1 Accounting for Executives Week 3 25/3/2011 (Fri) Lecture 3.

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Accounting for Executives

Week 3 25/3/2011 (Fri)

Lecture 3

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Part I – Income Statement and Statement of Financial

Position

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Balance Sheet (Statement of Financial Position)The balance sheet (or statement of financial position) is a development of the accounting equation. The balance sheet has the primary purpose of reporting the financial position of an organisation at a single point in time.

Recall the accounting equation we have learnt:-

Fixed assets+ Current assets - Current liabilities –

Long Term liabilities = Initial capital + Retained

profits

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Pro forma (Old Format)ABC Company Statement of Financial Position as at 31-Dec-2010

Non-current Assets $ $ $

Premises X,XXX

Vehicles X,XXX

X,XXX

Current Assets

Inventory XX,XXX

Bank XX,XXX

Cash XX,XXX XX,XXX

Less: Current liabilities (X,XXX)

Net current assets XX,XXX

Less: Non-current liabilities

Bank loan (XX,XXX)

XXX,XXX

Capital XXX,XXX

Add: Retained Profits (or Less: Accumulated loss) XX,XXX

XXX,XXX

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Example (con’t)

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Pro forma (New Format)ABC Company Statement of Financial Position as at 31-Dec-2010

Non-current Assets $ $

Premises X,XXX

Vehicles X,XXX

X,XXX

Current Assets

Inventory XX,XXX

Bank XX,XXX

Cash XX,XXX XX,XXX

Total Assets XX,XXX

Equity and Liabilities

Equity

Capital XX,XXX

Add: Retained Profits (or Less: Accumulated loss) XX,XXX

XX,XXX

Non-current Liabilities

Bank Loan XX,XXX

Current Liabilities XX,XXX

Total Equity and Liabilities XX,XXX

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Profit and Loss Account (Income Statement)Pro forma

Chris Black Income Statement for the year ended 31-Dec-2010

$ $

Sales X,XXX

Less: Cost of goods Sold

Opening Stock XXX

Add: Purchases XXX

Less: Closing Stock (XXX)

Cost of goods sold (XXX)

Gross Profit X,XXX

Less: Expenses

Wages XXX

Electricity XXX

Insurance XXX

Rent and rates XXX XXX

Net profit X,XXX

Trading Account

Profit and Loss Account

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Part II – Depreciation

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Depreciation – machine hour method

The life of the asset is estimated in hours (or appropriate units) and each unit is given a money value for depreciation purposes.

Suitable for high value machine e.g.) Aircraft

The rate of depreciation for each unit is calculated as:

Cost of asset - estimated residual value (scrap value)

Expected useful life of the asset in hours

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Depreciation- machine hour method

Example: An asset with a cost of $60,000 , it is expected that the asset could be used for 4,560 hours, after that period the asset must be disposed with an estimated scrap value of $14,400.

Required:

1) Compute the depreciation rate per hour

2) Calculate the depreciation charge and the net book value at the end of the following year

Year 11,300 hours

Year 21,400 hours

Year 31,050 hours

Year 4 810 hours

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Depreciation- machine hour method

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Straight Line Method vs Reducing Balance Method

Annual depreciation charge using Straight-line method

Annual depreciation charge using Reducing balance method

Y1 Y4

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Impact of depreciation

By choosing different ways of apportioning the depreciation method over the useful life of an asset would has an impact on the financial statements. In general terms the impact is revealed in two ways:

1 The annual depreciation expense charged to the profit and loss account differs for all three methods. This will have an impact on the annual profit figure.

2 The value of fixed asset in the accounts as revealed in the balance sheet by the net book value differs in all three methods. This will impact on the value of the total assets included in the balance sheet.

(Higher depn => Lower profit & Lower asset value)

(Lower depn => Higher profit & Higher asset value)

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Depreciation

Straight-line method (SLM)Fair allocation of costCertainty, simplicity and equalityWidely adopted methodApplicable to buildings, patents and leases where time is

the important factor It does not reflect the reality (loss will be greater in the

initial years and unevenness of the loss in the market value)

It does not provide an accurate measure of the cost

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Depreciation

Reducing balance method The reducing balance method charges larger depreciation in

the earlier years of the asset’s life, and smaller amounts in later years.

The method assumes that the benefits obtained by the business from using a fixed asset reduce over time.

The method can be used when it is considered equitable to charge a greater proportion of the total depreciable amount to the earlier years and a lower proportion to later years.

The reducing balance method approximates to reality in respect of certain fixed assets, e.g. motor vehicles where the depreciation calculated in the first year reflects the great loss in market value at the same time as when repairs are usually low.

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Depreciation

Machine hour methodThis method is considered suitable for any asset where it

is assumed that loss in value is a direct function of asset use rather than time and obsolescence.

The machine hour method requires an estimate of usage well into the future at the time the asset is acquired.

Depreciation is recorded only when the asset is used. The more units the asset produces or the hours used in a given year the greater the depreciation expense.

This is used in some manufacturing companies.

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Double entry records for Depreciation

There are two methods to record depreciation

1.Only depreciation account is opened, depreciation charge is debit to depreciation account and credit to asset account directly

DR. CR.

Depreciation Account(Expense) 2,436

Notebook Computer (Asset) 2,436

Profit and Loss account 2,436

Depreciation account 2,436

Being depreciation charged for the year.

Note: This method will make the asset account balance more fluctuate

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Depreciation- one step method

Depreciation

$ $

31.12 04 Notebook computer 2,436 31.12.04 Trf. Profit & Loss 2,436

31.12 05 Notebook computer 2,436 31.12.05 Trf. Profit & Loss 2,436

Assets-Notebook computer

1.1.04 Bank 10,000 31.12.04 Depreciation 2,436

31.12.04 Balance c/d 7,564

10,000 10,000

1.1.05 Balance b/d 7,564 31.12.05 Depreciation 2,436

31.12.05 Balance c/d 5,128

7,564 7,564

1.1.06 Balance b/d 5,128

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DEF Company Balance Sheet as at 31 December

2005 2004

Fixed Assets

Notebook Computer 5,128 7,564

Current Assets 25,400 20,300

Less: Current Liabilities

Accruals 400 300

25,000 20,000

30,128 27,564

Financed By

Owner’s capital 20,000 20,000

Retained profit / (loss) 10,128 7,564

30,128 27,564

Depreciation- one step method

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Double entry records for Depreciation

2. A provision for depreciation account is opened to record the amount, the balance will carried forward to contra against the asset balance in the balance sheet

DR. CR.

Depreciation Account(Expense) 2,436

Provision for depreciation (Asset) 2,436

Profit and Loss account 2,436

Depreciation account (Expense) 2,436

Being depreciation charged for the year.

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Depreciation- two steps method

Depreciation

$ $

31.12 04 Provision for Depn 2,436 31.12.04 Trf. Profit & Loss 2,436

31.12 05 Provision for Depn 2,436 31.12.05 Trf. Profit & Loss 2,436

Provision for depreciation

31.12.04 Balance c/d 2,436 31.12.04 Depreciation 2,436

31.12.05 Balance b/d 2,436

31.12.05 Balance c/d 4,872 31.12.05 Depreciation 2,436

4,872 4,872

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DEF Company Balance Sheet as at 31 December

2005 2004

Fixed Assets

Notebook Computer 10,000 10,000

Less: Accumulated Depn (4,872) (2,436)

5,128 7,564

Current Assets 25,400 20,300

Less: Current Liabilities

Accruals 400 300

25,000 20,000

30,128 27,564

Financed By

Owner’s capital 20,000 20,000

Retained profit / (loss) 10,128 7,564

30,128 27,564

Depreciation- two steps method

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Part III – Fixed Asset Disposal

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Disposal

During the course of business, assets of a company may be disposed due to various reasons. The proceeds received from the disposal may be greater( or less) than its net book value (i.e. cost - accumulated depn), in this case a paper profit (or loss) arise.

If the selling price >( cost of asset - accumulated depreciation)

=> Profit

If the selling price <( cost of asset - accumulated depreciation)

=> Loss

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Example

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Disposal of Fixed Assets

To record the transactions, a Disposal account is opened

1. Transfer the accumulated depreciation to the Disposal account

Dr. Provision for Depreciation Account

Cr. Disposal Account

2. Transfer the cost price of the asset to the Disposal account

Dr. Disposal Account

Cr. The Asset account

3. Credit the disposal with the cash (amount) received from the buyer

Dr. Cash or Bank Account


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4. Transfer the debit balance (loss) or the credit balance (profit) to the profit and loss account

Dr. TPL Account (if the cash received < the carrying value)


or

Dr. Disposal Account

Cr. TPL Account (if the cash received > the carrying value)

Exercise

Using the example of notebook computer in the previous lesson (using the SLM to determine the depn ), calculate the profit and loss on disposal if the notebook sell for :

1. $5,000 2. 3,000

Assuming the transaction take place at the ended of the year 2.

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Part IV – Accounting Concept and Depreciation

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Accounting concepts & Deprecation

The historic cost concept directs that transactions, i.e. the purchase of fixed assets are recorded at the value at the time the transaction occurred.

The going concern concept directs that assets are not recorded at their break-up value as it is assumed the business will continue in existence.

The matching/accruals concept directs that the main objective of depreciation is to match the cost of the fixed asset against the revenue the asset is helping to generate.

The consistency concept directs that the accounting treatment of depreciation should involve a method which is used consistently and gives comparability over accounting periods.

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Revaluation of fixed assets

Companies will periodically revalue their fixed assets to reflect the current market value, as these assets will increase in value over time; without revaluation, the total value of these assets might seem unrealistically low. The depreciation is then calculated on the revalued amount. The impact of the revaluation of fixed assets on the accounting equation is reflected in a corresponding increase in the owner’s capital funds.

Accounting entries

Dr. Asset (with the increase in value) $XXXX

Cr. Revaluation reserves (with the increase in value) $XXXX

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Part V – Capital and Revenue Expenditure

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Capital and Revenue Expenditure

Capital expenditure (CE) is expenditure that is likely to provide a benefit to the organisation for more than one accounting period/financial year.

Capital income (CI) is the proceeds of selling fixed assets.

The key points for CE and CI are as follows:

The benefits and period of those benefits may be difficult to predict.

Such expenditure can be defined as increasing the earning capacity of the business.

CE is incurred on the purchase of fixed assets such as land and buildings, plant and machinery, vehicles and fixtures and fittings and the cost of these fixed assets is, therefore, accounted for over their anticipated useful life.

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CE usually involves an annual depreciation charge

CE is concerned with purchasing high value, long-term and

permanent fixed assets for use in the business. These assets

are not bought to be resold.

Central government capital grants are an example of capital

income.

The principle is that capital grants should be recognized in the

profit and loss account so as to match with the expenditure to

which they are intended to contribute.


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Capital and Revenue Expenditures

Examples of capital expenditure:-

1. Acquiring fixed assets

2. Bringing them into the business

3. Legal cost of buying buildings

4.Carriage inwards on machinery bought, and

5. Any other cost needed to get the fixed asset ready for use

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Revenue expenditure: Expenditure on the supply andmanufacture of goods and provision of services charged inthe accounting period in which they are consumed.

Revenue income: Amounts derived from the provision of goods and services falling within the company’s ordinaryactivities, after deduction of returns, trade discounts andvalue added tax; also called turnover/sales It is expenditure that is likely to provide benefit to the

organisation for only the current accounting/financial year and so is charged against profits in the period to which it relates.


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It is a cost used by the organisation in trading.Revenue expenditure include running costs such as

electricity, business rates, wages and salaries of employees, interest charges, purchase of consumables such as stationery, goods purchased for resale etc.

Example of revenue expenditures:-

1. Repairs expenses paid for a company van

2. Petrol costs for van

3. Replacing a light tube inside office premises

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In some circumstances, expenditures may consist of both CE and RE. Accountants have to separate the total into different portion and charged to different book of accounts.

Example

YY company has been in business for many years, recently the boss decided to renovate the company’s premises and install a signage outside the building. After the contractor finished the works, YY co. received an invoice from the contractor as follow:-

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1. Repainting the front door $2,000 ( )

2. General repairs at public area $4,000 ( )

3. Signage production and installation $25,000 ( )

4. Replacement of electrical system $10,000 ( )

5. Installing a new entrance for wheelchair users $20,000 ( )

$61,000

Required: Mark C for Capital Expenditures and R for Revenue Expenditures in the bracket next to each item. Prepare the journal entries for the above transactions, assuming YY company pay cash to settle the bill immediately.

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DR. CR.

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1 Accounting for Executives Week 3 25/3/2011 (Fri) Lecture 3.

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