Transcript Slide 1

ACCOUNTING FOR
MANAGEMENT DECISIONS
WEEK 5
PROFIT MEASUREMENT FOR
DEPRECIATION, INVENTORY AND
RECEIVABLES
READING: TEXT CHAPTER 4
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Learning Objectives cont’d
• Analyse expense recognition for non-current
tangible assets (depreciation)
• Analyse expense recognition for accounts
receivable (bad debts)
• Analyse expense recognition for inventory
(cost of goods sold)
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit Measurement and the
Calculation of Depreciation
Learning Objective: Analyse expense
recognition for non-current tangible
assets
Depreciation is an example of a deferred
expense where the cash is paid in advance
of the expense being recognised.
Property, Plant and Equipment are usually
eventually used up in the process of
generating revenue for the business.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Depreciation
– Depreciation – is an attempt to measure the cost
of the future economic benefits of an item of
property, plant and equipment which has been
used up in generating the income recognised
during a particular period.
• Depreciation is not an attempt to recognise a
loss in the Market Value of the asset
• Accummulated Depreciation is the cumulative
total of all depreciation charges and is deducted
from the original cost of the asset on the Balance
Sheet. It is a contra asset.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Depreciation
• Four factors are considered:
1.The cost (or other value) of the
asset
2.The useful life of the asset
3.The estimated residual value of
the asset
4.The depreciation method
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit Measurement and the
Calculation of Depreciation cont’d
The cost of the asset - includes all costs incurred
by the business to bring the asset to its required
location and make it ready for use e.g. delivery,
installation, legal title, alterations, improvements etc
(See Activity 4.14, p 162 text)
The useful life of the asset - the economic life of
the asset determines the expected useful life of the
asset for the purpose of calculating depreciation. The
economic life of an asset ends when the cost of
operating or holding the asset exceeds the benefit
derived from it. Economic life may be shorter than
physical life in many cases.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit Measurement and the
Calculation of Depreciation cont’d
Estimated residual value (disposal
value): defined as the likely amount to be
received on disposal of the asset. Like
useful life, estimated residual value can be
difficult to predict
Depreciation method: The three common
methods of deriving a depreciation expense
are:
1. straight line
2. Accelerated (Reducing balance)
3. Units of production
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Straight line depreciation
• Straight line method of depreciation has equal depreciation
expense in each period. This method allocates the amount to
be depreciated equally over each year of the useful life of the
asset
See example 4.1 on page 163
Consider the following information:
Cost of machine
$40,000
Estimated residual value
$ 1,024
Estimated useful life
4 years
Depreciable amount = Cost minus residual value
= 40,000 – 1,024
= $38,976.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Depreciation
The depreciable amount is then divided by the
useful life to get the annual depreciation expense.
38,976/4 = $9,744
This expense will appear on the Income Statement.
On the Balance sheet, the asset will appear as
follows:
Machine
40,000
Less Accumulated Depreciation
9,744
Written down value
30,256
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Accelerated Depreciation
(reducing balance)
– Accelerated depreciation methods
have systematically higher depreciation
expense in the earlier periods of the
asset’s life. The most common
accelerated depreciation method is the
reducing balance method which applies
a fixed percentage rate of depreciation
to the written down value of an asset
each year
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Accelerated depreciation
• See page 165
• Let us assume the same information as for the
straight line method but this time we are using
reducing balance and a fixed percentage of 60%.
WDV beg
Depreciation expense
Acc Dep
WDV end
40,000
60% X 40,000 = 24,000
24,000
16,000
16,000
60% X 16,000 = 9,600
33,600
6,400
6,400
60% X 6,400 = 3,840
37,440
2,560
2,560
60% X 2,560 = 1,536
38,976
1,024
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Units of Production method
– The Units of Production method is based on the units of output. It is
similar to straight line, but the useful life changes from time to output.
This method multiplies the depreciable amount by the relative output
for each period.
See page 166
Depreciable amount = Cost minus residual value
= 40,000 – 1,024
= 38,976
This depreciable amount is then divided by the estimated total
output to get a depreciation expense per unit of output.
The estimated total output over 4 years is 10,000 units.
38,976/10,000 units = $3.8976/unit
In year 1, they produce 1000 units, so the depreciation charge
would be $3.8976 X 1,000 = $3,898.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Depreciation cont’d
• Depreciation methods should be selected to be
appropriate to the particular assets and to their use in
the business.
• Accounting standard AASB 116 - ‘Property, Plant and
Equipment’ reinforces this view
• Accelerated depreciation methods result in greater
depreciation expense and lower net income than
straight line depreciation in early years of an asset’s
life.
• Depreciation does not provide funds for asset
replacement, it is used to calculate net profit
• Depreciation is an example of an accounting process
that requires a lot of judgement
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit Measurement and the Problem of
Bad and Doubtful Debts
Learning Objective: Analyse expense recognition for
accounts receivable
• Bad and doubtful debts are associated with accrued
income derived from selling goods on credit
• The risk of credit sales is that the customer will not pay the
amount due, thus ‘bad debts’ are created and ‘doubtful
debts’ if the matter is uncertain
• Bad debts must be ‘written off’ when it is reasonably
certain that the customer will not pay. This increases
expenses and reduces accounts receivable
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Bad and doubtful debts
• The matching principle requires that the bad debt
be written off in the same period as that of the
sale that gave rise to the debt.
• The problem though is that by the end of the
accounting period, we do not know which debts
are going to be bad, or not paid. Therefore we
have to make an estimate of bad debts, these are
in fact classified as doubtful at the end of the
accounting period.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Bad and doubtful debts
• Doubtful debts are estimated using either the percentage
of credit sales or the aged debtors listing
• Both these methods will determine the amount of debtors
balance that is not expected to be received.
• This will be recorded as:
-an expense to be included in the income statement
-a deduction from the debtors account labelled ‘allowance
for doubtful debts’ to be included in the balance sheet.
This account is another example of a contra asset account
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit Measurement and the Problem of
Bad and Doubtful Debts
See example 4.2, page 181
Boston Enterprises has debtors of $350,000 at the end of
the accounting year to 30 June, 2009. Investigation of
these debtors reveals that 410,000 is likely to prove
irrecoverable and that recovery of a further $30,000 is
doubtful.
Extracts from the financial statements would appear as
follows:
Income Statement
Bad debts written off
10,000
Doubtful debts expense 30,000
Balance Sheet
Debtors
less allowance for DD
340,000
30,000
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Bad and doubtful debts
–
Assume now that during the next accounting
period, it was discovered that $26,000 of the
debts considered doubtful proved to be
irrecoverable.
These debts must now be written off as
follows:
-reduce debtors by $26,000
-reduce allowance for doubtful debts by
$26,000
An allowance for doubtful debts of $4,000 will
still remain.
An overall impairment test under AASB 132
may mean changes to the terminology within
the reporting for bad and doubtful debt
expenses
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Profit Measurement and the
Valuation of Inventory
Learning Objective: Analyse expense recognition for
inventory
What is Inventory?
Inventory - Finished goods, raw materials, stores or supplies and
work-in-progress
– Inventory represents another example of a deferred expense,
where the payment for inventory occurs before the recognition
of the expense.
– The cost of Inventory is carried in the Asset account until it is
sold.
– When the inventory is sold, the cost is transferred out of the
Inventory account, in to the expense account, at which time it
appears on the Income Statement.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
What is the Cost of Inventory - All costs directly
related to bringing the inventory into a saleable state.
See AASB 102, paragraph 10
– Cost of purchase
– Cost of conversion
– Costs incurred in bringing the inventories to their
present location and condition
How do you determine what the cost of sales is?
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory cost flow assumptions
• First in First out (FIFO) - the earlier
inventory held is the first to be sold
• Last in First out (LIFO) - the latest inventory
held is the first to be sold
• Average Cost - a weighted average cost is
determined, to derive cost of sales and cost of
remaining inventory held
• The Australian Accounting standard does not
allow the use of LIFO
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory cost flow assumptions
– In times of changing prices, each cost flow
assumption will result in different profit figures
for the period and different ending inventory
valuations.
– E.g. If FIFO is used the first costs in to Inventory
are the first costs out to cost of goods sold. In
times of rising prices, this means that the oldest
costs will go to Cost of goods sold and the more
recent costs will end up in ending Inventory.
– Therefore if costs are rising, we report a higher
profit under FIFO because of the lower Cost of
Goods sold.
– Over the life of the business, the total profit will
be the same whichever cost assumption has
been used
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory systems
• As well as deciding which cost flow
assumption to use, a business must also
decide which inventory system to use.
• Perpetual inventory system - maintains
continuous records of all inventory
movements, records both cost and selling
price, and volume.
• The advantage of the perpetual inventory
system is that at any point in time the
business knows what inventory should be on
hand and what the cost of sales for the
period to date has been.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory systems
• Physical / Periodic inventory system much simpler than perpetual, does not
maintain records of cost of inventory sold.
• the inventory (asset) account remains
unchanged during the year
• At year end a stock count is undertaken to
update the inventory balance and calculate
cost of goods sold
• All purchases and sales are assumed to be
at the end of the period.
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
– The business will have different format
Income Statements depending on which
inventory system is being used.
– The trading section of the Income statement
will differ because of cost of sales.
– If a perpetual inventory system is used, there
is a cost of sales account so the trading
section will appear as follows:
Sales
XXX
less cost of sales
= Gross Profit
XX
XXX
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
– If a periodic inventory system is used, cost of
sales has to be calculated so the trading
section will appear as follows:
Sales
XXX
Less cost of Sales
Beginning Inventory XX
Plus Net Purchases
XX
Minus Ending Inventory X
XX
= Gross Profit
XXX
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
Example
The inventory records of Rafters Ltd reflected the following
information for the year ending 31 December
No. of Units
Beg Inventory
Unit cost
Total cost
100
$15
150
17
$1500
Purchases
30 May
$2550
30 September
200
Goods available for
sale
450
20
$4000
$8050
Sales
28 February
(80)
30 June
(120)
31 October
(200)
Ending Inventory
50
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
a) Assume that Rafters uses a periodic
inventory inventory system and FIFO.
Calculate cost of goods sold and
ending inventory
b) Assume that Rafters uses a perpetual
inventory system and FIFO. Calculate
cost of goods sold and ending
inventory
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
a)Periodic
Ending Inventory = 50 X $20 = $1000
Cost of goods sold =
Beginning Inventory
$1500
Plus purchases
6550
Cost of goods available
$8050
for sale
Less ending Inventory
$1000
Cost of goods sold
$7050
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory
b)Perpetual
Cost of goods sold
80 X $15
$1200 (28/2)
20 X $15
$ 300 (30/6)
100 X $17
$1700 (30/6)
50 X $17
$ 850 (31/10)
150 X $20
$3000 (31/10)
Total COGS
$7050
Ending Inventory
50 X $20
$1000
Note that COGS + ending Inventory = Cost of goods
available for sale
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia
Inventory cont’d
• Net realisable value (NRV): The estimated selling price
less any further costs necessary to complete the goods
and any costs involved in selling and distributing the
goods
• AASB 102 ‘Inventories’ requires valuing inventory on the
basis of the lower of cost and net realisable value on an
item-by-item basis (prudence/conservatism assumption)
• Inventory valuation and depreciation are good examples
of where the ‘consistency convention’ should be applied
• Consistency convention: holds that when a particular
method of accounting is selected to deal with a
transaction, this method should be applied consistently
over time
Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia