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FIXED ASSETS MANAGEMENT OF A COMPANY

BY

NELSON M. ANUMAKA
(MBA, B.Sc., ACA, ACIB)

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 organisations 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.

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 companys
profit.

Assets are reported in the balance sheet of the company. The balance sheet
is the financial statement showing assets, liabilities and the owners 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 owners
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.

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

Average annual after tax profits are founded by adding up the after tax profits
expecting for each year of the projects 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

200,000

200,000

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

:. ARR = 200,000 x 100


200,000

100%

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

240,000

280,000

80,000

Required: Calculate the ARR for this project.


Solution
Average Profit =

200,000 + 240,000 + 280,000 + 80,000 = N200,000


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Average Investment = 400,000 + 40,000

= N220,000

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ARR = 200,000
220,000

100

90.9% or 91%

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 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.

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

N100,000

N120,000

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
2

N80,000
N100,000 = 180,000

Balance = N40,000
Year 3 = 40,000
120,000
:. Payback period = 2

= 1/3

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.

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 firms
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

d.

deduct the initial capital outlay from the summation.

sum

up

the

present

values;

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

40,000

40,000

40,000

Company cost of Capital:

10%

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


the viability of the project.

and

Solution:
Step 1 calculation of cash flows
Cash flows = accounting profit + depreciation
Depreciation = Cost Salvage value =

100,000 =

Life span

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

Accounting profits

40,000

40,000

40,000

40,000

+ Depreciation

25,000

25,000

25,000

25,000

65,000

65,000

65,000

65,000

Cash flow

The remaining steps


Year

Cash Flow

Discount Factor
1.00

NPV

(100,000)

(100,000)

65,000

0.9091

59,092

65,000

0.8264

53,716

65,000

0.7513

48,835

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
companys 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

N40,000

N40,000

N40,000

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

30,000

28,000

35,000

Required: Calculate the IRR for this project.


Solution
We have chosen 10% as our first trial.
Year

Cash flows

Discounting factor 10%

(100,000)

1.0000

(100,000)

35,000

0.9091

31,819

30,000

0.8264

24,792

3.

28,000

0.7513

21,036

35,000

0.6830

23,905

NPV

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)

35,000

0.8992

31,252

30,000

0.7972

23,916

28,000

0.7118

19,930

35,000

0.6835

22,243
(N2,659)

NPV

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

1,552 + 2659

( 12% -10%)

= 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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International Edition, The McGraw-Hill
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Underdown, B (1979) -

AccountingTheory and Practice


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