LECTURE TWO Accounting for Non Current assets and Current Assets

COMPANY ACCOUNTS - VALUATION OF ASSETS

Many companies now show property at a revaluation amount rather than at cost.

Companies which choose to show assets at revaluation rather than cost have to account for
the difference arising as a result of the revaluation by creating a revaluation reserve. For
example, if a company which has property with a book value of $1m, based on cost, decides
to show that property on the balance sheet at revaluation of $2m, then a Revaluation Reserve
of $1m will have to be created and shown as below:

Balance Sheet as at 31st December 2007 Before After

Revaluation Revaluation
$000 $000
Issued share capital 6000 6000
Revaluation Reserve - 1000
Retained Profit 2500 2500
8500 9500
Represented by:

Property (at cost) 1000 -

Property (at revaluation) - 2000
Other fixed assets 5000 5000
Net current assets 2500 2500
8500 9500

It should be noted that if assets are revalued then any depreciation of them will be based on
the revaluation figure.

ACCOUNTING FOR RESEARCH AND DEVELOPMENT

Three categories of research and development are identified and defined as follows:-

a) Pure (or basic) research: experimental or theoretical work undertaken primarily to

acquire new scientific or technical knowledge for its own sake rather than directed
towards any specific aim or application.
b) Applied research: original or critical investigation undertaken in order to gain new
scientific or technical knowledge and directed towards a specific practical aim or
objective.
c) Development: use of scientific or technical knowledge in order to produce new or
substantially improved materials, devices, products or services to install new processes
or systems prior to the commencement of commercial production or commercial
applications, or to improving substantially those already produced or installed.

Only expenditure with an `element of innovation' may be regarded as research and

development activity.

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Accounting policies adopted by companies in respect of research and development
expenditure must conform with fundamental accounting concepts, in particular the accruals
and the prudence concepts.

Expenditure on pure/and or applied research should be written off as it is incurred, whilst

expenditure on development of new products or services may, in certain circumstances be
carried forward to be matched against future revenues. That is, the expenditure should be
clearly identifiable with the development of a particular product or project and it is reasonably
certain that the development will turn out to be profitable in the future.

SAQ1

For the year ended 31st December 2007, Sherwood plc incurred research and
development costs of $193000. Part of this cost, $80000 was related to pure and
applied research, whilst the remainder was related to the development of a new
device that will be marketed from 2008 onwards. The directors are confident of the
success of this new device.

ACCOUNTING FOR GOODWILL

Goodwill is the difference between the value of a business as a whole and the aggregate of
the fair values of its separable net assets.

Only purchased goodwill should be recognised in financial statements, and that goodwill may
not be treated as a permanent asset but must be either:

a) written off directly against reserves upon acquisition (the preferred method),
or
b) subject to an Impairment Review

ACCOUNTING FOR LEASES AND HIRE PURCHASE CONTRACTS

A FINANCE LEASE usually involves the lessee paying the full cost of the asset together with
some element of interest to the lessor, over a period of time. The lessee has the majority of
the risks and rewards concerned with ownership.

Assets held under finance leases should be capitalised in the books of the lessee and that the
associated creditor should be recognised.

An OPERATING LEASE usually involves the lessee paying a rental for the hire of an asset for a
specified period of time. The lessor retains the risks and rewards associated with ownership.

The rental payment is passed through the profit and loss account as an item of expenditure.

Hire purchase is to be treated in the same way as finance lease.

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STOCKS AND LONG TERM CONTRACTS

In accordance with the matching concept, stock items which remain unsold or unused at the
end of an accounting period are carried forward to the next accounting period, so that the cost
can be matched with the related sales revenue. Stocks are valued at the lower of cost or net
realisable value, and that the valuation is undertaken separately on different stock groups
where possible.

Net realisable value is the estimated proceeds from the sale of items of stock less all further
costs to completion and less all costs to be incurred in marketing, selling and distributing
directly related to the items in question".

Costs of stock would comprise that expenditure which has been incurred in the normal course
of business in bringing the product or service to its present location and condition. Such costs
will include all related production costs, even though these may accrue on a time basis".

Replacement cost and LIFO are generally not appropriate methods.

SAQ2

Given the following information, calculate the figure for closing stock to be shown in the
Financial statements.

Stock Valuation $000

Stock Item FIFO LIFO Net Realisable Value

Group A 760 740 920
Group B 1040 960 1230
Group C 240 220 200

G. LONG-TERM CONTRACT WORK-IN-PROGRESS

A long term contract usually is of more than one year’s duration. However, where material
amounts are involved it is appropriate to treat any contract which spans the balance sheet
date as long-term.

If a company waited until the contract was fully completed before taking any profit, this would
result in a distortion of results. In order to avoid this, contract turnover and profit is to be
recognised over the life of the project to match turnover to costs.

Accounting Treatment

Where the outcome of a contract can be foreseen with reasonable certainty, attributable
profits should be calculated on a prudent basis and included in the accounts. The amount of
profit taken up should reflect the proportion of work carried out at the accounting date and
should take into account any known inequalities in the profit stream from the contract.

Where the outcome of a contract cannot be assessed with reasonable certainty, no profit

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should be reflected in the profit and loss account in respect of that contract.

If it is expected that the ultimate outcome will be a loss on the contract, all the loss should be
recognised as soon as it is foreseen.

Work that has been invoiced but not yet paid for is treated as a debtor in the balance sheet
and costs incurred relating to work not yet invoiced is included in the stock and valued at cost
under the heading "long-term contract balances".

Please note that attributable profit may be calculated in a number of ways. Another method is
to take the value of work certified/invoiced to date, less the cost incurred to date on that
work.

Example
PROJECT ALPHA

The project is in its first year, details are as follows:

$000
Total contract price 410
Costs incurred in year one 132
Estimated costs to completion 175
Payments on account 120
Value of work certified (at end of year one) 174

Estimated total contract profit is therefore:

$000 $000
Contract price 410
Less: costs incurred to date 132
costs to complete 175
307
Estimated profit on contract 103

The attributable profit for the first year is:

value of work certified less costs incurred to date ie $174000 - 132000 = $42000.

This is shown in the Statement of Financial Performance as follows:

$000
Included in turnover (value of work done) 174
Included in cost (cost of work done) 132
Gross profit 42

In the Statement of Financial Position, the difference between Turnover and Payments on
account is shown with debtors under the heading "Amounts recoverable on contracts", in this
example:
$000
Turnover 174
Payments on account 120
Amounts recoverable on contracts 54

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In this example all costs incurred in the year relate to that part of the contract which has been
valued by the architect and have been transferred to cost of sales at the year end, leaving a
zero balance in stocks.

SAQ3
You have recently been employed by Wigan plc as assistant to the financial accountant who
is, at the moment, preparing the published accounts for the year to 31st March 2007.

The directors are keen to report the highest possible figure for reported profit and you have
been asked to advise on the treatment of certain items, details of which are given below.

(i)The finished stock consists of three main product lines, A, B and C and the table below
gives relevant financial information relating to each.

Cost Cost Net realisable

Product line (FIFO) (AVCO) Value
$ $ $

A 120,000 118,500 157,000

B 68,000 66,000 84,000
C 43,000 40,000 38,000

(ii)The company has developed a new product which will be launched on the market in June
2007. There is general agreement that the new product will be a financial success. The cost
for research and development for the year is $28,000 of which $12,000 was for
development of the new product.

(iii)During the course of the present financial year, Wigan plc, took over the business of a
sole trader. Part of the purchase price was for goodwill which was valued at $50,000.

(iv)On 1st April 2007 the company decided to revalue its freehold premises. These were
shown in last year’s balance sheet at cost less depreciation $600,000. The revaluation figure
was $2.4 million.

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ANSWERS TO SAQ'S

SAQ1

The $80000 for pure and applied research would have to be written off in the year in which it
was incurred.

The remaining $113000 development expenditure could either be written off immediately as
incurred, or carried forward in the balance sheet as an intangible fixed asset and written off
over the years in which the new device is marketed.

This option is only available since the cost is clearly identifiable to the new device and the
directors are confident of the future profitability from sales of the device.

SAQ2

The lower of FIFO cost or net realisable value would be taken for each stock group.

The LIFO cost valuation is not considered acceptable.

Stock valuation:
Group A 760 (FIFO)
Group B 1040 (FIFO)
Group C 200 (NRV)
Stock Value $2000

SAQ3

(i) Stock is valued at lower of cost or net realisable value.

Both FIFO and AVCO are acceptable methods of stock valuation under the standard.
$
Product Line A 120000 (FIFO)
Product Line B 68000 (FIFO)
Product Line C 38000 (NRV)
$226000

Note that for product lines A and B the FIFO figure is used as this would result in the
higher reported profit figure.

(ii) The research cost of $16000 should be written off immediately against the profit.
The development cost of $12000 could be written off also against the profit, but it
would be better in this case to capitalise the cost and write it off over future years as
this would produce the higher profit figure.
The capitalisation option is available here because the cost can be identified with the
product, and future sales are expected to be profitable.
(iii) As this is purchased goodwill it can be recognised in the accounts.
It could either be written off immediately against reserves or subject to an impairment
review each year.

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 Immediate write off against reserves would produce the higher profit figure for this
year as the alternative option would result in some reduction in this year's Statement
of Financial Performance which would lower the reported profit figure.

(iv) The company could show the premises at revaluation amount but the depreciation
charge for the year would be based on this higher figure which would result in the
lowering of the reported profit.
It would be preferable, therefore, to leave the premises at historical cost if you are to
report the highest possible profit for the year.