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1
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
4
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.
16
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
22
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
Cr. Disposal Account
27
Disposal of Fixed Assets
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)
Cr. Disposal Account
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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Disposal of Fixed Assets
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Disposal of Fixed Assets
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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.
32
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.
Capital and Revenue Expenditure
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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.
Capital and Revenue Expenditure
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Capital and Revenue Expenditures
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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Capital and Revenue Expenditures
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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Capital and Revenue Expenditures
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.
41
Capital and Revenue Expenditures
DR. CR.
1.
2.
3.
4.