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

 

Accounting Principles

Accounting Principles

Introduction
Accounting has developed a number of rules which must be applied by everyone who is involved with the recording of financial information. If every accountant or bookkeeper followed their own rules it would be impossible for others to fully understand the financial position of a business. In the same way, it would be impossible to make a comparison between the financial results of two or more businesses if they had each applied their own rules in the preparation of their accounting statements.

Accounting Principles
Accounting principles are sometimes referred to as concepts and conventions. A concept is a rule which sets down how the financial activities of a business are recorded. A convention is an acceptable method by which the rule is applied to a given situation.
There are a number of accounting concepts and principles based on which we prepare our accounts. These generally accepted accounting principles lay down accepted assumptions and guidelines. The main accounting principles are explained below.

1. Business Entity
This is also known as the accounting entity principle. This means that the business is treated as being completely separate from the owner of the business. The personal assets of the owner, the personal spending of the owner etc. do not appear in the accounting records of the business.
If there is a transaction concerning both the business and its owner then it is recorded in the accounting records of the business. When the owner introduces capital into the business, it is credited to the capital account. When the owner makes drawings from the business a debit entry will be made in the drawings account which reduces the amount owed by the business to the owner.
Examples: Insurance premiums for the owner’s house should be excluded from the expense of the business. The owner’s property should not be included in the premises account of the business. Any payments for the owner’s personal expenses by the business will be treated as drawings and reduced the owner’s capital contribution in the business.

2. Money Measurement
This accounting principle means that only information which can be expressed in terms of money can be recorded in the accounting records. Money provides a common unit of measurement.
Examples: There are many aspects of a business which cannot be measured in terms of money and, therefore, do not appear in the accounting records. The morale of the workforce, the effectiveness of a good manager, market conditions, technological changes, the benefits of a staff training course all play an important part in the success of the business, but they will not appear in the accounting records as their value cannot be expressed in monetary terms.

3. Going Concern
The accounting records of a business are always maintained on the basis of assumed continuity. This means the business will continue in operational existence for the foreseeable future. This continuity means that the fixed assets shown in a balance sheet will appear at their book value, which is the original cost less depreciation, and stock will appear at the lower of cost or net realizable value.
If it is expected that the business will cease to operate in the near future the asset values in the balance sheet will be adjusted. Assets will be shown at their expected sale values which are more meaningful than their book value in this situation.
Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so
Example: Possible losses from the closure of business will not be anticipated in the accounts.
Fixed assets are recorded at historical cost.

4. Historical Cost
This principle requires that all assets and expenses are recorded in the ledger accounts at their actual cost. It is closely linked to the money measurement principle.
Example: The cost of fixed assets is recorded at the date of acquisition cost. The acquisition cost includes all expenditure made to prepare the asset for its intended use. It included the invoice price of the assets, freight charges, insurance or installation costs.

5. Accounting Period
The principle of going concern assumes that a business will continue to operate for an indefinite period of time. It is clearly not sensible or practical to wait until a business ceases trading before a report on its progress is made. Because reports are required at regular intervals, the life of the business is divided into accounting periods – usually years. This allows meaningful comparisons to be made between different periods for the same business and between one business and another business.
Example: The balance of the ledger accounts at the end of one trading period will be carried down to become the opening balance for the next accounting period. The expenses for the period will also be totaled and transferred to the profit and loss account for the period.

6. Matching
This is also referred to as the accruals principle. The revenue of the accounting period is matched against the cost of the same period (the timing of the actual receipts and payments is ignored). Revenues are recognized when they are earned, but not when cash is received. Expenses are recognized as they are incurred, but not when cash is paid. And the net income for the period is determined by subtracting expenses incurred from revenues earned.
Example: The figures shown in a trading and profit and loss account must relate to the period of time covered by that account, whether or not any money has changed hands.
Expenses incurred but not yet paid in current period should be treated as accrual/accrued expenses under current liabilities.
Expenses incurred in the following period but paid for in advance should be treated as prepayment expenses under current asset.
Depreciation should be charged as part of the cost of a fixed asset consumed during the period of use.

7. Prudence
This is also known as the principle of conservatism. This principle ensures that the accounting records present a realistic picture of the position of the business. Accountants should ensure that profits and assets are not overstated and that liabilities are not understated. The phrase “never anticipate a profit, but provide for all possible losses” is often used to describe the principle of prudence. Profits should only be recognized when it is reasonably certain that such a profit has been realized and all possible losses should be provided for.
Example: Stock valuation sticks to rule of the lower of cost and net realizable value.
The provision for doubtful debts should be made.
Fixed assets must be depreciated over their useful economic lives.

8. Materiality
This principle applies to items of very low value (items which are not “material”) which are not worth recording as separate items. Immaterial amounts may be aggregated with the amounts of a similar nature or function and need not be presented separately. Materiality depends on the size and nature of the item. Classes of similar items are to be presented separately in the financial statements. This would apply to a grouping such as current assets.
Example:What is material for one business may not be so for another business. A lap top computer may be regarded as immaterial for a large multi-national business, but would be material for a small sole trader.
A large business may decide that fixed assets costing less than $1000 will be regarded as immaterial and be charged as expenses. A small business may have a much lower figure.
The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss account as revenue expenditures, although they can last for more than one accounting period.
Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be grouped together as sundry expenses.

9. Consistency
There are some areas of accounting where a choice of method is available. For example, there are several different ways to calculate the depreciation of a fixed asset. Where a choice of method is available, the one with the most realistic outcome should be selected. Once a method has been selected, the method must be used consistently from one period to the next. If this is not done, a comparison of the financial results from year to ear is impossible, and the profit of a particular year can be distorted.
Companies should choose the most suitable accounting methods and treatments, and consistently apply them in every period. Changes are permitted only when the new method is considered better and can reflect the true and fair view of the financial position of the company. The change and its effect on profits should be disclosed in the financial statements.
Examples: If a company adopts straight line method and should not be changed to adopt reducing balance method in other period.

10. Duality
This is also referred to as the dual aspect principle. Every transaction has two aspects – a giving and a receiving. The term double entry is used to describe how these two aspects of a transaction are recorded in the accounting records.