Have you ever started a conversation with your accountant by saying; “This may be a stupid question but….”? Typically, these questions are the things which matter most to you at that point in time and therefore deserve to be explored and answered.
In this new quarterly series, I will explore questions posed by our charity clients over the preceding weeks, together with my responses to these questions – which usually start with “There’s no such thing as a stupid question!”
This installment has a notable non-current (or ‘fixed’) assets theme….
Property accounting – depreciation v appreciation?
Q: We have purchased a property in the last twelve months. The trustees believe that it will have appreciated in value, so why are we depreciating it in the annual accounts and what’s the logic here?
A: Depreciation serves two purposes:
- To write down the value of the asset in the balance sheet over its deemed useful economic life; and
- To spread the cost of the asset, over it’s useful life, as an expense in the SOFA – thereby matching against the benefit derived from the asset in that time.
A building, for example, could be used to run key workshops which are grant funded. The income generated from these workshops each year, needs to have the costs associated with running those workshops matched against it in the SOFA each year.
The annual depreciation charge for a charity is calculated in two ways, before being taken to the SOFA as an expense each year and reducing the carrying value on the charity’s balance sheet:
- Straight line – where we take the cost of an asset and divide it by its estimated Useful Economic Life (UEL). This gives the same depreciation expense every year.
This method is typically adopted for assets with short lives – for example computer equipment may be deemed to have a UEL of 2-3 years – or those assets with longer lives and more stable values over the asset life – such as a building.
- Reducing balance (RB) – where the diminished carrying value of the asset brought forwards (from the prior year) is multiplied by the selected RB rate – e.g. 25%. This gives a reducing depreciation expense every year (as the name suggests) as it is calculated on a reducing asset value.
This method is usually adopted for assets where a large amount of value is ‘lost’ early in the UEL (i.e. the value of the asset to the charity is ‘consumed’, to a greater extent, in the early years) – for example a motor vehicle.
A building – unless perhaps a portable one, for example with a ten-year UEL – would typically be allocated a 50-year UEL, with depreciation being applied on a straight-line basis. Thereby seeing a 2% of cost write down each year.
Q: OK so, what are the implications of adopting a revaluation policy over historical cost accounting?
A: There are two ways to account for non-current assets:
- Historical Cost Accounting (HCA) – where we capitalise the original monetary cost of the asset and depreciate based upon this value from year one. At the end of the asset’s UEL the Carrying Value will be nil in the charity’s balance sheet.
- Revaluation Policy – where an asset’s value is periodically re-assessed to current market value. The asset Carrying Value is adjusted to the new market value, with depreciation being re-calculated based upon this market value and remaining UEL.
The trustees can decide to move to Revaluation Policy at any time, however there are some salient points to be mindful of if adopting this approach:
- Regular valuations are required – the asset must be valued by an independent external valuer every few years. In between such times, the trustees can note that they are happy with the current valuation.
The charity should weigh up the benefits of adopting Revaluation Policy against the potential cost to be incurred each time a professional valuation is required.
There is also the matter of what happens when an asset’s value drops – unfortunately you must reflect movements both ways. This could potentially reduce the net assets value on your balance sheet.
- Cherry picking is not allowed – all assets within a particular category must be accounted for using the same accounting policy.
For example, Land and Buildings as a category may contain 5 assets, however you cannot choose for property A to be revalued but continue to account for properties B through E under HCA. All assets in that category must be revalued together, using the same accounting policy.
Worth noting though is that different categories could be accounted for differently – i.e. computer equipment and fixtures and fittings could be accounted for under the HCA method, whilst land and buildings are under a revaluation policy.
This saves the hassle of trying to assess 2nd-hand values for smaller, immaterial assets, which have been kicking around for a while.
- Higher depreciation expense – as the charity will be depreciating based upon a market value (which is usually greater than the original monetary cost), the annual depreciation expense will be higher. This will have the effect on paper of reducing the charity’s surplus for the year – and associated funds carried forward – by a greater amount.
- Higher asset values = greater net assets value – at a time when charities are being scrutinised for the level of reserves held, it is generally ‘frowned upon’ for charities to be seen to be holding excessive reserves. The belief is that the charity is not spending its resources in accordance with its charitable objectives, perhaps to the detriment of its beneficiaries.
It is worth considering whether a revaluation policy – whilst nice to see an asset with a rising value in your accounts – is really of any benefit to your organisation.
Asset replacement – finance lease v outright purchase?
Q: We are looking to replace our minibus however we are considering a finance lease option over a self-funded vehicle from our unrestricted reserves. What are the pros and cons of each approach and which would you recommend?
Self-funding a vehicle would have the impact of reducing your cash at bank and, ultimately, your free reserves in the year of acquisition. You would, of course, recognise the asset on your balance sheet and depreciate accordingly – as outlined above.
Taking out a financing arrangement would have the following accounting implications:
- Asset plus liability – The charity would capitalise the cost of the vehicle in the usual way, however there would be a corresponding liability to be shown in the balance sheet for the amount outstanding on the ‘loan’ element.
The charity would need to disclose the Carrying Value of financed assets, together with any security granted over such assets, in its accounts.
The borrowing against the asset would also need to be added back in your free reserves calculation – i.e. unrestricted general funds, less unrestricted fixed assets, less unrestricted investments, adding back any borrowings secured on unrestricted fixed assets.
- Depreciation differences – An asset acquired under a finance lease would adopt a straight-line deprecation method, seeing the cost of the asset being spread across the lesser of the asset’s UEL or lease term.
The reason for this is that the charity may purchase an asset with say a 10-year UEL yet the finance lease term is 4 years.
Remember that the purpose of depreciation is to match the cost of the asset against the period of benefit in the SOFA. As the trustees may decide to return the asset after the end of the 4-year lease term, the depreciation should be spread across the 4 years rather than the 10-year UEL.
- Liability accounting – In the charity’s accounts the liability must be split between current (i.e. amounts falling due within one year) and non-current (i.e. the balance to be paid beyond one year).
To calculate the split the overall liability should be assessed annually on an amortised cost basis, with the effective market rate of interest applied to the lease being reflected.
Attributing part of the liability to a current liability balance can be calculated as follows:
Lease payments are made in advance (e.g. day 1 of the financial period) – interest is added to the liability after payment has been made, therefore the current liability at the end of a period equates to the capital amount to be repaid.
Lease payments made in arrears (e.g. at the end of a financial period) – interest is added before the payment is made. In this situation, take your projected year 2 liability carried forward (from your worked amortisation table) and deduct this from your total liability. The balancing figure is your current position.
Of course, the above is not exhaustive advice in this area, covering only salient points. Always obtain full and proper advice before making key decisions.
Have you got any burning charity-specific questions which you’d like answered? Why not pop them our way and we’d be happy to respond.
Article as published by Accounting Web July 2017