Every business needs items that are fundamental to enabling its existence, be that a laptop for a self-employed consultant like myself or a factory full of machinery for a large manufacturing organisation.
These items are non-current assets and their accounting treatment is a significant topic which all accounting students need to understand. This is because the cycle of buying, owning and disposing of non-current assets incorporates a variety of accounting concepts and advanced bookkeeping skills.
We are going to look at this cycle over the course of three articles to try and better understand the theory, processes and double entry bookkeeping involved.
I recently noticed that my laptop was making a funny noise. It is six years old and coming to the end of its useful economic life. I cannot work without it though, as everything I do for clients is done using a computer.
As I am a self-employed I can easily make the decision to replace it because my capital expenditure doesn’t need authorising. My most challenging issue is how I fund a replacement as I do not have the capital reserves or access to credit that larger organisations usually have.
Non-current assets policies
Now let’s contrast my situation with that of a large manufacturing organisation (LMO Ltd) as the same issues arise but because the scale is bigger they need to be dealt with differently. As organisations grow they reach a point where it is impossible for the owner(s) to make every single decision because there are just too many.
Therefore they create policies and procedures to enable others to make decisions in line with the owners’ wishes. There are often policies around replacing non-current assets after a set period of time rather than just waiting for them to go wrong or wear out. There are also likely to be authorisation procedures that mean different amounts of expenditure can be sanctioned at appropriate levels.
For example, a production manager might be authorised to buy replacement parts to ensure that machinery is kept running on a day to day basis, but is unlikely to have the authority to actually replace a machine itself.
Strategic capital expenditure
Non-current assets are defined as items purchased with the intention of long term use within a business. Therefore their purchase is often a strategic decision and involves significant capital expenditure.
I spent an afternoon researching laptops on the internet and found a suitable replacement that costs £380 plus £10 delivery, and £36 for software. I also applied for a 0% credit card and calculated the monthly repayments needed to clear the debt by the end of the 18 month term.
Now, for comparison, let’s say a machine at LMO Ltd is due to be replaced and will cost around £10,000. LMO have a policy of capitalising items over £500 and the procedure is for the procurement manager to acquire three competitive quotes from the company’s approved suppliers. At the same time the finance manager may be looking at funding options to see if there is enough spare capital to make a cash purchase or whether financing, in the form of a bank loan or lease agreement, might be best.
The next step in the process could be for the management accountant to analyse the options using some capital investment appraisal techniques, such as calculating the payback period, discounting the net cashflows to calculate the net present value (NPV) of each option and comparing the NPVs to the company’s required internal rate of return. A management meeting is likely then to take place to decide which machine to buy and the most suitable funding method.
Is it revenue or capital expenditure?
I researched, bought and had my laptop up and running in two days and spent £426. However, LMO Ltd’s capital expenditure procedure is likely to take months to complete, even before the delivery and installation time is factored in, plus its spend will be around £10,000. The disparity is due to the significant differences between the two businesses such as their types, sizes and decision making processes.
However, despite this, capital expenditure will have been made and a non-current asset purchased in both examples.
Let’s now imagine that LMO Ltd need to replace a laptop and just happens to select the same make and package as me. The company’s capitalisation policy means that the purchase will be treated as revenue instead of capital expenditure, even though the laptop is intended for long term use in the business.
The concept of materiality
This is an example of the fact that accounting is not one size fits all, and is made possible by the application of International Accounting Standard 1 (IAS 1) and specifically the accounting concept of materiality.
The concept states that an item is material if its omission will influence the economic decisions of the users of the accounts. IAS 1 allows organisations to select appropriate accounting policies as long as accounting concepts, such as accruals, going concern and materiality are adhered to, and objectives like relevance and comparability are adopted.
Judgement needs to be applied in the case of materiality and this means that as a sole trader the laptop is material to my accounts and should be shown as an asset on my statement of financial position (SoFP). However, it also means that LMO Ltd can adopt a capitalisation policy which is appropriate to its size and write off items, which are technically assets but are determined to be immaterial, as expenses on the statement of profit or loss (SoPL) instead.
In part two we will look at the invoice for LMO Ltd’s new machine, and how to record its acquisition in the accounting records and non-current asset register.
We will also look at other policies and procedures the company has regarding non-current assets and how it complies with IAS 16 – Property, Plant and Equipment.
Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.