Accounting Concepts_ Match Exercise

Accounting Concpts_Fill in the Blanks Exercise

Methods of calculating depreciation

Methods of calculating depreciation

There are several ways in which depreciation can be calculated. The aim is to match that proportion of the cost of the fixed asset to the revenue earned by it each year. This is not an easy task in reality and many factors must be considered, such as:
How long will the fixed asset last?
How much will be received when the fixed asset is sold at some point in the future?
How can the benefits gained from the use of the fixed asset be measured?
There are three main methods of depreciation:
1. Straight line method      2.Reducing balance method       3.Revaluation method

There are other methods which may be used, but these are outside the scope of our syllabus.

Different types of fixed assets may be depreciated using different methods and using different rates. The method chosen must be the one which spreads the cost of the asset as fairly as possible over the years which benefit from the use of the asset. Once a method has been selected, it should be applied to that asset each year. This is an application of the concept of consistency.

Straight line method of depreciation

This may also be called the fixed installment method. Under this system the same percentage rate is used each year and the amount of the depreciation charged is the same each year. It is used for fixed assets which provide equal benefits to the business each year they are in operation. Using this method, it is possible for an asset to reach a nil value in cases where no residual value is expected. The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.

Reducing balance method of depreciation

This may also be called the diminishing balance method. Under this method the same percentage is used each year but, because it is calculated on a different value each year, the amount of depreciation will reduce each year. At the end of the first year the agreed percentage of depreciation is deducted from the cost of the fixed asset. In later years the same percent­age is used, but it is calculated on the cost of the asset less the depreciation already charged (the reduced balance). This means that a higher amount of depreciation will be charged against profits in the early years of the life of the fixed asset. Reducing balance depreciation is used for assets which, in the early years, have lower maintenance costs but give greater benefits than in later years. As the depreciation is always calculated as a percentage of the written-down value (reduced balance) of the fixed asset, the asset will never reach a nil value in the books. Any estimated residual value will be taken into consideration when the percentage rate is decided upon.
 

Revaluation method of depreciation

Sometimes it is not possible to maintain detailed records of certain types of fixed assets. For assets such as very small items of equipment, packing cases, and hand tools it is not practical to maintain full records of each particular asset. Without full accounting records the straight line and reducing value methods of depreciation cannot be operated. In such cases the revaluation method of depreciation is used.

Under this method the assets are valued at the end of each year. This value is compared with the previous valuation (or the cost, if it is the first year of ownership of the asset) and the amount by which the asset has fallen in value is the depreciation for the year.

Formula:

Use of fixed asset (Depreciation) = Value of Fixed Assets at start add Purchases of Fixed Assets during the year Less Value of Fixed Assets at end

CAUSES FOR DEPRECIATION

CAUSES FOR DEPRECIATION

1. Physical deterioration 

This may be through wear and tear, when a fixed asset wears out through being used or ' it may be through rust, rot and decay, when a fixed asset falls into a bad physical condition.

 2. Obsolescence 

 An asset becoming out-of-date (or) obsolete either through technological advances or a change in tastes and fashions. When it becomes out of date because newer and more efficient assets are available or it may become inadequate as it is no longer able to meet the needs of the business.

3. Passage of Time
 This arises when a fixed asset has a fixed life of a certain number of years e.g. a lease.

4. Depletion 

This occurs in assets such as wells or mines: when the worth of the asset falls over a period of time as value is removed from the asset.

ACCOUNTING FOR DEPRECIATION

ACCOUNTING FOR DEPRECIATION

 

Depreciation is an estimate of the loss in value of a fixed asset over its expected working life. Most fixed assets lose value over time. The accounts of a business should show a fair view of the financial position so it is necessary to record this loss in value.

In the Income Statement depreciation of fixed assets will appear with the other expenses and the net profit will be reduced. In the Balance Sheet the fixed assets will be shown at a value below cost price, the written-down value, or book value, which is the cost minus the amount of depreciation up to that date.

Fixed assets are purchased to enable the business to earn profits over several years. It would not, therefore, be correct to charge the total cost against the profits of one year only. Depreciation enables the cost of a fixed asset to be spread over all the years which will benefit from the use of the asset. This is an application of the matching concept, as the cost is matched against the sales of the years which benefit from the use of the fixed asset.

Depreciation is essentially an estimate of the loss in value of a fixed asset: the exact amount of depreciation can only be calculated when the asset is sold. It is also important to remember that depreciation does not involve any actual money going out of the business - it is a non-monetary expense. Because it is charged in the Income Statement, depreciation will reduce the net profit to a more realistic figure. This is an application of the prudence concept. If depreciation is not taken into account the net profit will be over-stated, which could result in the owner of the business making excessive cash drawings which the business cannot really afford. This concept is also applied in the Balance Sheet when the fixed assets are not recorded at cost, but at a more prudent figure (written-down value). Just as depreciation does not involve a monetary expense, neither does it provide a cash fund for the replacement of fixed assets.

Objectives in Selecting Accounting Policies standards

Objectives in Selecting Accounting Policies standards

The quality of information contained in financial statements determines the usefulness of these statements. This quality of information can be measured in terms of four factors – relevance, reliability, comparability and understandability.

Relevance

Financial statements should be prepared to meet the objectives of the users. Relevant information which can satisfy the needs of most users is selected and recorded in the financial statement. These financial statements can be used as the basis for financial decisions. This means that it can be used to confirm, or correct, prior expectations about past events and also to help forming, revising or conforming expectations about the future.

Reliability

The information is free from material error and bias. The information provided in financial statements can be reliable if it is:

• Capable of being depended upon by users as being a true representation of the underlying transactions and events which it is representing
• Capable of being independently verified 
• Free from bias 
• Free from significant errors 
• Prepared with suitable caution being applied to any judgements and estimates which are necessary. 

Comparability

The information enables comparisons over time to identify and evaluate trends. The information contained in financial statements can be useful if it can be compared with similar information about the same business for another accounting period or at another point in time. It is also useful to be able to compare the information with similar information about other business.

In order to make comparisons, it is necessary to be aware of any different policies used in the preparation of the financial statements, any changes in these policies and the effects of such changes. It is important to be able to identify similarities and differences between the information in the financial statement and the information relating to other accounting periods or other businesses.

Understandability

It is important that financial statements can be understood by the users of those statements. This depends partly on the clarity of the information provided.

It also depends on the abilities of the users of the financial statements. It is normally assumed that users of financial statements have a reasonable knowledge of business and economic activities and accounting and that they will be reasonably diligent when studying the financial statements because it is decided that it is too difficult for users to understand.

Professional Ethics in Accounting

Professional Ethics in Accounting

 
Ethics is a branch of philosophy and is about the way people judge rights and wrongs of their actions. It is a code of conduct that is followed by members of a community.

To explain ethics, people say that ethics begins where the law ends. A person or business may act legally according to laws of the particular country, but their actions are not necessarily ethical.

Profitability should not be the only consideration when formulating the policy of a business: social and moral aspects are also considered. By including such factors, a business is not only applying the laws of the country, but is also applying a moral or ethical approach.

Solely from an accounting point of view, an ethical approach covers things like honesty, trustworthiness, prevention of fraud and prevention of corruption. The increased use of information and communications technology in bookkeeping and accounting brings additional ethical problems such as computer-based fraud.

All the accounting organizations actively encourage their members to apply a minimum code of conduct. If such minimum standards are not upheld, an accountant is guilty of professional misconduct (which can result in loss of reputation, a monetary fine, and even imprisonment).

It is not enough for a business simply to formulate a code of ethics and expect it to be followed by its employees. The actions and attitudes of the employees need to be regularly monitored. The code may need to be reassessed at regular intervals and modified to meet changes within the business.

Why an accountant would consider it is professionally unethical to improve the financial results of a business by making the adjustments in the accounting records:

Ø Accountants work with generally accepted rules such as accounting standards

Ø Accountants are expected by profession and public to produce reliable financial information

Ø Professional standards are more important than individual organizations

Ø Preparing accounts for the temporary benefit of one individual or organisation, even an employer, is against these rules and training

Ø An accountant could be penalised legally or professionally for not following agreed practice