Accounting for Depreciation Theory

* Common theory Q&A 
What is depreciation ?

*the fall in value of the fixed Assets(Vehicle , Machines) .

*It is the allocation of the cost of an asset over its useful life.

Why does a business need to open a depreciation account?

*Because the whole cost of the fixed assets should be spread out over its useful life and it is not just treated as an expense in the year of purchase.- by GOING CONCERN CONCEPT (business operation is assumed to be indefinitely)

Causes of depreciation?

*1)Physical Deterioration (Wear & Tear) -Due to the exposed of asset to the elements of nature. eg Furniture & Fittings

*2) Obsolescence- Outdated eg, Computers

*3) Depletion of assets as time passes - disappear eg , mining land

*4) Passage of time - Shorten life of assets eg , rent on land , patent rights

Calculation of Depreciation


Straight-line method
formula:

Original cost$ - Estimated Scrap Value$ / No. of useful Life(Years)

OR

Rate of  Depreciation% / year X Original cost$

Adv(+) VS Disadv(-)

+Easy to calculate and understand

-In real life, its not accurate amount of wear and tear may vary every year.

Reducing balance method
formula:

Rate of Depreciation% / year X Net Book Value$ (Remaining value aft every accounting year)

Adv(+) VS Disadv(-)

+Most Efficient in giving asset a more truthful allocation of depreciation

- takes a long time to write off the books

-Rate of depreciation is high as compared to straight-line method

Revaluation method( not in O lvl, A lvl syllabus ) 
formula:

Value of purchase $ + Any New Purchases $ - Value of asset at the end $

Adv(+)Vs Disadv(-)

+More realistic financial position to be expressed

- In practical takes up a lot of time and effort ,thus increase cost of labour.

Control Accounts

2 reason why control accounts are prepared

Define : A control account is a summary account in the general ledger (GL) . The details that support the balance in the summary account are contained in a subsidiary ledger --a Ledger outside of the general ledger .

1) The purpose of control account is to reduce details in the(GL), yet have the correct balance for P&L and BS.

2) It saves effort when the sales manager and credit manager wants to know the details and information of every individual customers ,including whether a customer recently reduced their account balance. The company can provide these individuals with access to the Debtors Subsidiary Ledger and keep the(GL) free of a tremendous amount of details.

ADV of Subsidiary Ledgers :

1) Reduces the number of accounts in the (GL) as two Largest groups *debtors & creditors* are taken out. Frees (GL) from unnecessary details because only the totals were recorded in it .

2) Making it possible to keep track of these accounts.

3) It helps the business to locate errors as each ledger contains fewer accounts than if all accounts are kept in one (GL).

4) It allows division of labor as different checks can be employed to take charge of the Ledgers

Accruals and Prepayments

Accrued Expense : expenses incurred by business for the accounting year , but not yet paid or recorded in books , are included in the expenses for the period.

Accrued Revenue : Revenue earned by business for the accounting year , but not yet received or recorded in books , is included in the revenue for the period.

Prepaid Expense : Expenses paid or recorded in books , but it is related to the next accounting year are excluded from the expenses for the current year .

Prepaid Revenue : Revenue received and recorded in books , but will not be earned , until the next financial period , is excluded from the revenue for the current year.
 

A Qn on Accruals and prepayments:

Bad Debts and Provision for Doubtful Debts

BAD DEBTS & PROVISION FOR DOUBTFUL DEBTS

*Bad debts : An operating expense from credit sales and not collecting the customers entire accounts receivable balances.

Bad debts due to -

1) Customer declares bankrupt

2) Customer passed away 

3) Customer no where to be found                            

*Bad debts Recoverable: Bad debts being written off previously has been paid by customers now .

*Provision for Doubtful Debts : Allowance for Doubtful Accounts is contra current asset account associated with accounts receivable. When the credit balance of allowance for doubtful accounts is subtracted from the debit balance in accounts receivable the result is known as the net realizable value of the accounts receivable.

GOODWILL

Define Goodwill : It is an intangible asset, it can only exist if the business was brought over and the amount paid was greater than the value of net assets . Goodwill represents the value of reputation when it was brought over.

e.g. Business cost $1 million , Sold at $1.5 million .
Therefore , the difference of $0.5million is known as GOODWILL .
*Reasons for Goodwill ,
1) Business has good reputation
2) Business has good relations with suppliers
3) Located at a strategic location
4) Has a good management and skilled employees
5)etc.

When a business is brought over , partnership will be concered as profit sharing ratio changes accordingly.

WHY change?

Due to :
1) Partner is retiring
2) Partner is devoting lesser time to the business
3) New partner is introduced
4)etc.

*3 cases altogether (1) Change in profit ratio within existing partners (2) Partner Leaving partnership (3) New admission of partner

A Change in Profit Sharing Ratio in existing partners due to :

- partner devoting lesser time to the business due to poor health conditions

-partner have developed more skills, after learning from a new course

Financial RATIOS Analysis & FORMULAS

Profitability Ratios
(No. 4ii onwards Alvl)
1) Gross Profit Margin%  =		Gross Profit		X 100%
		Net Sales Revenue
2) Profit Margin % =		Net Profit		X 100%
		Net Sales Revenue
3) Percentage on expenses% =		Expenses		X 100%
		Net Sales Revenue
4i) Return on Equity% =		Net Profit		X 100%
(Assuming no dividends)		(Opening + Closing Equity) /2
4ii) Return on Equity% =		Net Profit aft Preference Dividends		X 100%
(Equity = Ordinary Shares +Reserves)		Equity
5) Mark-up on cost% =		Gross Profit		X 100%
		Cost of sales (COGS)
6) Operating Profit Margin% =		NPBI (Net Profit B4 Interest)		X 100%
		Net Sales Revenue
7) Return on total Assets% =		NPBI (Net Profit B4 Interest)		X 100%
		Total Assets
8) Return on LT Capital Employed =		NPBI (Net Profit B4     Interest)		X 100%
(Capital Employed =Assets-Liabilities + LTL)		Capital Employed

Liquidity Ratios (No. 3 onwards A lvl)
1) Working Capital/Current ratio=		Current Assets
		Current Liabities
2) Quick/ Acid test ratio=		Current Assets-Inventory-Prepayment
		Current Liabities
3) Debtors/AR Turnover (in days) =		Debtors		X 365     days
		Credit Sales
4) Creditors/AP Turnover (in days) =		Creditors		X 365 days
		Credit Purchases
5) Working Capital Cycle (in days)=		Debtor turnover + Inventory turnover - (Creditor turnover)
6) Debt to Equity ratio =		LTL
		Equity
7) Gearing ratio =		LTL+ Preference Shares
(Outside lenders / Owners' Capital)		Equity
Inventory Management
1) Inventory Turnover rate =		Cost of sales (COGS)
		(Opening + Closing Inventory) /2

Investment Ratio (Alvl)
1) Earning per share =		Net Profit- Preference Shares
		Number of shares
2) Price Earning/ PE ratio =		Market Price$/share
		Earning per share (1)
3) Dividend Yield =		Declared dividend/share
		Market Price$/share
4) Dividend Cover =		Profits paid to Ordinary Dividend$
		Ordinary Dividend paid$

Further Reading
http://www.bized.co.uk/compfact/ratios/index.htm
http://peregrin.imu.edu/~drakepp/principles/module2/fin_rat.pdf
Formulas can be found in O & A lvl syllabuses

A SUMMARY OF ACCOUNTING THEORY

A SUMMARY OF ACCOUNTING THEORY

Accounting Equation -Assets - (Liabilities) = Equity

Owner's Equity - An amount of money own by the owner of the business (Capital + Net Profit - Drawings)

*Assets - Items owned by business (FA)+(CA)

*Expenses- Amount spent for business use eg, carriage outwards , business rates (electrical bills)

-Capital expenditure - Expenses spent on FA eg, machines

-Revenue expenditure - Expenses spent on recurring items eg, rent , decorations

*Liabilities - Amount of money owe by business (L-T-L)+ (CL)

*Accruals - Amount due but not paid of the accounting year

*Prepayments - Amount paid in advance but not due for the accounting year

*Trading Account- To find Gross profit

-Returns Inwards- Sales Returns

-Returns Outwards - Purchases Returns

*Profit and loss account - To find Net profit or Net Loss

-Revenue - Income generated by business eg, discounts received

-Cash discounts - Discount allowed or received to encourage early payment

-Trade discounts - Discount allowed or received to encourage bulk purchases

Net profit= Revenue -Expenses =$+(amount)

Net Loss= Revenue- Expenses =$-(amount)

*Balance Sheet - To show all assets , owner's Equity and liabilities of business at that accounting year

-Debtors/Acct Receivables - Debts owning by customers from Sales on Credit

-Creditors/Acct Payables -Debts owning by business from Purchases on Credit

*Trial Balance - To prove arithmetic accuracy of accounting entries

SOURCE DOCUMENTS

*Invoice - A reminder to buyer to pay for goods and services from seller of business

*Credit Note - A note to correct an overcharge in invoice

*Debit Note - A note to correct an undercharge in invoice

*Cheque Counterfoil - A record of amount paid on a numbered cheque to payee

*Receipt - A note to acknowledge amount received

*Payment Voucher - Evidence of payment to a person

*Bank statement - A summary of transactions of current bank account holder for the month

.

*Petty cash Voucher -A record of cash payments out of petty cash

COMMON TERMS USED

*Dishonoured Cheque - A cheque that is rejected by the bank , due to insufficient funds or because the cheque is not in order

*Bank Loan - An amount borrowed by a customer from the bank (L-T-L)

*Bank overdraft - A situation in which a current bank account holder have overdrawn an amount which is more than what he/she has in her bank account currently

*Uncredited deposits - Cheque deposits that have not been credited on the bank statement

*Unpresented Cheques - Cheques that have not been presented at the bank for payment

*Direct Credits - Amount received and is directly credited on bank statement eg, Dividends , Credit transfer

*Direct Debit - Amount paid and is directly debited on bank statement eg, Standing order ,GIRO , Dishonoured cheques , bank charges

*Imprest System - A petty cashier will always reimbursed the fixed amount of the petty cash back when there is a paid out ,thus he/she will always have the same amount to start with every month

ACCOUNTING CONCEPTS TO KNOW !

*Accounting Entity - Business is in separated unit with owner

*Monetary - Only transactions with money value are recorded

*Historical cost - Transactions are recorded at cost

*Going concern - Business will continue to operate for an indefinite period

*Accounting period - The life span of a business in a fixed period of time

*Objectivity - Transactions must be factual , supported by document evidence

*Consistency -A method of recording adpoted must be used again after every period

*Prudence - The use of careful accounting practice, assets and profits cannot be overstated or understated

*Realisation - Revenue earned must be recognized

*Matching - Expenses incurred of the period must be matched against the Revenue in the same period

CORRECTIONS OF ERRORS(COE)

1) Error of omission - transactions not recorded in books

2) Error of commission - wrong person

3) Error of original Entry - Incorrect amount$ posted

4) Error of Principle -Wrong class of account , expenses treated as assets

5) Compensating Error- One side of Ledger compensated by errors of the same amount on the other side

6) Complete Reversal of Entries - Account should be debited but is credited (Vice versa)

PARTNERSHIP

*P&L appropriation - continue of Trading, Profit and loss account it shows the categories of the partners

*Interest on capital - Interest to be paid to partners for capital contributions

*Interest on drawings- Interest to be charged to partners for early withdrawals of profits from business

*Shares of Profit /Loss - An agreed ratio of amount to be shared by partners after accounting for interest on capital , partners salary /Bonus , interest on drawing .

HAPPY READING! =D