accounting b lecture notes
ACCOUNTING B LECTURE NOTES LECTURE 1 – INTRODUCTION LO1: DEFINE ACCOUNTING Accounting: the art of recording, classifying and summarising transactions in a significant manner and in terms of money, transactions and events that are, in part at least, of a financial character, and interpreting the results. Accounting is a service activity. Its function is to provide qualitative information, primarily financial in nature, about economic entities e.g. businesses that is intended to be useful in making economic decisions and in making reasoned choices among alternative courses of action. Objective of General Purpose Financial Reporting Para 43: General purpose financial reports shall provide information useful to users for making and evaluating decisions about the allocation of scarce resources. LO2: DESCRIBE THE FUNCTIONS OF ACCOUNTING Stewardship function: focus on demonstrating compliance with delegated authorities i.e. following the law. Decision making: providing information for decisions about the allocation of scarce economic resources. LO3: DESCRIBE THE PROCESSES BY WHICH ACCOUNTANTS RECORD, SUM MARISE AND REPORT INFORMATION Recording transactions Transactions are recorded according to Generally Accepted Accounting Practices Economic entity: economic entity assumes that a business’s financial activities can be separated from the business owners’ financial activities. This allows a user to examine a business’s accounting information without worrying that that information includes personal affairs of the business owner or other business activities. Going concern: going concern assumes that a company will continue to operate indefinitely into the foreseeable future unless there is evidence to suggest the contrary. Those that are not going concerns are often in the process of liquidation (selling the resources and paying off debts). This assumption allows accountants to use certain techniques e.g. if entity is not selling its assets, then assume cost principle. Transactions are recorded under accrual accounting, and employs the revenue recognition principle and matching principle. Revenue recognition principle: states that revenue is recorded when it is earned, regardless of whether or not payment has been received i.e. when service has been carried out or goods have been sold. Cost principle: states that assets should be recorded and reported according to the cost paid originally to acquire them, regardless of how long ago that was. For this reason, the amounts shown on financial statements are referred to as historical costs. Matching principle: states that an expense is recorded when it is incurred to generate revenue i.e. expenses should be recorded in the period resources are used to generate revenue. E.g. for assets like equipment, the cost of the asset must be spread over the periods that it is used- equip used for 4 months means that cost is divided by 4 (straight line depreciation). Conservatism: this is a qualitative characteristic of accounting info. When uncertainty exists in terms of how to account for or report a transaction, accounting info should present the least optimistic alternative as to avoid overstating revenues or assets. Objectivity: accountants should maintain objectivity when recording transactions. Summarising transactions Transactions are summarised in ledger accounts and in the chart of accounts. Ledger: a collection of T-accounts and their balances. When an accounting transaction is recorded in the journal, amounts recorded in the debit and credit columns are transferred to the debit and credit columns of the respective T-accounts in the ledger. This process is called posting. This is useful for examining the total balance of each account. The ledger needs to have the company name followed by ‘general ledger’, and then the T-accounts listed in categories of assets, liabilities, equity, revenue, expenses, and dividend. Chart of accounts: the list of various accounts that a company uses to capture its business activities. Chart of accounts will vary across businesses e.g. a bank will have accounts relating to customer deposits, while a biotech company will have accounts relating to research and development. Reporting transactions Transactions are reported in the statement of comprehensive income, statement of cash flows, & statement of financial position. Statement of comprehensive income: reports a company’s profitability by reporting its revenues and expenses. Shows a company’s revenues, followed by expenses and a list of those expenses, total expenses and then net profit/loss. Statement of financial position: to answer questions such as “what does the business own?” and “what does it owe?” the statement of financial position reports a business’s assets, liabilities and equity. Statement of cash flows: reports business’ cash inflows & outflows from its operating, financing and investing activities over a specific period of time.
LO5: ACCOUNTING FOR ETHICS AND THE ENVIR ONMENT Business managers make ethical decisions every day. There are ethical dimensions to most of business decisions faced by managers. In today’s business environment, companies not only have to be aware of the economic impacts of their decisions, but also their ethical impacts. Ethical problems arise in organisations for a variety of reasons e.g. undue pressure to achieve short-term productivity and profitability goals may lead to unethical behaviour such as forcing employees to work hours that exceed limits set by state and federal agencies, intentionally ignoring product safety concerns, or falsifying accounting records or other documentation. Economist Milton Friedman argued that the only social responsibility of corporations was to increase their profits. He stated that business managers should not be expected to make socially responsible decisions because they are not trained to do so. Given the world that we now live in, this perspective is no longer valid. Business ethics results from the interaction of personal morals and the processes and objectives of business. Business ethics is nothing more than our personal views of right and wrong applied in a business setting. Managers must also consider various stakeholders when evaluating ethical dilemmas. A chief executive officer cannot simply make the decision that is best for her without considering the interest of other employees, shareholders, customers, suppliers, etc. Companies frequently create ethics programs to establish and help maintain an ethical business environment. Some common elements of ethics programs include written codes of conduct, employee hotlines and ethics call centres, ethics training, processes to register anonymous complaints about wrongdoing and ethics offices. The case of Enron in the US is an example where ethics programs within organisations were not effective. In late 2001, the company Enron filed for bankruptcy protection. Investigations into the company’s failure revealed a series of dubious transactions designed by the company’s top officials to enrich themselves. The company’s former chief financial officer and two former chief executive officers were found guilty of the fraud. Each year, The Ethisphere Institute identifies the world’s most ethical companies by ranking the companies on seven key dimensions: corporate citizenship and responsibility; corporate governance; innovation that contributes to public wellbeing; industry leadership, executive leadership and tone from the top; legal, regulatory and reputation track record; and internal systems and ethics/compliance program. One of the interesting findings is the strong, positive correlation between ethical standards and successful financial performance. The major professional accounting bodies in Australia jointly subscribe to the guidelines of the Accounting Professional and Ethical Standards Board (APESB). These standards broadly define the ethical obligations of accountants in practice.
LECTURE 2 – NON-CURRENT ASSETS & INTANGIBLE ASSETS LO1: DESCRIBE NON -CURRENT ASSETS AND HOW THEY ARE RECORDED, EXPENSED AND REPOR TED Asset: something that has future value for the company. It is measurable and the business has to own it. Non-current asset: any tangible resource that is expected to be used in the normal course of operations for more than one year and is not intended for resale e.g. land, buildings, equipment, furniture, fixtures, etc. Some non-current assets e.g. land are not depreciable because they have indefinite lives. If a business buys something that it intends to resale, it is inventory (current asset). The three primary activities for property, plant and equipment (the main non-current assets) are: 1. Acquisition of non-current assets 2. Depreciation of non-current assets over their useful lives 3. Disposal of non-current assets Recording non-current assets Non-current assets should be recorded at the cost of acquiring them, including compulsory costs such as the purchase price, taxes and duties paid on the purchase, fees e.g. closing costs paid to attorneys, delivery costs, insurance costs during transit, & installation costs. That is, all costs that are required for the asset to be used in operations. E.g. Assume Tran Paper Supply buys a delivery truck and pays the following: a) Purchase price: $60,000 b) Additional import duty: $3,600 c) Stamp duty: $400 d) GPS system: $1,000 e) Non-compulsory insurance: $1,400 Entry to record the purchase of the truck is: Date Description Debit Credit Insurance is not included here because it’s non-compulsory. (Date) Delivery truck 65,000 It needs to be recorded using a separate journal entry. Cash
65,000
Expensing non-current assets A non-current asset converts to an expense as it is used or consumed. The expensing of non-current assets is accomplished through depreciation. Depreciation: the process of allocating the cost of a non-current asset over its useful life.
Depreciation is an application of the matching principle. Because a non-current asset is used to generate revenues period after period, some of its cost should be expensed in, or matched to, those same periods. For accounting purposes, depreciation is a process of allocating an asset’s cost, not a method of determining an asset’s net realisable or market value. Depreciation is not about getting an asset to its market value. E.g. you buy a pair of shoes for $200 expecting to wear them 200 times, and expecting them to be worthless after this usage. After you wear them once, they might have a net realisable value (NRV) of $100, but depreciation might only be $1 if it is based on “use”. Recording depreciation Depreciation expense is normally calculated at the end of an accounting period and recorded with an adjusting journal entry. The general form of the entry to record depreciation is: 1. Debit depreciation expense (expense increasing) 2. Credit accumulated depreciation (contra-asset increasing) Accumulated depreciation is a contra-asset account, meaning that it sits just below the non-current asset it is related to, and its accumulating balance is subtracted from its related non-current asset account to give the carrying amount i.e. net book value of the non-current asset. Therefore, carrying amount decreases over time. Reporting depreciation Like other expenses, depreciation expense is reported on the statement of comprehensive income, often as a separate line item. In 2012 Wesfarmers reported depreciation and amortisation expenses of $995 million as one of the expenses in the income statement, while Woolworth’s depreciation and amortisation expenses were approximately $896 million. A different depreciation method may alter profits by millions. LO2: COMPARE DEPRECIATION EXPENSE USING STRAIGHT-LINE, REDUCING-BALANCE & UNITS-OF-ACTIVITY This is the second of the primary activities associated with non-current assets. When a company owns depreciable assets, it must calculate depreciation expense each period. Doing so requires the following information about the asset: a) Its cost (usually what you bought it for i.e. historical cost) b) Its residual or salvage value (what you think you will sell it for, when you do) c) Its useful life (how long you will keep it) d) Depreciation method (how you are going to spread its cost over its life) Straight-line depreciation method Straight-line depreciation spreads depreciation evenly over the useful life of an asset. It is commonly used because it is simple. The depreciable cost of the asset is divided by the useful life of asset to yield the amount of depreciation expense per period. 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒) ÷ 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 E.g. Assume that Tran’s truck purchased on 1/7/2012 for $65,000 has a salvage value of $15,000 and a 5-year life or 100,000km. Using straight-line depreciation, Tran would record $10,000 per year, or (65,000-15,000) ÷ 5 = 10,000. Date 30/06/13
Description Depreciation expense Accumulated depreciation- truck
Debit 10,000
Credit 10,000
After this entry is recorded, the carrying amount (book value) of Tran’s truck after one year is $55,000. Net book value decreases $10,000 yearly until it equals the salvage value estimated for the asset. Reducing-balance depreciation method The reducing-balance method of depreciation is an accelerated method that results in more depreciation expense in the early years of an asset’s life and less depreciation expense in the later years. They provide larger expenses (and if used for tax purposes larger tax deductible expenses) in earlier years of a non-current asset’s life. Accelerated depreciation methods may match expenses to revenues better than the straight-line method. More depreciation expense is recorded when the asset is more useful in its early years. To simplistically calculate the depreciation rate for the reducing-balance method of depreciation, we use 2 times the straight-line rate. This often means the last depreciation expense calculation is to reduce the book value to the residual value. 1 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡/𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 × (2 × ) 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
E.g. Truck purchased for $65,000 on 1/7/2012 has a residual value of $15,000 and a 5-year life. The straight-line rate is 1/5 or 20%. If we use two times the straight-line rate for 2013, it would be $65,000 x (2 x 20%) = $26,000. Date 30/06/13
Description Depreciation expense Accumulated depreciation- truck
Debit 26,000
Credit 26,000
Companies may opt for the reducing-balance method when they desire government assistance, have union problems e.g. Qantas lowering profit figure to show they can’t possibly pay employees any more than they do now, or want good growth in future years.
There are several key issues to notice in the reducing-balance depreciation schedule: a) The depreciation rate is applied to the carrying amount of the asset b) Over an asset’s life, an entity cannot record more total depreciation than the asset’s depreciable cost. That is why some adjustment must be made in 2015, since the depreciable cost can’t exceed $50,000 (or $65,000 - $15,000). c) There is more depreciation expense in the earlier years and less in the later years.
Over an asset’s life, an entity cannot record more total depreciation than the asset’s depreciable cost. That is why some adjustment must be made in 2015, since the depreciable cost can’t exceed $50,000 (or $65,000 - $15,000). Units-of-activity depreciation method Both the straight-line and reducing-balance methods are a function of the passage of time rather than the actual use of the asset. In contrast, the units-of-activity depreciation method calculates depreciation based on use. Because it relies on an estimate of an asset’s lifetime activity, the method is limited to assets whose units-of-activity can be determined in some way. Depreciation per unit-of-expected activity is the depreciable cost of the asset divided by the estimated units-of-activity over the life of the asset. It is more difficult to implement, but more accurate for certain assets. 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒) ÷ 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 × 𝐴𝑛𝑛𝑢𝑎𝑙 𝑢𝑠𝑒 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 E.g. Truck purchased for $65 000 on 1/1/2012 has a residual value of $15,000 and a life of 100 000 km. Depreciation per unit is $0.50/km or ($65 000 – $15 000) ÷ 100 000 km. If the truck is driven 24,000 km in 2012-13, depreciation expense is $12,000, or 24,000 x $0.50. Date 30/06/13
Year
Description Depreciation expense Accumulated depreciation- truck
Calculation
Debit 12,000
Credit 12,000
Depreciation expense
Accumulated depreciation Carrying amount $0 $65,000 2013 $0.50 x 24,000km $12,000 $12,000 $65,000 – $12,000 = $53,000 2014 $0.50 x 22,000km $11,000 $12,000 + $11,000 = $23,000 $53,000 – $11,000 = $42,000 2015 $0.50 x 27,000km $13,500 $23,000 + $13,500 = $36,500 $42,000 – $13,500 = $28,500 2016 $0.50 x 17,000km $8,500 $36,500 + $8,500 = $45,000 $28,500 – $8,500 = $20,000 2017 $0.50 x 10,000km $5,000 $45,000 + $5,000 = $50,000 $20,000 – $5,000 = $15,000 There are a couple of key issues to notice in the units of activity depreciation schedule: a) Depreciation expense is a function of usage. b) The total kilometres used in all years is equal to 100,000km and the total depreciable cost is $50,000. Comparison of depreciation methods Straight-line Reducing balance Units-of-activity Year Depreciation exp. Carrying amount Depreciation exp. Carrying amount Depreciation exp. Carrying amount 2013 $10,000 $55,000 $26,000 $39,000 $12,000 $53,000 2014 $10,000 $45,000 $15,000 $23,400 $11,000 $42,000 2015 $10,000 $35,000 $8,400 $15,000 $13,500 $28,500 2016 $10,000 $25,000 $0 $15,000 $8,500 $20,000 2017 $10,000 $15,000 $0 $15,000 $5,000 $15,000 Total $50,000 $50,000 $50,000 The summary shows: Total depreciation expense over the life of the asset is $50,000. No method is right or wrong, just different. Companies choose a method based on different reasons. Depreciation method depends on the asset and how the asset is used. Businesses can change depreciation method from year to year as long as they disclose the changes they’ve made. LO3: THE EFFECTS OF ADJUSTMENTS THAT MAY BE MADE DURING A NON-CURRENT ASSET’S USEFUL LIFE Since non-current assets are used for multiple years, companies sometimes need to make adjustments as new information is available or as new activity occurs. These adjustments can arise from changes in the estimates of useful life, additional money spent to improve/maintain the non-current asset, or significant declines in the asset’s net realisable value.
Changes in depreciation estimates E.g. Matthew purchases a machine for $90,000 on 1/7/2010 with a 10 year useful life and a $10,000 residual value. Using straightline, Matthew records $8,000 depreciation expense each year. Date 30/06/13
Description Depreciation expense Accumulated depreciation- machine
Debit 8,000
Credit 8,000
Start of year 5: Matthew estimates that the machine will now only last 8 years and has a residual value of $6,000. The prospective revision (current and future) will not correct the first four years. What is the new annual depreciation? 1. Calculate the carrying amount at the start of the new year i.e. year 5 (2014): $90,000 – (4 x $8,000) = $58,000. 2. Calculate remaining depreciable cost by subtracting residual value from carrying amount: $58,000 – $6,000 = $52,000. 3. Calculate revised depreciation expense per year by dividing depreciable cost by years remaining: $52,000 ÷ 4 = $13,000 Additional expenditures after acquisition Most non-current assets require expenditures throughout their useful lives. The accounting treatment for expenditures made during the useful life of a non-current asset depends on whether they are classified as ‘capital’ or ‘revenue’ expenditures. Capital expenditure: an expenditure that increases the expected useful life or productivity of the asset. Record new expenses as part of the asset’s value and recalculate depreciation expense per year. Revenue expenditure: an expendi2ture that maintains the expected useful life or productivity of the asset. Just expense these off. Capital expenditure (changes asset’s value) example: A company purchases a non-current asset for $50 000 on 1/1/2013, with a 5 year life and no residual value. During the 5th and final year of the asset’s life, the company incurs $8,000 for upgrades that extend the asset’s life to 7 years. Date Year 5
Description Non-current asset Cash (To record upgrade to asset)
Debit 8,000
Credit 8,000
Change in depreciation due to capital expenditure: 1. Calculate net book value after capital expenditure: $50,000 + $8,000 = $58,000. 2. Calculate carrying amount for the current (5th) year by subtracting book value by salvage: $58,000 – ($10,000 x 4) = $18,000. 3. Calculate depreciation expense per year: $18,000 ÷ 3 = $6,000 per year. Revenue expenditure example: A company purchases a non-current asset for $50 000 on 1/7/2010, with a 5 year life and no residual (salvage) value. During the 5th and final year of the asset’s life, the company incurs $1,000 in ordinary maintenance. Date Year 5
Description Maintenance expense Cash (To record normal maintenance)
Debit 1,000
Credit 1,000
Asset impairment (asset write-downs) and asset revaluation When a non-current asset’s recoverable amount i.e. market value falls below its carrying amount, the asset is impaired. Under AASB 136, entities apply conservatism by writing these assets down from their carrying amount to their recoverable amount (through use or sale). Normally any loss on impairment is an expense. Special rules apply to impairment of assets previously revalued and reversal of impairments. E.g. A business has an equipment that makes a unique toy. The equipment has a carrying amount of $140,000 and a higher market value. Suppose that the toy suddenly loses its popularity, and the company is unable to alter the machine to produce anything else. As a result, the fair (market) value of the machine plummets to $40,000. The company declares that the asset is impaired. After the impairment entry, depreciation expense would be calculated based on the revised depreciable amount and remaining useful life. The asset impairment would be recorded as follows: Date Description Debit Credit ‘Impairment loss’ account is increased to reflect the decline Impairment loss (decrease equity) 100,000 in value of the asset. This reduces equity. This loss is part of Non-current asset/Intangible asset 100,000 the profit and loss and would be included with other (To record permanent impairment) expenses. E.g. when revaluating land that has increased significantly in market price, the following entry would be recorded: Date Description Debit Credit ‘Asset revaluation reserve’ is NOT a revenue account and Land 100,000 thus, not included in profit and loss statement. Asset revaluation reserve (To record permanent impairment)
100,000
LO4: RECORD THE DISP OSAL OF NON -CURRENT ASSETS The accounting for the disposal of a non-current asset consists of the following 3 steps: 1. Update depreciation on the asset. 2. Calculate gain or loss on the disposal. 3. Record the disposal.
Rules for calculating gain or loss on disposal: 1. Record any necessary depreciation expense (possibly for a partial period) to update the accumulated depreciation account. 2. Calculate any gain or loss on the disposal by comparing the asset’s carrying amount to its recoverable amount. 3. Prepare a journal entry that decreases the asset account and its related accumulated depreciation account. 4. Record any gain or loss on the disposal. E.g. a company purchases machine on 1/1/2013 for $30,000 with a useful life of 4 years and residual value of $2,000. The company uses the straight-line method and records depreciation expense annually on 31 December. The annual depreciation expense for the machine is $7,000. The company sells the machine on 30th June 2015 for $12,000. To account for the sale, the company must first update the accumulated depreciation account. The asset has been used for 6 months since the last time depreciation was recorded (31 December), so the company must record 6 months of dep. Expense i.e. $3,500. Thus, this entry would be made: Date 30 June 2015
Description Depreciation expense Accumulated depreciation (To record accumulated dep.)
Debit 3,500
Credit 3,500
The accumulated depreciation account is updated to $17,500 (7,000+7,000+3,500). With this balance, the gain/loss on disposal can be calculated as follows: Proceeds from sale $12,000 Cost of machine $30,000 Less: accumulated depreciation (17,500) Carrying amount at 30 June 2015 12,500 Loss/gain on sale (500) Gain/Loss = Sales price – (Initial cost – Accumulated depreciation) The business has generated a loss of $500. With this info, the company can prepare the following entry to record the disposal: Date 30 June 2015
Description Cash Accumulated depreciation Loss on disposal Machine (To record disposal of machine)
Debit 12,000 17,500 500
Credit
30,000
LO5: MANAGEMENT OF NON-CURRENT ASSETS USING HORIZONTAL, VERTICAL AND RATIO ANALYSES Three issues are important when managing non-current assets: a) How productive are the company’s non-current assets in generating revenues? b) What is the condition of the company’s non-current assets? c) How are cash flows affected by the purchase of non-current assets? Horizontal and vertical analysis These two analyses show whether a company’s non-current assets are stable or not. Horizontal analysis: shows an increase/decrease in non-current assets and depreciation expense from this year to prior year. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 − 𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 = 𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 Vertical analysis: shows as a % how much non-current assets make up total assets or how much depreciation expense makes up sales revenue/net sales e.g. depreciation expense is 5%. This shows that for every dollar in sales revenue, the company incurs about 5 cents in depreciation expense. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 %= 𝑜𝑟 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒/𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 Non-current asset turnover ratio Non-current asset turnover ratio shows whether the company is using non-current assets productively to generate revenues. Non-current asset turnover ratio: compares total revenues during a period to the average carrying amount of non-current assets during that period. Because this ratio compares total revenues to non-current assets, it indicates the productivity of every dollar invested in non-current assets. 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 = (𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑛𝑒𝑡 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝑛𝑒𝑡 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒) ÷ 2 In general, companies want this ratio to be higher rather than lower. All other things being equal, a higher ratio indicates that the company is using its non-current assets more effectively to produce more revenue. E.g. a ratio of 1.14 shows that the total revenues for 2012 were 1.14 times the average carrying amount of its non-current assets i.e. for every dollar of non-current assets, on average, the business was able to generate $1.14 in revenue during the period.
Average useful life ratio and average age ratio This is used to understand the condition of a company’s non-current assets. While a user of most companies’ financial statements cannot physically examine their non-current assets, one way to get a rough idea of the general condition of a company’s noncurrent assets is to look at the age of the assets in comparison to their useful lives. Average useful life ratio: represents the number of years, on average, that a company expects to use its non-current assets. A higher number represents a longer useful life. It is calculated as follows: 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑛𝑜𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑟𝑎𝑡𝑖𝑜 (𝑦𝑒𝑎𝑟𝑠) = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 Average age ratio: represents the number of years, on average, that a company has used its non-current assets. A higher number or ratio means that the assets are older. It is calculated by: 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 (𝑦𝑒𝑎𝑟𝑠) = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 Both ratios work best when the company uses the straight-line method of depreciation. LO6: DESCRIBE THE CA SH FLOW EFFECT OF ACQUIRING NON -CURRENT ASSETS Buying non-current assets is a major use of cash in many organisations. An expansion will usually require the purchase of property, plant and equipment or the replacement of aging or obsolete items. Determining non-current assets’ effects on cash flow is another important issue. Woolworths net expenditures on PPE From the statement of cash flows Figures in $ millions 2012 2011 (1 935) (1 729)
A negative number indicates investment in operating activities.
LO7: DESCRIBE INTANG IBLE ASSETS AND HOW THEY ARE RECORDED, EXPENSED AND REPORTED Intangible asset: a resource that is used in operations for more than one year but has no physical substance. Businesses often possess other long-term assets known as intangible assets, including the following: a) Patent: the right to manufacture, sell or use a particular product or process exclusively for a limited period of time. b) Trademark or trade name: the right to exclusively use a name or a symbol to identify the business. Cannot be amortised. c) Copyright: the right to reproduce or sell an artistic or published work. d) Franchise: the right to operate a business under the trade name of the franchisor. e) Goodwill: goodwill is created when one company buys another company and pays more than the value of the net assets of the purchased company. Good will cannot be amortised. The purchasing company may want to acquire the other company’s customers, its reputation, its employees, its market share or its research. Recording intangible assets Intangible assets are recorded at their acquisition costs. However, what is included as an acquisition cost can vary given the type of intangible asset and how it is acquired: a) Externally acquired: when an intangible asset is acquired through an external transaction e.g. company purchases a product patent/goodwill from another company. Generally, an externally acquired patent’s acquisition cost is its purchase price. b) Internally generated: when an intangible asset is developed internally, the accounting is more conservative. AASB 138 divides the internal generation of an intangible into 2 phases: R&D. Expenditure on research is recognised as an expense when incurred. In development, six criteria must all be demonstrated before an asset can be recognised. R&D costs are included in an internally developed intangible asset’s acquisition cost to avoid overstating the asset. Recording goodwill Suppose that Buyer Company purchases Seller Company for $8 million when the value of the Seller Company’s net assets is $6 million. This will be recorded as: Date (Date)
Description Net assets of seller company Goodwill Cash
Debit 6,000,000 2,000,000
Credit
8,000,000
The premium paid for goodwill is usually due to the acquired company’s customers, its reputation, its employees, its market share, or its research. Amortising intangible assets Intangible assets such as patents are amortised by expensing them. That is, we increase an expense account e.g. ‘amortisation expense’ and decrease the related intangible asset e.g. patent.
A company holds a $60,000 patent that has the maximum legal life of 20 years. The company estimates the patent will be useful for only 12 years and then it will be worthless. How do we record amortisation? $60,000 ÷ 12 years = $5,000 per year Date End of year
Description Amortisation expense Patent
Debit 5,000
Credit 5,000
Amortisation applies only to intangible assets with limited lives, like patents. Assets with indefinite lives e.g. trademarks and goodwill are instead examined periodically to check for impairment.
LO5: ACCOUNTING FOR ETHICS AND THE ENVIR ONMENT Business managers make ethical decisions every day. There are ethical dimensions to most of business decisions faced by managers. In today’s business environment, companies not only have to be aware of the economic impacts of their decisions, but also their ethical impacts. Ethical problems arise in organisations for a variety of reasons e.g. undue pressure to achieve short-term productivity and profitability goals may lead to unethical behaviour such as forcing employees to work hours that exceed limits set by state and federal agencies, intentionally ignoring product safety concerns, or falsifying accounting records or other documentation. Economist Milton Friedman argued that the only social responsibility of corporations was to increase their profits. He stated that business managers should not be expected to make socially responsible decisions because they are not trained to do so. Given the world that we now live in, this perspective is no longer valid. Business ethics results from the interaction of personal morals and the processes and objectives of business. Business ethics is nothing more than our personal views of right and wrong applied in a business setting. Managers must also consider various stakeholders when evaluating ethical dilemmas. A chief executive officer cannot simply make the decision that is best for her without considering the interest of other employees, shareholders, customers, suppliers, etc. Companies frequently create ethics programs to establish and help maintain an ethical business environment. Some common elements of ethics programs include written codes of conduct, employee hotlines and ethics call centres, ethics training, processes to register anonymous complaints about wrongdoing and ethics offices. The case of Enron in the US is an example where ethics programs within organisations were not effective. In late 2001, the company Enron filed for bankruptcy protection. Investigations into the company’s failure revealed a series of dubious transactions designed by the company’s top officials to enrich themselves. The company’s former chief financial officer and two former chief executive officers were found guilty of the fraud. Each year, The Ethisphere Institute identifies the world’s most ethical companies by ranking the companies on seven key dimensions: corporate citizenship and responsibility; corporate governance; innovation that contributes to public wellbeing; industry leadership, executive leadership and tone from the top; legal, regulatory and reputation track record; and internal systems and ethics/compliance program. One of the interesting findings is the strong, positive correlation between ethical standards and successful financial performance. The major professional accounting bodies in Australia jointly subscribe to the guidelines of the Accounting Professional and Ethical Standards Board (APESB). These standards broadly define the ethical obligations of accountants in practice.
LECTURE 2 – NON-CURRENT ASSETS & INTANGIBLE ASSETS LO1: DESCRIBE NON -CURRENT ASSETS AND HOW THEY ARE RECORDED, EXPENSED AND REPOR TED Asset: something that has future value for the company. It is measurable and the business has to own it. Non-current asset: any tangible resource that is expected to be used in the normal course of operations for more than one year and is not intended for resale e.g. land, buildings, equipment, furniture, fixtures, etc. Some non-current assets e.g. land are not depreciable because they have indefinite lives. If a business buys something that it intends to resale, it is inventory (current asset). The three primary activities for property, plant and equipment (the main non-current assets) are: 1. Acquisition of non-current assets 2. Depreciation of non-current assets over their useful lives 3. Disposal of non-current assets Recording non-current assets Non-current assets should be recorded at the cost of acquiring them, including compulsory costs such as the purchase price, taxes and duties paid on the purchase, fees e.g. closing costs paid to attorneys, delivery costs, insurance costs during transit, & installation costs. That is, all costs that are required for the asset to be used in operations. E.g. Assume Tran Paper Supply buys a delivery truck and pays the following: a) Purchase price: $60,000 b) Additional import duty: $3,600 c) Stamp duty: $400 d) GPS system: $1,000 e) Non-compulsory insurance: $1,400 Entry to record the purchase of the truck is: Date Description Debit Credit Insurance is not included here because it’s non-compulsory. (Date) Delivery truck 65,000 It needs to be recorded using a separate journal entry. Cash
65,000
Expensing non-current assets A non-current asset converts to an expense as it is used or consumed. The expensing of non-current assets is accomplished through depreciation. Depreciation: the process of allocating the cost of a non-current asset over its useful life.
Depreciation is an application of the matching principle. Because a non-current asset is used to generate revenues period after period, some of its cost should be expensed in, or matched to, those same periods. For accounting purposes, depreciation is a process of allocating an asset’s cost, not a method of determining an asset’s net realisable or market value. Depreciation is not about getting an asset to its market value. E.g. you buy a pair of shoes for $200 expecting to wear them 200 times, and expecting them to be worthless after this usage. After you wear them once, they might have a net realisable value (NRV) of $100, but depreciation might only be $1 if it is based on “use”. Recording depreciation Depreciation expense is normally calculated at the end of an accounting period and recorded with an adjusting journal entry. The general form of the entry to record depreciation is: 1. Debit depreciation expense (expense increasing) 2. Credit accumulated depreciation (contra-asset increasing) Accumulated depreciation is a contra-asset account, meaning that it sits just below the non-current asset it is related to, and its accumulating balance is subtracted from its related non-current asset account to give the carrying amount i.e. net book value of the non-current asset. Therefore, carrying amount decreases over time. Reporting depreciation Like other expenses, depreciation expense is reported on the statement of comprehensive income, often as a separate line item. In 2012 Wesfarmers reported depreciation and amortisation expenses of $995 million as one of the expenses in the income statement, while Woolworth’s depreciation and amortisation expenses were approximately $896 million. A different depreciation method may alter profits by millions. LO2: COMPARE DEPRECIATION EXPENSE USING STRAIGHT-LINE, REDUCING-BALANCE & UNITS-OF-ACTIVITY This is the second of the primary activities associated with non-current assets. When a company owns depreciable assets, it must calculate depreciation expense each period. Doing so requires the following information about the asset: a) Its cost (usually what you bought it for i.e. historical cost) b) Its residual or salvage value (what you think you will sell it for, when you do) c) Its useful life (how long you will keep it) d) Depreciation method (how you are going to spread its cost over its life) Straight-line depreciation method Straight-line depreciation spreads depreciation evenly over the useful life of an asset. It is commonly used because it is simple. The depreciable cost of the asset is divided by the useful life of asset to yield the amount of depreciation expense per period. 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒) ÷ 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 E.g. Assume that Tran’s truck purchased on 1/7/2012 for $65,000 has a salvage value of $15,000 and a 5-year life or 100,000km. Using straight-line depreciation, Tran would record $10,000 per year, or (65,000-15,000) ÷ 5 = 10,000. Date 30/06/13
Description Depreciation expense Accumulated depreciation- truck
Debit 10,000
Credit 10,000
After this entry is recorded, the carrying amount (book value) of Tran’s truck after one year is $55,000. Net book value decreases $10,000 yearly until it equals the salvage value estimated for the asset. Reducing-balance depreciation method The reducing-balance method of depreciation is an accelerated method that results in more depreciation expense in the early years of an asset’s life and less depreciation expense in the later years. They provide larger expenses (and if used for tax purposes larger tax deductible expenses) in earlier years of a non-current asset’s life. Accelerated depreciation methods may match expenses to revenues better than the straight-line method. More depreciation expense is recorded when the asset is more useful in its early years. To simplistically calculate the depreciation rate for the reducing-balance method of depreciation, we use 2 times the straight-line rate. This often means the last depreciation expense calculation is to reduce the book value to the residual value. 1 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡/𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡 × (2 × ) 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
E.g. Truck purchased for $65,000 on 1/7/2012 has a residual value of $15,000 and a 5-year life. The straight-line rate is 1/5 or 20%. If we use two times the straight-line rate for 2013, it would be $65,000 x (2 x 20%) = $26,000. Date 30/06/13
Description Depreciation expense Accumulated depreciation- truck
Debit 26,000
Credit 26,000
Companies may opt for the reducing-balance method when they desire government assistance, have union problems e.g. Qantas lowering profit figure to show they can’t possibly pay employees any more than they do now, or want good growth in future years.
There are several key issues to notice in the reducing-balance depreciation schedule: a) The depreciation rate is applied to the carrying amount of the asset b) Over an asset’s life, an entity cannot record more total depreciation than the asset’s depreciable cost. That is why some adjustment must be made in 2015, since the depreciable cost can’t exceed $50,000 (or $65,000 - $15,000). c) There is more depreciation expense in the earlier years and less in the later years.
Over an asset’s life, an entity cannot record more total depreciation than the asset’s depreciable cost. That is why some adjustment must be made in 2015, since the depreciable cost can’t exceed $50,000 (or $65,000 - $15,000). Units-of-activity depreciation method Both the straight-line and reducing-balance methods are a function of the passage of time rather than the actual use of the asset. In contrast, the units-of-activity depreciation method calculates depreciation based on use. Because it relies on an estimate of an asset’s lifetime activity, the method is limited to assets whose units-of-activity can be determined in some way. Depreciation per unit-of-expected activity is the depreciable cost of the asset divided by the estimated units-of-activity over the life of the asset. It is more difficult to implement, but more accurate for certain assets. 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒) ÷ 𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 × 𝐴𝑛𝑛𝑢𝑎𝑙 𝑢𝑠𝑒 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 E.g. Truck purchased for $65 000 on 1/1/2012 has a residual value of $15,000 and a life of 100 000 km. Depreciation per unit is $0.50/km or ($65 000 – $15 000) ÷ 100 000 km. If the truck is driven 24,000 km in 2012-13, depreciation expense is $12,000, or 24,000 x $0.50. Date 30/06/13
Year
Description Depreciation expense Accumulated depreciation- truck
Calculation
Debit 12,000
Credit 12,000
Depreciation expense
Accumulated depreciation Carrying amount $0 $65,000 2013 $0.50 x 24,000km $12,000 $12,000 $65,000 – $12,000 = $53,000 2014 $0.50 x 22,000km $11,000 $12,000 + $11,000 = $23,000 $53,000 – $11,000 = $42,000 2015 $0.50 x 27,000km $13,500 $23,000 + $13,500 = $36,500 $42,000 – $13,500 = $28,500 2016 $0.50 x 17,000km $8,500 $36,500 + $8,500 = $45,000 $28,500 – $8,500 = $20,000 2017 $0.50 x 10,000km $5,000 $45,000 + $5,000 = $50,000 $20,000 – $5,000 = $15,000 There are a couple of key issues to notice in the units of activity depreciation schedule: a) Depreciation expense is a function of usage. b) The total kilometres used in all years is equal to 100,000km and the total depreciable cost is $50,000. Comparison of depreciation methods Straight-line Reducing balance Units-of-activity Year Depreciation exp. Carrying amount Depreciation exp. Carrying amount Depreciation exp. Carrying amount 2013 $10,000 $55,000 $26,000 $39,000 $12,000 $53,000 2014 $10,000 $45,000 $15,000 $23,400 $11,000 $42,000 2015 $10,000 $35,000 $8,400 $15,000 $13,500 $28,500 2016 $10,000 $25,000 $0 $15,000 $8,500 $20,000 2017 $10,000 $15,000 $0 $15,000 $5,000 $15,000 Total $50,000 $50,000 $50,000 The summary shows: Total depreciation expense over the life of the asset is $50,000. No method is right or wrong, just different. Companies choose a method based on different reasons. Depreciation method depends on the asset and how the asset is used. Businesses can change depreciation method from year to year as long as they disclose the changes they’ve made. LO3: THE EFFECTS OF ADJUSTMENTS THAT MAY BE MADE DURING A NON-CURRENT ASSET’S USEFUL LIFE Since non-current assets are used for multiple years, companies sometimes need to make adjustments as new information is available or as new activity occurs. These adjustments can arise from changes in the estimates of useful life, additional money spent to improve/maintain the non-current asset, or significant declines in the asset’s net realisable value.
Changes in depreciation estimates E.g. Matthew purchases a machine for $90,000 on 1/7/2010 with a 10 year useful life and a $10,000 residual value. Using straightline, Matthew records $8,000 depreciation expense each year. Date 30/06/13
Description Depreciation expense Accumulated depreciation- machine
Debit 8,000
Credit 8,000
Start of year 5: Matthew estimates that the machine will now only last 8 years and has a residual value of $6,000. The prospective revision (current and future) will not correct the first four years. What is the new annual depreciation? 1. Calculate the carrying amount at the start of the new year i.e. year 5 (2014): $90,000 – (4 x $8,000) = $58,000. 2. Calculate remaining depreciable cost by subtracting residual value from carrying amount: $58,000 – $6,000 = $52,000. 3. Calculate revised depreciation expense per year by dividing depreciable cost by years remaining: $52,000 ÷ 4 = $13,000 Additional expenditures after acquisition Most non-current assets require expenditures throughout their useful lives. The accounting treatment for expenditures made during the useful life of a non-current asset depends on whether they are classified as ‘capital’ or ‘revenue’ expenditures. Capital expenditure: an expenditure that increases the expected useful life or productivity of the asset. Record new expenses as part of the asset’s value and recalculate depreciation expense per year. Revenue expenditure: an expendi2ture that maintains the expected useful life or productivity of the asset. Just expense these off. Capital expenditure (changes asset’s value) example: A company purchases a non-current asset for $50 000 on 1/1/2013, with a 5 year life and no residual value. During the 5th and final year of the asset’s life, the company incurs $8,000 for upgrades that extend the asset’s life to 7 years. Date Year 5
Description Non-current asset Cash (To record upgrade to asset)
Debit 8,000
Credit 8,000
Change in depreciation due to capital expenditure: 1. Calculate net book value after capital expenditure: $50,000 + $8,000 = $58,000. 2. Calculate carrying amount for the current (5th) year by subtracting book value by salvage: $58,000 – ($10,000 x 4) = $18,000. 3. Calculate depreciation expense per year: $18,000 ÷ 3 = $6,000 per year. Revenue expenditure example: A company purchases a non-current asset for $50 000 on 1/7/2010, with a 5 year life and no residual (salvage) value. During the 5th and final year of the asset’s life, the company incurs $1,000 in ordinary maintenance. Date Year 5
Description Maintenance expense Cash (To record normal maintenance)
Debit 1,000
Credit 1,000
Asset impairment (asset write-downs) and asset revaluation When a non-current asset’s recoverable amount i.e. market value falls below its carrying amount, the asset is impaired. Under AASB 136, entities apply conservatism by writing these assets down from their carrying amount to their recoverable amount (through use or sale). Normally any loss on impairment is an expense. Special rules apply to impairment of assets previously revalued and reversal of impairments. E.g. A business has an equipment that makes a unique toy. The equipment has a carrying amount of $140,000 and a higher market value. Suppose that the toy suddenly loses its popularity, and the company is unable to alter the machine to produce anything else. As a result, the fair (market) value of the machine plummets to $40,000. The company declares that the asset is impaired. After the impairment entry, depreciation expense would be calculated based on the revised depreciable amount and remaining useful life. The asset impairment would be recorded as follows: Date Description Debit Credit ‘Impairment loss’ account is increased to reflect the decline Impairment loss (decrease equity) 100,000 in value of the asset. This reduces equity. This loss is part of Non-current asset/Intangible asset 100,000 the profit and loss and would be included with other (To record permanent impairment) expenses. E.g. when revaluating land that has increased significantly in market price, the following entry would be recorded: Date Description Debit Credit ‘Asset revaluation reserve’ is NOT a revenue account and Land 100,000 thus, not included in profit and loss statement. Asset revaluation reserve (To record permanent impairment)
100,000
LO4: RECORD THE DISP OSAL OF NON -CURRENT ASSETS The accounting for the disposal of a non-current asset consists of the following 3 steps: 1. Update depreciation on the asset. 2. Calculate gain or loss on the disposal. 3. Record the disposal.
Rules for calculating gain or loss on disposal: 1. Record any necessary depreciation expense (possibly for a partial period) to update the accumulated depreciation account. 2. Calculate any gain or loss on the disposal by comparing the asset’s carrying amount to its recoverable amount. 3. Prepare a journal entry that decreases the asset account and its related accumulated depreciation account. 4. Record any gain or loss on the disposal. E.g. a company purchases machine on 1/1/2013 for $30,000 with a useful life of 4 years and residual value of $2,000. The company uses the straight-line method and records depreciation expense annually on 31 December. The annual depreciation expense for the machine is $7,000. The company sells the machine on 30th June 2015 for $12,000. To account for the sale, the company must first update the accumulated depreciation account. The asset has been used for 6 months since the last time depreciation was recorded (31 December), so the company must record 6 months of dep. Expense i.e. $3,500. Thus, this entry would be made: Date 30 June 2015
Description Depreciation expense Accumulated depreciation (To record accumulated dep.)
Debit 3,500
Credit 3,500
The accumulated depreciation account is updated to $17,500 (7,000+7,000+3,500). With this balance, the gain/loss on disposal can be calculated as follows: Proceeds from sale $12,000 Cost of machine $30,000 Less: accumulated depreciation (17,500) Carrying amount at 30 June 2015 12,500 Loss/gain on sale (500) Gain/Loss = Sales price – (Initial cost – Accumulated depreciation) The business has generated a loss of $500. With this info, the company can prepare the following entry to record the disposal: Date 30 June 2015
Description Cash Accumulated depreciation Loss on disposal Machine (To record disposal of machine)
Debit 12,000 17,500 500
Credit
30,000
LO5: MANAGEMENT OF NON-CURRENT ASSETS USING HORIZONTAL, VERTICAL AND RATIO ANALYSES Three issues are important when managing non-current assets: a) How productive are the company’s non-current assets in generating revenues? b) What is the condition of the company’s non-current assets? c) How are cash flows affected by the purchase of non-current assets? Horizontal and vertical analysis These two analyses show whether a company’s non-current assets are stable or not. Horizontal analysis: shows an increase/decrease in non-current assets and depreciation expense from this year to prior year. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 − 𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 = 𝑃𝑟𝑖𝑜𝑟 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 Vertical analysis: shows as a % how much non-current assets make up total assets or how much depreciation expense makes up sales revenue/net sales e.g. depreciation expense is 5%. This shows that for every dollar in sales revenue, the company incurs about 5 cents in depreciation expense. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 %= 𝑜𝑟 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒/𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 Non-current asset turnover ratio Non-current asset turnover ratio shows whether the company is using non-current assets productively to generate revenues. Non-current asset turnover ratio: compares total revenues during a period to the average carrying amount of non-current assets during that period. Because this ratio compares total revenues to non-current assets, it indicates the productivity of every dollar invested in non-current assets. 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 = (𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑛𝑒𝑡 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 + 𝐸𝑛𝑑𝑖𝑛𝑔 𝑛𝑒𝑡 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒) ÷ 2 In general, companies want this ratio to be higher rather than lower. All other things being equal, a higher ratio indicates that the company is using its non-current assets more effectively to produce more revenue. E.g. a ratio of 1.14 shows that the total revenues for 2012 were 1.14 times the average carrying amount of its non-current assets i.e. for every dollar of non-current assets, on average, the business was able to generate $1.14 in revenue during the period.
Average useful life ratio and average age ratio This is used to understand the condition of a company’s non-current assets. While a user of most companies’ financial statements cannot physically examine their non-current assets, one way to get a rough idea of the general condition of a company’s noncurrent assets is to look at the age of the assets in comparison to their useful lives. Average useful life ratio: represents the number of years, on average, that a company expects to use its non-current assets. A higher number represents a longer useful life. It is calculated as follows: 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑛𝑜𝑛𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑟𝑎𝑡𝑖𝑜 (𝑦𝑒𝑎𝑟𝑠) = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 Average age ratio: represents the number of years, on average, that a company has used its non-current assets. A higher number or ratio means that the assets are older. It is calculated by: 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 (𝑦𝑒𝑎𝑟𝑠) = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 Both ratios work best when the company uses the straight-line method of depreciation. LO6: DESCRIBE THE CA SH FLOW EFFECT OF ACQUIRING NON -CURRENT ASSETS Buying non-current assets is a major use of cash in many organisations. An expansion will usually require the purchase of property, plant and equipment or the replacement of aging or obsolete items. Determining non-current assets’ effects on cash flow is another important issue. Woolworths net expenditures on PPE From the statement of cash flows Figures in $ millions 2012 2011 (1 935) (1 729)
A negative number indicates investment in operating activities.
LO7: DESCRIBE INTANG IBLE ASSETS AND HOW THEY ARE RECORDED, EXPENSED AND REPORTED Intangible asset: a resource that is used in operations for more than one year but has no physical substance. Businesses often possess other long-term assets known as intangible assets, including the following: a) Patent: the right to manufacture, sell or use a particular product or process exclusively for a limited period of time. b) Trademark or trade name: the right to exclusively use a name or a symbol to identify the business. Cannot be amortised. c) Copyright: the right to reproduce or sell an artistic or published work. d) Franchise: the right to operate a business under the trade name of the franchisor. e) Goodwill: goodwill is created when one company buys another company and pays more than the value of the net assets of the purchased company. Good will cannot be amortised. The purchasing company may want to acquire the other company’s customers, its reputation, its employees, its market share or its research. Recording intangible assets Intangible assets are recorded at their acquisition costs. However, what is included as an acquisition cost can vary given the type of intangible asset and how it is acquired: a) Externally acquired: when an intangible asset is acquired through an external transaction e.g. company purchases a product patent/goodwill from another company. Generally, an externally acquired patent’s acquisition cost is its purchase price. b) Internally generated: when an intangible asset is developed internally, the accounting is more conservative. AASB 138 divides the internal generation of an intangible into 2 phases: R&D. Expenditure on research is recognised as an expense when incurred. In development, six criteria must all be demonstrated before an asset can be recognised. R&D costs are included in an internally developed intangible asset’s acquisition cost to avoid overstating the asset. Recording goodwill Suppose that Buyer Company purchases Seller Company for $8 million when the value of the Seller Company’s net assets is $6 million. This will be recorded as: Date (Date)
Description Net assets of seller company Goodwill Cash
Debit 6,000,000 2,000,000
Credit
8,000,000
The premium paid for goodwill is usually due to the acquired company’s customers, its reputation, its employees, its market share, or its research. Amortising intangible assets Intangible assets such as patents are amortised by expensing them. That is, we increase an expense account e.g. ‘amortisation expense’ and decrease the related intangible asset e.g. patent.
A company holds a $60,000 patent that has the maximum legal life of 20 years. The company estimates the patent will be useful for only 12 years and then it will be worthless. How do we record amortisation? $60,000 ÷ 12 years = $5,000 per year Date End of year
Description Amortisation expense Patent
Debit 5,000
Credit 5,000
Amortisation applies only to intangible assets with limited lives, like patents. Assets with indefinite lives e.g. trademarks and goodwill are instead examined periodically to check for impairment.
