FIXED ASSETS MANAGEMENT OF A COMPANY

BY

NELSON M. ANUMAKA

(MBA, B.Sc., ACA, ACIB)

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ABSTRACT

A fixed asset that runs a full cycle of existence in a firm has three stages of life

for the purpose of management. These stages are the funding stage, the

preservation stage and the abandonment stage. The stage of funding

concentrates mainly on apprising the economic viability or otherwise of the asset

making use of techniques such as accounting rate of return, payback period, and

the discounted cash flow methods.

The preservation stage concentrates on maintenance techniques to keep the

asset in good condition and top form. Repairs and regular checking are the main

techniques to employ at this stage. Costs of normal repairs and services shall be

treated judiciously and expeditiously. If the cost of repairs and services that

upgrades the value of the asset is high, it may therefore be capitalised.

The final stage in fixed assets management is the abandonment stage. The

main jobs of the organisation’s management at this stage are the determination

of the purchase price and identification of the preferred buyers.

The paper examines all the three stages of fixed assets management and

surmises that the use of management techniques is necessary at each of the

stages in the full life cycle of a fixed asset.

INTRODUCTION

Assets are the valuable possessions, especially properties that a person or a

company owns which are capable of yielding revenues. In other words, they are

investments in resources that are expected to generate future earnings through

operating activities. In accountancy parlance we can distinguish between five

groups of assets.

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a. Fixed Assets: These are assets that are used over a long period of time.

Examples of fixed assets are Land and Buildings, Plant and Machinery,

Fixtures and Fittings, and Motor Vehicles. These are alternatively called

tangible assets or real assets. They are gradually depreciated over time and

the company usually makes provisions out of profit on a yearly basis. These

groups of assets are replaced when they are worn out.

b. Financial Assets: These assets are usually traded on the Money Market

and floors of the Nigerian Stock Exchange as securities. These are the

investments in treasury bills, treasury certificates, Federal Government

Development Stocks, Ordinary and Preference shares and Debentures and

Bonds.

c. Intangible Assets: These represent the assets that exist but difficult to

describe, understand, or measure. They include goodwill, patent rights,

trademarks, staff morale, and recently technical know-how and technological

collaborations.

d. Current Assets: These are assets that are expected to be converted to

cash or used in operations within one year or the operating cycle, whichever

is longer. The usual items of current assets are stocks, debtors,

prepayments, and cash.

e. Fictitious Assets: These are not assets per se but expired costs and capital

losses awaiting amortization. They are used as balancing figures in the

balance sheet. Fictitious assets include preliminary expenses, debit balance

in the Profit and Loss account, and discount on shares and debentures.

They are usually and gradually amortized over time against the company’s

profit.

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Assets are reported in the balance sheet of the company. The balance sheet

is the financial statement showing assets, liabilities and the owner’s equity of

a firm on a specific date (Glautier and Underdown, 1976: 156). The balance

sheet of a firm consists of two sides – the assets side and the liabilities and

the owners’ equity. Because all assets are financed by liabilities and owner’s

equity, the two sides of the balance sheet must agree, i.e. balance. The

accounting equation also called balance sheet identity is the basis of the

accounting system: Assets = Liabilities and Equity.

Liabilities are funding from creditors and represent obligations of a company

or, alternatively, claims of creditors on assets. Equity is the total of funding

invested or contributed by owners and accumulated earnings in excess of

distributions to owners since inception of the company. From the owners’

point of view, equity represents their claim or interest on company assets.

In managing assets, two types of assets are of particular importance - fixed

and current assets. These assets are applicable in all businesses. Some

companies are known to thrive without financial assets, intangible assets and

fictitious assets but definitely not fixed or current assets.

This paper therefore, is going to look at fixed assets management from the

points of funding, preservation, and abandonment.

FUNDING

The point of funding is called investment appraisal. Investment appraisal is

defined as the “quantitative methodology for assisting the economic viability

or otherwise of capital investment Projects’ (Brealey and Myers, 1996:293).

It is a long term planning for proposed capital outlays and their financing. It is

also called Capital Budgeting. The main techniques of capital investment

appraisal are the accounting rate of return, payback period, and the

discounted cash flow methods.

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ACCOUNTING RATE OF RETURN

The accounting rate of return is defined as the average annual after tax profit,

divided by the average book value of investment over the project life. It is

customary to multiply the result by 100 to have it in percentage terms. The

general formula for calculating the ARR is given as:

Average annual Profit X 100

Average Investments 1

Average annual after tax profits are founded by adding up the after tax profits

expecting for each year of the project’s life and dividing the total by the number of

years.

Average investment is found by dividing the initial investment by 2. This process

assumes that the company is using straight-line depreciation with no salvage

value.

Illustration

A firm, Okirie Enterprises has made the following financial information available.

Project cost: N400,000

Accounting Profits

Year 1 N200,000

2 200,000

3 200,000

4 200,000

Required: Calculate the ARR for this project.

Solution

Average Profit = 200 +200 + 200 + 200 (all in 000) = N200,000

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Average Investment = 400,000 = N200,000

2

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:. ARR = 200,000 x 100 = 100%

200,000 1

In this illustration the company would recoup its initial capital outlay of N400,000

and still make a profit of N400,000 hence the 100% score in the ARR.

In the situations of uneven profits and Working Capital, the formular for

calculating the ARR is generally the same and may even be more sensible.

Illustration

A Company Modebe Limited has made the following data available to you.

Project cost: N400,000

Working Capital N40,000

Accounting Profit

Year 1 N200,000

2 240,000

3 280,000

4 80,000

Required: Calculate the ARR for this project.

Solution

Average Profit = 200,000 + 240,000 + 280,000 + 80,000 = N200,000 4

Average Investment = 400,000 + 40,000 = N220,000

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ARR = 200,000 x 100 = 90.9% or 91%

220,000 1

In both illustrations, the projects are viable as the utility as expressed by the ARR

is very high. Again, a benchmark may be set against which the decision to

accept or reject a project proposal may be taken. All acceptable projects in this

case must have a return higher than, or equal to the benchmark.

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THE PAYBACK PERIOD

The payback period refers to the length of time required for cash proceeds from

an investment to equal the initial capital outlay required by that investment. It is

therefore, the period expressed in years, which the initial investment is recouped

by cash inflows. The usual decision rule is to accept the project with the shortest

payback period. This technique is one of the widely used in practice and also

called payout or payoff period.

In the situation of even or constant cash flows, the formula for calculating the

payback period is given as:

Initial outlay Annual cash flows

Illustration:

A company, Ijenelly Enterprises, has made the following financial data

available to you:

Investment: N400,000

Life span of: 4 years

Method of depreciation: Straight line

Cash flows: N160,000 each year (year 1 to year 4)

Required: Calculate the payback period for this project.

Solution

Payback period = 400,000/160,000 = 2 ½ Years

Where the cash flows are not even or constant, the technique is to add up

the yearly cash flows including fractions where necessary until the initial

capital sum is recouped.

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Illustration

A Company; Opted Limited has the following financial data:

Project cost: N200,000

Method of Depreciation: Straight Line

Working Capital: N20,000

Cash flows: Year 1 N80,000

2 N100,000

3 N120,000

4 N20,000

Required : Calculate the payback period for this project in the Company.

Solution

Capital sum invested initially = N200,000 + 20,000 = N220,000 less cash flows:

Year 1 N80,000

2 N100,000 = 180,000

Balance = N40,000

Year 3 = 40,000 = 1/3 120,000

:. Payback period = 2� years or 2 years 4 months

The fraction is necessary because the 3rd cash flow of N120,000 is far greater

than the N40,000 required to finally recoup the initial capital outlay. In using the

payback period for evaluating projects for investment, the usual practice is to set

a benchmark in terms of the period required to recoup capital outlays. The

results of the analyses are then compared with the benchmark to arrive at

decisions. If our calculated periods is within the benchmark period, the project is

acceptable but if other wise the project should be rejected.

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DISCOUNTED CASH FLOW (DCF) TECHNIQUES

The Discounted Cash Flow techniques which take account of the timing of cash

proceeds and outlays and utilize the concept of present value would be

discussed under three headings: Net Present Value (NPV), Profitability Index

(PI), and Internal Rate of Return (IRR).

NET PRESENT VALUE (NPV)

This is a method of calculating the expected utility of a given project by

discounting all expected future cash flows to their present values using the firm’s

cost of capital as the discounting factor.

Steps in Calculating the NPV:

a. calculate the annual cash flows;

b. discount the individual cash flows to their present values;

c. then sum up the present values; and

d. deduct the initial capital outlay from the summation.

Illustration

A Company, Abokiya Limited, has the following cash flow data

Project cost: N100,000

Method of depreciation: Straight-line

Accounting Profits:

Year 1 N40,000

2 40,000

3 40,000

4 40,000

Company cost of Capital: 10%

Required: Calculate the NPV of these cash flows and advise on

the viability of the project.

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Solution:

Step 1 – calculation of cash flows

Cash flows = accounting profit + depreciation

Depreciation = Cost – Salvage value = 100,000 =

Life span 4 N25,000

Note that the straight-line method of depreciation provisions evenly

throughout the life span of the project. In the illustration, there was no

salvage value.

Years 1 2 3 4

N N N N

Accounting profits 40,000 40,000 40,000 40,000

+ Depreciation 25,000 25,000 25,000 25,000

Cash flow 65,000 65,000 65,000 65,000

The remaining steps

Year Cash Flow Discount Factor NPV

0 (100,000) 1.00 (100,000)

1 65,000 0.9091 59,092

2 65,000 0.8264 53,716

3 65,000 0.7513 48,835

4 65,000 0.6830 44,395

NPV N106,038

Notes

a. In the year of investment, the entire capital outlay is regarded as a cost

or loss - that is why it appears in bracket.

b. At the time of investment the value of the currency being used, in this

case the Naira, will not have been affected by depreciation or inflation –

this is why the discounting factor remains a whole number.

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c. The discounting factor is obtainable from the NPV tables that are usually

found in Financial Management and Managerial Accounting textbooks.

Calculators may also be used to calculate them in the absence of tables.

d. The summation of the cash flows was N206,038 so when we deducted

the initial capital outlay of N100,000 we arrived at N106,038 which

represents the NPV for the Project.

e. When the NPV is positive as it is in this illustration, the project is viable

and should be accepted and vice versa.

PROFITABILITY INDEX (PI)

The PI approach to investment appraisal does not differ greatly from the

NPV approach. The only difference is the fact that profitability index

measures the present value return per Naira invested whilst the NPV

approach gives the Naira difference of the present value of returns and the

initial investment. The PI is defined by the following formular:

PI = Present Value of Cash Inflows

Initial Investment

If PI is greater than or equal to 1, accept the project; otherwise reject the

project.

Using the same example in NPV, we could derive the PI as follows:

N206,038 = 2.06

N100,000

INTERNAL RATE OF RETURN (IRR)

This gives a rate of return on project, which can be compared with the

company’s cost of capital to determine acceptance, or rejection of capital

investment proposals. Strictly speaking, it is the rate of interest at which the

present values of expected future cash flows of a particular project equal to

its present capital outlays. At the correct rate of IRR, there is no gain and

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no loss. In a situation of even or constant cash flows, the adjustment for

calculating the IRR is given as:

Investment

Annual cash flows

Illustration

A company, Ofinjala Limited has the following data:

Project cost N100,000

Annual cash flows:

Year 1 N40,000

2 N40,000

3 N40,000

4 N40,000

Required: Calculate the IRR for this project in the Company.

Solution

IRR = 100,000 = 2.5%

40,000

This figure will then be read off the annuity table to determine the appropriate

rate for the project. In this particular illustration the figure must fall along line 4

since the project has a life span of four years. The appropriate rate therefore

falls between 21% and 22% and when we found the average of the 2 we arrived

at 21.5%. The appropriate IRR for this project is 21.5%.

In the situation of uneven cash flows, there is no clear cut formular for finding the

IRR, so we usually resort to trial and error arrangement in order to try all possible

discounting factors until we arrive at the rate which will bring the NPV to zero.

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Illustration

A firm, Maverick Enterprises, has the following financial data:

Project cost – N100,000

Annual Cash Flows:

Year 1 N35,000

2 30,000

3 28,000

4 35,000

Required: Calculate the IRR for this project.

Solution

We have chosen 10% as our first trial.

Year Cash flows Discounting factor 10% NPV

0 (100,000) 1.0000 (100,000)

1 35,000 0.9091 31,819

2 30,000 0.8264 24,792

3. 28,000 0.7513 21,036

4 35,000 0.6830 23,905

NPV 1,552

The NPV in this trial is positive, so it is not equal to zero. This means that

we have not arrived at the appropriate IRR. We therefore need to trial

further discounting factors. In making a choice of the discounting factors,

the guiding principle is that if the first trial results to positive figure, as it is in

the illustration we choose a higher rate but if it results to a negative figure

we have to go for a lower rate.

Our next trial rate is 12% because the first trial resulted to a positive figure.

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Year Cash flows Discounting Factor NPV

12%

0 (100,000) 1.0000 (100,000)

1 35,000 0.8992 31,252

2 30,000 0.7972 23,916

3 28,000 0.7118 19,930

4 35,000 0.6835 22,243

NPV (N2,659)

The first trial resulted to a positive figure while the second result to a

negative figure. This means that the appropriate rate must lie somewhere

between 10% and 12% of the NPV table. We then need to reconcile the

two rates by the process of interpolation as follows:

12% NPV gives the sum of N (2,659)

10% ,, ,, ,, ,, ,, N1,552

2% ,, ,, ,, ,, ,, N(4,211)

Note that we subtracted 10% from 12% to get the 2%. When we subtracted

the positive N1,552 from the negative N2,659 we arrived at the negative

figure of N4,211.

10% + 1,552 ( 12% -10%)

1,552 + 2659

= 10% + 1,552 (2%)

4,221

= 10 % + 0.737 = 10.74%

PRESERVATION

Throughout the life of the fixed asset, appropriations are made out of

yearly profit in the name of provision for depreciation, which is meant to

assist the company in replacing the asset when it wears out or becomes

obsolete. Every business is supposed to be a going concern, which

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means that it will continue in proper operational existence for the

foreseeable future. Since the life of the business is a continuous one but

the lives of the assets being employed by it may not be continuous, it

means that in the life of the business, assets may be used up and

replaced several times over. In order to continue in business, a company

does two things to the fixed assets it employs, namely:

provides for depreciation in preparation for replacement; and

repairs and services the assets while in usage.

Depreciation

SAS 9 defines depreciation as an estimate of the portion of the historical

cost or revalued amount of fixed asset chargeable to operations during an

accounting period.

The main causes of depreciation include:

a. wear and tear;

b. physical factors such as evaporation of liquid, loss of potency of

acids, erosion and dampness;

c. obsolescence due to invention or changes in fashion;

d. fall in market prices which include unfavourable foreign exchange

rates; and

e. effluxion of time

Many methods exist for providing for the depreciation of a fixed asset.

Management is at liberty to make choice of the method considered most

suitable to its operations, but once the choice has been made, the

consistency concept required that such a method be applied from year to

year. Any change in such a policy is both legally and professionally

required to be disclosed in the notes accompanying the main accounts.

Providing for depreciation is a formula attempt to set aside money for the

replacement of a fixed asset when it wears out. The weakness of

providing for depreciation of a fixed asset is that it is usually based on the

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historical cost of the asset concerned and not replacement cost so that the

provisions are usually short of the amount required replacing the asset at

current cost. In spite of the obvious weakness of depreciation provision, it

serves as a reminder to management that once in the life of the business

a fixed asset will need to be replaced. Management is therefore put at

alert to prepare for the future.

Repairs and Services

A fixed asset as in the employment of a company needs to be maintained. After acquisition, the assets cannot continue to work indefinitely without repairs and services. The cost of maintenance may be material or immaterial. It is material where the cost is such that it cannot be written off within one accounting year. In this case it is to be amortized over a number of years. In practice, when a situation like this occurs, the best method to apply is to add up the new cost to the existing one so that together they can form the new value of the asset. Provisions for depreciation will now be based on the new value of the asset. On the other hand, the cost of maintenance may be immaterial. If it is immaterial the cost should be written off the profit and loss account and forgotten.

ABANDONMENT

This is the last point in the life of a fixed asset in the company. The

company at this stage has tapped all the potentials of the asset and a

continuing maintenance of the asset will be unnecessary cost to the

company. The cost of maintenance may become higher than its

contribution to productivity in the company. At this point the asset will

have to go. An asset may be discarded and thrown away completely or

be discarded and sold at a give-away price. Any asset that has residual

value is one that is discarded and can still sell for value, no matter how

infinitesimal.

The amount of estimated scrap value has a great effect on the provision

for depreciation of each fixed asset in the firm. In using the straight-line

method of depreciation, for instance, depreciation provision is calculated

with the formular:

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Cost less scrap value

Life span

This means that a depreciation provision based on the full cost of the fixed

asset will be greater than the one based on cost minus the salvage value.

CONCLUSION

Analysis prior to investment in fixed assets may not be the problem in the

Nigerian workplace. It is the maintenance. It is a true saying that

maintenance culture is very poor among the developing countries of the

world. Managers watch helplessly assets wasting away only to result to

importation of such assets when they finally ground. Inflation is also a

common phenomenon in the 3rd world economies. This makes

depreciation provision not enough to replace wearing out fixed assets.

We conclude that no stage in the life of fixed assets should be ignored, as

the application of management techniques is necessary in the entire life of

each fixed asset.

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