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

2. 2 Part I – Income Statement and Statement of Financial Position

3. 3 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. 4 Pro forma (Old Format) ABC Company Statement of Financial Position as at 31-Dec-2010 Non-current Assets$$ $ PremisesX,XXX VehiclesX,XXX X,XXX Current Assets InventoryXX,XXX BankXX,XXX CashXX,XXXXX,XXX Less: Current liabilities(X,XXX) Net current assetsXX,XXX Less: Non-current liabilities Bank loan(XX,XXX) XXX,XXX CapitalXXX,XXX Add: Retained Profits (or Less: Accumulated loss)XX,XXX XXX,XXX

5. 5 Example (con’t)

6. 6 Pro forma (New Format) ABC Company Statement of Financial Position as at 31-Dec-2010 Non-current Assets$$ PremisesX,XXX VehiclesX,XXX X,XXX Current Assets InventoryXX,XXX BankXX,XXX CashXX,XXXXX,XXX Total AssetsXX,XXX Equity and Liabilities Equity CapitalXX,XXX Add: Retained Profits (or Less: Accumulated loss)XX,XXX XX,XXX Non-current Liabilities Bank LoanXX,XXX Current LiabilitiesXX,XXX Total Equity and LiabilitiesXX,XXX

7. 7 Profit and Loss Account (Income Statement) Pro forma Chris Black Income Statement for the year ended 31-Dec-2010$ SalesX,XXX Less: Cost of goods Sold Opening StockXXX Add: PurchasesXXX Less: Closing Stock(XXX) Cost of goods sold(XXX) Gross ProfitX,XXX Less: Expenses WagesXXX ElectricityXXX InsuranceXXX Rent and ratesXXXXXX Net profitX,XXX Trading Account Profit and Loss Account

8. 8 Part II – Depreciation

9. 9 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

10. 10 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

11. 11 Depreciation- machine hour method

12. 12 Straight Line Method vs Reducing Balance Method Annual depreciation charge using Straight-line method Annual depreciation charge using Reducing balance method Y1 Y4

13. 13 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 dep n => Lower profit & Lower asset value) (Lower dep n => Higher profit & Higher asset value)

14. 14 Depreciation Straight-line method (SLM) Fair allocation of cost Certainty, simplicity and equality Widely adopted method Applicable 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

15. 15 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. 16 Depreciation Machine hour method This 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.

17. 17 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 account2,436 Depreciation account 2,436 Being depreciation charged for the year. Note: This method will make the asset account balance more fluctuate

18. 18 Depreciation- one step method Depreciation $ 31.12 04 Notebook computer2,43631.12.04 Trf. Profit & Loss2,436 31.12 05 Notebook computer2,43631.12.05 Trf. Profit & Loss2,436 Assets-Notebook computer 1.1.04 Bank10,00031.12.04 Depreciation2,436 31.12.04 Balance c/d7,56410,000 1.1.05 Balance b/d7,56431.12.05 Depreciation2,436 31.12.05 Balance c/d5,1287,564 1.1.06 Balance b/d5,128

19. 19 DEF Company Balance Sheet as at 31 December 20052004 Fixed Assets Notebook Computer5,1287,564 Current Assets25,40020,300 Less: Current Liabilities Accruals400300 25,00020,000 30,12827,564 Financed By Owner’s capital20,00020,000 Retained profit / (loss)10,1287,564 30,12827,564 Depreciation- one step method

20. 20 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 account2,436 Depreciation account (Expense) 2,436 Being depreciation charged for the year.

21. 21 Depreciation- two steps method Depreciation $ 31.12 04 Provision for Dep n 2,43631.12.04 Trf. Profit & Loss2,436 31.12 05 Provision for Dep n 2,43631.12.05 Trf. Profit & Loss2,436 Provision for depreciation 31.12.04 Balance c/d2,436 31.12.04 Depreciation2,436 31.12.05 Balance b/d2,436 31.12.05 Balance c/d4,87231.12.05 Depreciation2,4364,872

22. 22 DEF Company Balance Sheet as at 31 December 20052004 Fixed Assets Notebook Computer10,00010,000 Less: Accumulated Dep n (4,872)(2,436) 5,1287,564 Current Assets25,40020,300 Less: Current Liabilities Accruals400300 25,00020,000 30,12827,564 Financed By Owner’s capital20,00020,000 Retained profit / (loss)10,1287,564 30,12827,564 Depreciation- two steps method

23. 23 Part III – Fixed Asset Disposal

24. 24 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 dep n ), 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

25. 25 Example

26. 26 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. 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 dep n ), calculate the profit and loss on disposal if the notebook sell for : 1. $5,0002. 3,000 Assuming the transaction take place at the ended of the year 2.

28. 28 Disposal of Fixed Assets

29. 29 Disposal of Fixed Assets

30. 30 Part IV – Accounting Concept and Depreciation

31. 31 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. 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

33. 33 Part V – Capital and Revenue Expenditure

34. 34 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.

35. 35 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

36. 36 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

37. 37 Revenue expenditure: Expenditure on the supply and manufacture of goods and provision of services charged in the accounting period in which they are consumed. Revenue income: Amounts derived from the provision of goods and services falling within the company’s ordinary activities, after deduction of returns, trade discounts and value 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

38. 38 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

39. 39 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:-

40. 40 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. 41 Capital and Revenue Expenditures DR.CR. 1. 2. 3. 4.