These items will be added/charged to the share premium account as and when necessary.

Effectively, the share premium account is just a part of the company’s share capital, but its
value is included in ‘Other reserves’ in the statement of financial position format used in
Chapter 10.

It shows the excess of shareholder investment over the nominal value of the shares.

2.2 Revaluation reserve

Despite the cost concept, it is common practice to revalue land and buildings in the
statement of financial position.

If, for example, the company owned a factory which had cost £300,000 and had been
depreciated by £70,000 it would be valued at a net book value of £230,000 in the statement
of financial position. If the company’s advisers valued the property at, say, £400,000 then
this could be reflected in the financial statements by restating the depreciation to date as
zero and replacing the ‘cost’ of £300,000 with a ‘valuation’ of £400,000.

Simply increasing the book value of assets by £170,000 would throw the statement of
financial position out of balance. This is rectified by increasing the ‘revaluation reserve’ by
£170,000.

The amount of the revaluation reserve is included in ‘Other reserves’ in the statement of
financial position format used in the previous chapter.

Question

State where else the £170,000 is mentioned in this company’s accounts.

Solution

In addition to appearing in the revaluation reserve in the statement of financial position, the
£170,000 would also be shown as a gain on revaluation in the ‘other comprehensive income’
section at the bottom of the statement of comprehensive income.

It would also appear in the statement of changes in equity.

Gains on revaluation are the one exception to the statement (in the previous chapter) that
‘other comprehensive income’ will not be examined in this subject. If a gain on revaluation
is recognised in any year then the profit for the year is calculated as before, but the gain on
revaluation is then shown as one element of ‘other comprehensive income’.

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The annual depreciation is then based upon the revalued amount. The valuation will be

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written off over the estimated useful life of the asset. It is acceptable for the company to

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revise its expectations as to the expected useful life at the time of the revaluation.

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The following example shows revaluation through the revaluation reserve.

To illustrate the effect of revaluation, assume that the company which owned the factory
had no other assets. Its statement of financial position entries before and after the
revaluation might be made up as follows:

31 December 20X0 31 December 20X0

before revaluation after revaluation

(£) (£)

Non-current assets
Factory (cost) 300,000 400,000
Factory (depreciation) (70,000) –
230,000 400,000
Total assets 230,000 400,000

Share capital 25,000 25,000

Other reserves
Share premium 15,000 15,000
Revaluation reserve – 170,000
Retained earnings 90,000 90,000
Total equity 130,000 300,000

Non-current liabilities
Long-term borrowings 100,000 100,000
Total non-current liabilities 100,000 100,000
Total liabilities 100,000 100,000
Total equity and liabilities 230,000 400,000

The second statement appears much stronger. Assets are now four times greater than non-
current liabilities instead of just over twice as great. Equity has more than doubled. And
yet all that has happened is that the company has decided to restate the basis for the
valuation of its assets.

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Question

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Discuss the advantages and disadvantages of fair value accounting for all assets and liabilities,

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ie the annual revaluation of assets and liabilities in the accounts.

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Solution

Advantages
 Readers of accounting information may want to know the current market value of the
company’s assets and liabilities.
 More realistic valuation of the company’s capital will give a more realistic rate of return
on capital.
 Fair values are a better basis for decision making than historical costs. They offer a more
realistic view of the net worth of the business. This would be useful when selling assets,
merging or being taken over.
 Company would, by increased allowance for depreciation, be conserving adequate funds
for the replacement of the assets.
 Company could obtain more loan finance on the basis of the increased value of its assets.
 If a company’s assets have fallen in value, this indicates poor stewardship of the
company’s assets and should be reflected in the statement of profit or loss.

Disadvantages
 Fair values are not a better basis for decision making unless all items in the statement of
financial position are measured at fair values. At the moment some measurements are
made at fair value and others at historical cost.
 Fair values increase the risk of misunderstanding on the part of existing or potential
investors. Although each asset is broadly shown at its market value, the net value of the
balance sheet will not necessarily equate to the market value of the company because of
internally generated goodwill in the form of intangible assets, such as the value of the
customer base.
 Properly qualified regulated professionals will be required to undertake the revaluation if
fair values are to be relied on.
 The data on fair values may not be reliable. Where there is a well-defined market in the
asset, this is not a problem, but for illiquid assets and liabilities it may be necessary to use
a model, such as one based on the present value of future income. The models used, and
the assumptions made within those models, will differ across companies, causing
problems for auditors.

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2.3 Retained earnings

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The balance on the retained earnings reserve is normally the aggregate amount of profits

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earned during the lifetime of the company, less amounts paid out of profits for tax and

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dividends.

Normally the balance on the retained earnings reserve provides all of the company’s
distributable reserves. Company law restricts dividends by linking the maximum payout to
distributable reserves to protect the interests of creditors. Otherwise the directors could
use all of a failing company’s remaining assets to pay a massive dividend to its
shareholders. Doing so would act against the interests of the company’s creditors and
lenders.

In the preceding example, the maximum dividend payment would be £90,000 and this is not
affected by the fact that equity increases as a result of the revaluation.

Question

Goright plc is in the process of preparing its statement of financial position for 31 December 20X2.
So far, the items (valued at 31 December 20X2 unless otherwise stated) are:

£000s
Non-current assets at cost 547
Accumulated depreciation (31 December 20X1) 50
Current assets 165
Long-term loans 200
Share capital 300
Share premium 50
Revaluation reserve 30
Retained earnings (31 December 20X1) 55

For the year to 31 December 20X2:

 the depreciation figure in the statement of profit or loss is £12,000
 the profit after tax is £30,000
 the directors distributed half of the company’s earnings to its shareholders in the form of
a dividend.

The company’s accountants take the view that the company’s non-current assets should be
revalued at £600,000.

Prepare the statement of financial position for Goright plc at 31 December 20X2:

(i) without revaluation of the non-current assets

(ii) with revaluation of the non-current assets.

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Solution

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(i) Without revaluation of the non-current assets

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Statement of financial position for Goright plc at 31 December 20X2 (£000s)

Non-current assets:
Cost 547
Depreciation (62)
485
Current assets 165
Total assets 650
Share capital and reserves:
Share capital 300
Other reserves:
Share premium 50
Revaluation reserve 30
Retained earnings 70
450
Long-term loans 200
Total equity and liabilities 650

(ii) With revaluation of the non-current assets

Statement of financial position for Goright plc at 31 December 20X2 (£000s)

Non-current assets:
Cost 600
Depreciation 0
600
Current assets 165
Total assets 765
Share capital and reserves:
Share capital 300
Other reserves:
Share premium 50
Revaluation reserve 145
Retained earnings 70
565
Long-term loans 200
Total equity and liabilities 765

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Chapter 11 Summary

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Depreciation

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Depreciation shows the cost of using non-current assets. It measures the amount of capital
stock that has been used up over the year due to wear and tear, passage of time or
obsolescence.

The manner in which an asset’s life diminishes varies according to the nature of the asset.
 A financial asset, such as a lease on some property, has a life span which is fixed in
terms of time.
 Physical assets are likely to wear out through use and are likely to deteriorate more
rapidly when they are used more heavily.
 Some assets, such as computers, are more likely to become obsolete.

The value of the assets may be written off evenly over a number of years using the straight
line method. Alternatively a constant rate of depreciation may be used, using the reducing
balance method.

Share capital and reserves

There are three main items in the share capital and reserves.
 Share capital is the nominal value of the shares issued.
 Other reserves include:
(a) the share premium account, which records the additional amount raised
from the share issue in excess of the nominal value
(b) the revaluation reserve, which records the increase in the value of non-
current assets if non-current assets are revalued upwards.
 Retained earnings records the profit retained in the business to date.

Normally the balance on the retained earnings reserve provides all of the company’s
distributable reserves. Company law restricts dividends by linking the maximum
payout to distributable reserves in order to protect the interests of creditors.

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