Unit 4 Accounting and Finance The Balance Sheet Depreciation and Revaluation

What is Depreciation? Depreciation is the fall in value of an asset over time. Accounts must give a true and accurate picture of a firm’s finances. As assets lose their value over time, this must be reflected in the balance sheet. It is considered prudent to reduce (‘write down’) their value. Depreciation is shown in the ‘notes to the accounts’ section. Depreciation is based on estimates of working life and its value at the end of the period. Depreciation appears as a cost on the Profit and Loss Account

Plant, machinery and vehicles Depreciation and Amortisation Notes to the accounts of Crestfell PLC showing depreciation of tangible fixed assets Land and Buildings Plant, machinery and vehicles Fixtures and fittings Total (£million) Cost 380 950 70 1400 Depreciation and Amortisation 50 400 30 480 Net Book Value

But hang on…some assets increase in value! Good point! Property in particular has seen big increases in value over recent years. This must also be reflected in the balance sheet. The ‘revaluation reserve’ shows the increase in value of fixed assets. Appears in shareholders’ funds (or Capital and Reserves). Important when a business has a majority of its assets in the form of land and buildings. If the value of fixed assets increases, then the value of the business for shareholders must also increase.

Revaluation – a simple example 2003 2002 Fixed assets 550 500 Current assets 200 Current Liabilities 100 Net current assets ? Long term liabilities 50 Net assets 600 Capital and reserves Share capital Revaluation reserve

Revaluation - notes N.B. Although revaluation appears in capital and reserves, it cannot be drawn upon when the business needs finance. Like retained profit, it is a ‘balancing item’. Seeing the increase in value of a business as a source of finance assumes that the business can turn the extra value into cash!

Depreciation (straight line method): advantages and disadvantages The most widely used in Britain, by far. Does not depreciate assets such as cars and machinery realistically, and therefore leaves assets overvalued on the balance sheet Relies heavily on ‘guesstimation’ of an asset’s future useful life and future residual value. Approved for tax calculations by the Inland Revenue. Encourages long term thinking because it does not cut profits too much in the first year of investment. If an asset such as a computer becomes obsolete earlier than expected, the under-provision for depreciation will require a large write-down of the asset’s book value.