Every SME is based upon a Business Model that is specific to that SME. Even Business Models of two similar businesses in the same industry and geographic location will be different in nature as they are likely comprised of a different collection of assets, suppliers and associated costs. What is relevant from one Business Model to the next is that the infrastructure is comprised of the business’ collection of Non-Current Assets or Asset Base.

Non-Current Assets are reported on the Balance Sheet and are important when evaluating the financial stability of a SME. It is therefore necessary to distinguish when an item would be considered to be an asset and reported on the Balance Sheet, or an expense and reported on the Profit & Loss Statement.

So what is a Non-Current Asset? Let’s first look at the definition of an Asset.

Asset: is an object, a right or a resource that is owned by a business representing a value which provides future benefits.

It is distinct from an expense which provides a benefit that is extinguished or consumed immediately.

Non-Current Assets: are assets held in their current form and provide future benefits to the entity for a period longer than twelve-month period. These assets are also referred to as Fixed Assets. The total of Non-Current Assets is also referred to as the Asset Base.

From a business sense, Non-Current Assets are seen as revenue producing in that they are used to create, provide and ready the goods and services you trade for sale. They therefore provide the basis or foundation of your Business Model.

The most common Non-Current Assets include but are not limited to:

• Commercial Property;
• Motor Vehicles;
• Plant and Equipment;
• Office Equipment;
• Office Furniture & Fittings.

In addition, any long-term investments that provide ongoing revenue or financial gain when sold are also classified as Non-Current Assets. Such examples would be shares, rental properties, antiques or exclusive wine. 

Non-Current Assets are reported on the Balance Sheet more often than not at the value that they were purchased for. However, there are accounting methods used to adjust them to their current market value. Which accounting methods that are applied are dependent upon how the asset’s values change over time. Assets that go up in value are appreciated, while assets that reduce in value over time are depreciated. They are therefore classified as follows:

Appreciating Assets: are non-current assets that hold their value and increase in value over time.

Depreciating Assets: are non-current assets that reduce in value overtime or as the result of use.

Appreciating v Depreciating

It is important to understand which non-current assets reported on your Balance Sheet will appreciate in value and which ones will depreciate. You can then make an assessment of whether the total Asset Base is reflective of their current value.

We often measure the wealth of an entity by measuring the debts and obligations of the business against the value of the total assets. When the actual value of the non-current assets differs from what is reported it can distort this analysis.

Whether an asset appreciates or depreciates will also assist in regards to how you should fund particular non-current assets, particularly when you would like to retain your cash for purposes other than purchasing assets. As a general rule and in theory, it is wise to purchase appreciating non-current assets and rent/lease depreciating assets.

For example, a motor vehicle decreases in value over time and as it is used in the day to day running of your business. The value it has if purchased when new, will not be the market value after several years of use and when you have finished extracting utility from it. If you enter into a lease when financing a motor vehicle, you effectively are paying for the value you use on an ongoing basis.

If we look at land which hosts a building where your business may reside, in comparison, this is more than likely to increase in value the longer you hold it. If you were to lease the same site, you would have to incur rent without receiving the benefit of the equity earned on the land over the same time.

It therefore makes sense to rent or lease a depreciable asset like a motor vehicle and purchase an appreciable asset like the land the building your business resides in. However, it is often unrealistic to apply this theory in every case, because to purchase a building will often require an amount of money your business does not possess. Leasing land & building allows you to keep the funds you do have to invest in operating your business.

There are methods that can be applied to correct the value of non-current assets on the Balance Sheet, so that you do not have to make a mental mathematical adjustment.

The appreciation value of assets can be

• Captured through revaluation when seeking finance, or
• Captured when purchasing your business and is represented as goodwill, or
• The revaluation of Non-Current Assets held.

The objective is for the Balance Sheet to report conservative values. For this reason, appreciative assets are generally reported at their original purchase value regardless of an increase in the market value unless one of the first two circumstances mentioned above occur.

In contrast, depreciable assets should be depreciated on a monthly basis. This ensures that the depreciable asset is reported at a conservative value. When depreciation is applied each monthly Balance Sheet will report the reduction in the cost of the asset purchased. Some characteristics of Depreciation are as follows; 

• Depreciation is representative of the rental value if the asset was hired rather than purchased;
• Depreciation is expensed monthly and reported on the Profit & Loss Statement;
• Depreciation for the time the asset is held is reported as accumulated depreciation on the Balance Sheet;
• Accumulated Depreciation is deducted from the original cost of asset;
• If the depreciation method chosen is accurate, the adjusted cost of the asset is equated to current day value or less.

Common Depreciation Methods

When choosing a method to calculate the amount to depreciate an asset you hold, you need to take into account how reflective the method is to how quickly the asset devalues in the market and from use. If you are placing higher usage on the asset during the earlier years than the later years then you are more likely to choose a method that depreciates higher in the early years and less in the later years. If your usage is expected to be even across the assets life then you will choose a depreciation method that reflects even usage.

The three most common depreciation methods are;

• Straight Line Depreciation Method: spreads depreciation evenly over the life of the asset.
• Diminishing Value Depreciation Method: has higher valuation of depreciation in the early years than the later years.
• Sum of Digits Depreciation Method: has higher valuation of depreciation in the early years than the later years, yet uses a different calculation to the Diminishing Value Method.  

Below we will demonstrate the calculation for each method to clarify the difference. However, for each method you will need to know the following specifications of the asset you are wishing to depreciate:

• Useful Life: the number of years you expect to hold and use the asset.
• Original Cost: the dollar amount of what you paid to gain ownership of the asset.
• Depreciation Percentage: the rate at which the asset will be depreciated.

We will use the example of purchasing a truck at the original cost of $40,000 with an expected life of 5 years and an annual depreciation percentage of 20%.

Straight Line Depreciation Method

The straight-line method spreads depreciation evenly over the life of the asset. For our truck example the calculation each year is as follow:

Original Cost / Useful Life = Annual Depreciation Expense

$40,000 / 5 = $8,000

For each of the five years the asset is held, $8,000 will be deducted off of the value of the truck. 

Diminishing Value Depreciation Method

The Diminishing Value method depreciates greater value in the early years. The depreciation percentage is applied to the original cost of the asset less the depreciation expensed to date. Here is the calculation for our example for the first three years.

 Year 1

Original Cost x 20% = Annual Depreciation

$40,000 x 20% = $8,000

Year 2

(Original Cost – Accumulated Depreciation) x 20% = Annual Depreciation

($40,000 – $8000) x 20% = $6,400

Year 3

(Original Cost – Accumulated Depreciation) x 20% = Annual Depreciation

($40,000 – $8,000 – $6,400) x 20% = $5,120

You will see that the earlier years the truck is depreciated at a higher value than in the third year.

Sum of the Digits Depreciation Method

Sum of the Digits depreciation method is similar to the Diminishing Value Method in that the earlier years are depreciated at a higher value than the later years. The difference is that instead of using the percentage provided, it uses the sum of the remaining years. The result is that it is more aggressively depreciated in the early years and lighter in the later years than the Diminishing Value Method. Here is our example with the depreciation calculated for the first three years.

Year 1

Original Cost x Remaining Useful Life/Sum of the Useful Life = Annual Depreciation

$40,000 x 5/(5+4+3+2+1) = $14,333

Year 2

Original Cost x Remaining Useful Life/Sum of the Useful Life = Annual Depreciation

$40,000 x 4/(5+4+3+2+1) = $10,666

Year 3

Original Cost x Remaining Useful Life/Sum of the Useful Life = Annual Depreciation

$40,000 x 3/(5+4+3+2+1) = $8,000

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These are the three main depreciation methods used today. There are other more sophisticated calculations however for the smaller entity one of the above should be more than sufficient. Remember, choose the method which best mirrors the reducing value of the asset as it is used from one year to the next. Once you decide on a depreciation method, this is the method you will need to use for the life of the asset, so choose wisely.

Accounting v Taxation Depreciation

It is feasible to use different depreciation methods for accounting purposes than what are used for taxation purposes. The benefits of applying representative depreciation of the reduction in value of the assets you hold in your business for accounting purposes will allow you to assess the financial stability and performance of your business.

An example is when for a temporary period all assets up to a set value can be written off in the year of purchase. For taxation reasons, it is required to be deducted in full in the first year, however you may decide to depreciate the original cost over a few years from an accounting perspective. This will allow you to calculate ratios and financial measures to assess your level of financial viability.

Two examples include the following:

• Return on Assets Ratio
  • This ratio is represented as a percentage and reports on a business profitability in respect to the assets it owns. Assets are used by a business to generate revenue. Profit is the remainder of revenue and the return you earn by using your assets to earn revenue.
  • The higher the percentage the better the return you have on your asset investment.
  • When the Total Asset value is incorrect, the resulting calculation will be misleading.
• Long-Term Liquidity Ratio
  • This measures the ability of a business to meet its long-term debts and obligations. As assets can be sold for cash, their value represents a possible future benefit of cash being paid into the business. Total Assets are therefore used to measure a business’ liquidity.
  • The greater the value of Total Assets over all of your debts and obligations the better your liquidity.
  • When Total Assets is incorrect it will therefore distort this measure.

These are just two calculations you can use to assess your business in respect to the assets held. It therefore makes sense to use an accurate value for your Non-Current Assets to ensure these calculations are also correct.

If you are depreciating your assets on an accounting basis in your records, note that you would only be required to depreciate the asset until you reach the market value of the asset or the value you are likely to receive if you sold it. This will allow you to continue to make accurate calculations that use your Asset Base value in regards to the ratios and measure mentioned above.

If you are recording depreciation in line with you regions taxation laws, then you will continue depreciating your assets until they reach a zero value.

When only applying the taxation laws to your depreciation and assuming the same rules for your accounting depreciation may mean that you lose access to this invaluable information. Adjustments can be made at tax time to determine the tax depreciation that can be accounted for in your tax return. 

Fixed Asset Register

In order to manage the calculation of multiple non-current assets you will need to compile an Asset Register and keep it up to date on a monthly basis. This register will include every Non-Current Asset you purchase and will equate to the total asset value reported on your Balance Sheet.

If you choose to record depreciation on a monthly basis, it is a requirement to maintain an asset register. It will provide all the details in regards to the depreciation method you have chosen.

The asset details an asset register record include: original cost, date of purchase, supplier, useful life, monthly depreciation, year to-date depreciation and accumulated depreciation for the life of the asset.

For the smaller entity, this will require time to maintain so consideration must be made in regards to the resources you have in-house to manage an asset register and associated depreciation. When your entity becomes significant in size and has a significant investment in non-current assets than the need to maintain an Asset Register increases.

Summary

It is important to understand the true value of the non-current assets you have reported on your Balance Sheet. This will allow you to make an accurate assessment on the wealth you retain in your business. By using accounting methods, you can appreciate or depreciate asset values to ensure they reflect the market value. However, always remember to keep your Non-Current Asset values conservative.

While original cost is the conservative value for appreciable assets, depreciating assets that lose value over time, will ensure you are reporting your assets at a value that is consistent with their worth.

For the smaller entity, the cost of managing an Asset Register and Depreciation Schedule may be too onerous until they are of a sufficient size or their reliance on non-current assets warrants closer management of their assets.

There are three main depreciation methods: Straight-Line Depreciation Method, Diminishing Value Depreciation Method, Sum of the Digits Depreciation Method. The choice between them should be in line with how the asset devalues over time.

If you decide not to depreciate your assets and leave it for your tax accountant to manage at tax time, just remember which assets appreciate and which assets depreciate and you’ll have a better idea of your true Asset Base value.

I hope you have enjoyed this article.

In the meantime, keep your businesses humming.

Written by Debra Cooper

Owner and Founder of Zephyr Management Solutions