Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 1 Accounting for Management Decisions (DBA10AMD) WEEK 5 depreciationinventory receivables Profit measurement for depreciation, inventory and receivables READING: TEXT CH 4

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 2 Learning Objectives cont’d expense recognitionAnalyse expense recognition for non-current tangible assets (depreciation) Analyse expense recognition for accounts receivable (bad debts) Analyse expense recognition for inventory (cost of goods sold - COGS)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 3 Profit Measurement and calculation of Depreciation Learning Objective: Analyse expense recognition for non-current tangible assets Depreciation is an example of a expense where the cash is paid in of the expense being recognised. Property, Plant and Equipment are usually eventually up in the process of revenue for the business.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 4 Depreciation : : an attempt to measure the cost of the future economic benefits of an NCA which has been used up in generating the income in an accounting period. Depreciation is an attempt to recognise a in the Market Value of the asset : : is the cumulative of all depreciation charges and is from the original cost of the asset on the Balance Sheet. It is a asset.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 5 Depreciation: “the gradual of the cost of an asset into an expense over its expected useful life” Depreciation cont'd –Nature of depreciation –Refer: AASB 116 PPE

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 6 Depreciation 4 factors are considered: 1.The (or other value) of the asset 2.The of the asset ( ) 3.The estimated value of the asset (aka salvage or scrap value) 4.The depreciation (3 types) Annual depreciation = expense (p.a.)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 7 Profit Measurement and calculation of Depreciation cont’d Cost - includes incurred by the business to bring the asset to its required and make it ready for eg delivery, installation, alterations, improvements, etc (see Activity 4.14, p.162 text) EUL of asset - the life of the asset determines the useful life of the asset for the purpose of calculating depreciation expense. The economic life of an asset ends when the cost of operating/holding the asset exceeds the benefit derived from it; may be than physical life in many cases (can be difficult to predict ie computer)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 8 Profit Measurement and the Calculation of Depreciation cont’d Estimated value ( value): defined as the likely amount to be on disposal of the asset. Like useful life, estimated residual value can be difficult to predict Depreciation method: The common methods of calculating depreciation expense are: 1.Straight line method 2.Accelerated (Reducing balance) method 3.Units of production method

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 9 Straight line depreciation Straight line method of depreciation: has depreciation expense in each period. This method allocates the amount to be depreciated over each year of the EUL of the asset. see example 4.1 on p.163: Consider the following information: Machine cost 40,000; residual value 1,024; EUL 4 yrs Depreciation exp= (Cost - residual value)/EUL =

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 10 Depreciation This expense will appear on the income statement On the balance sheet, asset appears as follows: Machine40,000 less: Accumulated Depreciation - 9,744 Written down value (WDV) After 3 years: Machine 40,000 less: Accumulated Depreciation - Written down value (WDV)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 11 Accelerated Depreciation (reducing balance) Accelerated depreciation methods have systematically depreciation expense in the periods of the asset’s life. The most common accelerated depreciation method is the method which applies a percentage rate of depreciation to the written down value of an asset each year Accelerated depreciation methods result in depreciation expense and depreciation expense and net income than straight-line depreciation in the years of an asset’s life. the years of an asset’s life.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 12 Accelerated depreciation See p.165 Assume the same information as for straight line method but this time we are using reducing balance and a fixed percentage of WDV beg Depreciation expense ( ) Acc DepWDV end 9,6006,400 3,84037,4402,560 1,53638,976

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 13 Units of Production method Units of Production method: based on units of output. Is similar to straight line, but EUL changes from time to. This method multiplies the depreciable amount by the relative output for each period (re p.166). Assume output over 4 years is 10,000 units. Depreciable amount = (Cost - residual value)/EUL units = (40,000 – 1,024)/10,000 = 38,976/10,000 = In year 1, they produce 1,000 units, so dep’n charge would be X 1,000 =

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 14 Depreciation cont’d Depreciation methods should be selected to be appropriate to the particular assets and to their in the business. Accounting standard AASB ‘Property, Plant and Equipment’ reinforces this view Depreciation does provide funds for asset replacement, it is used to calculate net profit Dep’n is an example of an accounting process that requires (ie is )

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 15 Profit Measurement and Bad and Doubtful Debts Learning Objective: Analyse expense recognition for accounts receivable Bad and doubtful debts arise from selling goods on (ie debtors/ accounts receivable) The risk is that the customer may not pay the amount due, thus ‘bad/doubtful debts’ may result if debt is Bad debts must be when it is reasonably certain that the customer will not pay. This increases expenses, reduces accounts receivable (and reduces profit)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 16 Bad and doubtful debts The matching principle requires that the bad debt be written off in the period as that of the sale that gave rise to the debt. The problem though is that by the end of the accounting period, we do know which debts are going to be bad, or not paid. Therefore we have to make an of bad debts, these are in fact classified as doubtful at the end of the accounting period (ie is another amount).

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 17 Bad and doubtful debts Doubtful debts are using either the percentage of credit sales or aged debtors listing Both methods will resolve the amount of debtors balance that is expected to be received. This is recorded as: ―an in the income statement ―allowance for doubtful debts is included in the balance sheet as a from the debtors account. ―doubtful debts is another example of a asset account.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 18 Profit Measurement and the Problem of Bad and Doubtful Debts See example 4.2, p.181 Boston Enterprises has debtors of $350,000 as at 30 June, Investigation of these debtors reveals that $10,000 is not likely to be collectible and that collection of a further $30,000 is doubtful. Financial statements would appear as follows: Income Statement Bad debts written off 10,000 Doubtful debts expense 30,000 Balance Sheet Debtors340,000 less: allowance for DD

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 19 Bad and doubtful debts –Assume now that during the next accounting period $26,000 of the doubtful debts proved to be uncollectible. –These debts must now be written off as follows: $ - reduce debtors by $ $ - reduce allowance for doubtful debts by $ $ –An allowance for doubtful debts of $ will still remain.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 20 Profit Measurement and valuation of Inventory Learning Objective: Analyse expense recognition for inventory What is ? Finished goods, raw materials, stores, supplies and work-in-progress ( )  Inventory is another example of a expense, where the payment for inventory occurs before recognition of the expense.  The cost of inventory is recorded in the asset account ‘ ’ until it is sold (sales).  When the inventory is sold, its cost is transferred out of the inventory account into the expense account, at which time it appears on the Income Statement as.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 21 Inventory What is included in th of Inventory - All costs directly related to bringing the inventory into a saleable state. See AASB 102, paragraph 10 – Cost of purchase – Cost of conversion – Costs incurred in bringing the inventories to their present location and condition

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 22 Inventory cost flow assumptions How do we determine the cost of sales amount? ‘ ’‘ ’ (FIFO): the earlier inventory held is the first to be sold ‘ ’‘ ’ (LIFO): the latest inventory held is the first to be sold : a weighted average cost is determined to derive COS and cost of remaining inventory held The Australian Accounting standard does allow the use of LIFO

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 23 Inventory cost flow assumptions With changing prices each cost flow assumption will result in profit figures for the period and different ending inventory valuations. eg if FIFO is used the first costs in to inventory are the first costs out to COGS. In times of rising prices, this means that the costs will go to COGS and the more costs will end up in ending. Therefore if costs are rising, we report a profit under FIFO because of the lower COGS. Over the life of the business, the total profit will be the same whichever cost assumption has been used

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 24 Inventory systems As well as deciding which cost flow assumption to use, a business must also decide which of inventory systems to use inventory system: maintains a records of all inventory movements, records both cost and selling price, and volume. The of the perpetual inventory system is that at any point in time the business knows what inventory should be on hand and how much the COS is in the period to date.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 25 Inventory systems inventory system – much than perpetual, does maintain records of cost of inventory sold. the inventory (asset) account is during the year At year end a is undertaken to update the inventory balance and to calculate COGS All purchases and sales are assumed to be at the end of the period.

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 26 Inventory The business will have format income statements depending on which inventory system is being used. The section of the Income statement will because of COS. A inventory system uses a specific so the trading section will appear as follows: SalesXXX less: cost of sales XX Gross ProfitXXX

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 27 Inventory If a inventory system is used, COS has to be so the trading section will appear as follows: SalesXXX less: COS Beginning Inventory XX + Net Purchases XX cost of goods available XX - Ending Inventory X XX = Gross Profit XX

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 28 Inventory Eg: The inventory records of Rafters Ltd showed the following information for the year ending 31 Dec No. UnitsUnit costTotal cost Beg Inventory100$15$1500 Purchases 30 May150$17$ September200$20$4000 Goods available for sale450$8050 Sales 28 February(80) 30 June(120) 31 October(200) Ending Inventory50

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 29 Inventory a)Assume that Rafters uses a periodic inventory system and FIFO. Calculate COGS/COS and ending inventory b)Assume that Rafters uses a perpetual inventory system and FIFO. Calculate COS and ending inventory

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 30 Inventory a) system: $20$1,000 Ending Inventory = 50 x $20 = $1,000 COGS: Beginning Inventory$ 1,500 + purchases +6,550 Cost of goods available for sale 8,050 - ending Inventory - 1,000 $7,050 COGS $7,050 Note: COGS + ending Inventory = Cost of goods available for sale

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 31 Inventory b) system: COGS 28 Feb 80 x $1, June 20 x x 1,700 2, Oct 50 x x 3,000 3,850 $ Total COGS$ $ Ending Inventory 50 x $20$

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 32 Inventory cont’d Net realisable value ( ): The estimated selling price less any further costs necessary to complete the goods and any costs involved in selling and distributing the goods AASB 102 ‘Inventories’ requires valuing inventory on the basis of the lower of cost and net realisable value ( ) on an item-by-item basis (prudence/conservatism assumption)

Atrill, McLaney, Harvey, Jenner: Accounting 4e © 2008 Pearson Education Australia 33 Inventory cont’d Inventory and are both good examples of where the ‘consistency convention’ should be applied Consistency convention: holds that when a particular accounting method is selected to deal with a transaction, this method should be applied over time