Introduction to Accounting Depreciation and Bad Debts

Outline of Lecture Depreciation Bad Debts Provision for Bad Debts Exercises

Lecturer: Chara Charalambous3 Depreciation According to IAS 16 ‘Depreciation is the measure of the cost of the tangible - fixed asset that has been consumed during the period’ In other words is the cost of using a fixed asset. Depreciation is recorded each year and has a dual effect: 1.Reduce the value of the fixed asset by the accumulative depreciation (total depreciation) in the balance sheet to reflect the wear and tear (damage, tiring, exhausting). In accounting we use the definition ‘accumulated depreciation’ and we mean by this the total amount of the loss of the fixed asset. 2.Record the depreciation charge as an expense in the income statement (profit and loss account).

Lecturer: Chara Charalambous4 Depreciation may arise from: Use Physical wear and tear Passing of time The fact that a fixed asset is old-fashion and imperfect because of the technology and market changes for e.g. the creation of a new machinery which is more specialized in a sector Land has an unlimited life and so does not require depreciation, but buildings should be depreciated. Depreciation of an asset begins when it is available for use.

Lecturer: Chara Charalambous5 Methods of calculating depreciation STRAIGHT LINE Depreciation charge is the same each year and so assumes that the benefit is consumed equally Useful for assets which provide equal benefit each year e.g. machinery REDUCING BALANCE A reducing amount of depreciation is charged each year and so assumes that more benefit is consumed in earlier years Useful for assets which provide more benefit in earlier years e.g. cars, IT equipment

Lecturer: Chara Charalambous6 Straight line method Depreciation Charged = Cost - Residual Value Useful life Or Depreciation = Cost* X% Straight line depreciation is often expressed as a percentage of original cost. Residual Value: the estimated disposal (clearance/removal/scrap) value of the asset at the end of its useful life. The residual value may be a second hand value or a scrap value: not a significant amount and is often zero. Useful Life: the estimated number of years during which the business will use the asset. The useful life does not necessarily equal the physical life of an asset. For e.g. Many business use a three year useful life for computers. This does not mean that the computer can no longer be used after three years, it means that the business is possible to replace the computer after three years due to a technological advancement.

Lecturer: Chara Charalambous7 Reducing balance method Depreciation Charged =Carrying value* X% Carrying value (CV) is the original cost of the fixed asset less the accumulated depreciation on the asset to date. Example 1: (reducing balance method) Chris, a trader, purchased a computer for € 1000 on August Y12 which he depreciates on the reducing balance method at 20% per annum. What is the depreciation charged for each of the first five years if the accounting year end is 31 July? Solution: Depreciation Charge Cumulative Depen *20% ( )*20% ( )*20% ( )*20% ( )*20%

8 Bad Debts If sales are made on credit, there may be problems collecting the amounts owing from customers because some may refuse to pay their debt or they may declared bankrupt and unable to pay the amounts owing. At this case the debt is known as an irrecoverable debt or Bad Debt. As it will probably never be received, it is written off by writing it out of the ledger accounts completely. The Bad debts amount is deducted from Debtors Lecturer: Chara Charalambous

Accounting for Bad Debts The debtors account is credited so as to reduce them, and an account named Bad Debts expense is debited. This expense is treated as all other expenses and for that reason is included in the income statement (profit and loss a/c) and is reducing the net profit.

10 Provision for Bad Debts If there is some doubt whether a customer can or will pay his debt, a provision for bad debts is created, these debts are not yet Bad Debts. However the creation of a provision for bad debts means that the possible loss is taking into consideration immediately. The amount of the original debt will still remain the same just in case the customer does eventually pay. The Debtors are not reduced but we multiply the amount of Debtors with the percentage of the provision. The debtors amount remain the same – we are not reducing it as we did in the case of Bad Debts – because the customer may finally pay. Lecturer: Chara Charalambous

11 Accounting for Provision for Bad Debts The account ‘Provision fro Bad Debts’ has a credit balance in contrast to the account ‘Bad Debts’ which has debit b/ce. The Provision for Bad Debts goes indirectly to the profit and loss through the account Bad Debts. We add the amount of provision for Bad Debts in the amount of Bad Debts. The balance, at the end of the year, of the a/c ‘Provision for Bad Debts’ goes to balance sheet below Debtors and is deducted there from Debtors to show the net Debtors. Lecturer: Chara Charalambous

12 Example 1: Stamp Ltd has opening balances at 1 ST Jan Y12 Debtors € During the year the company made credit sales € and received cash later from the clients € At 31 st Dec Y12 the company find out that €2000 of the clients are Bad Debts and also believes that 5% of the remaining clients will might not pay and since this is not sure the accountant makes a provision for Bad Debts. Required:. find the amount of Provision for Bad Debts that will added to Bad Debts amount. 2.find the amount of Bad Debts which will go to Profit and Loss 3. Show how Debtors will be presented in the Balance Sheet Lecturer: Chara Charalambous

13 Provision for Bad Debts If there is already an opening amount in the account ‘Provision for Bad Debts’ then only the movement (difference) in the provision is charged to the Profit & Loss through ‘Bad Debts’ (closing provision less opening provision) Lecturer: Chara Charalambous

If an exercise with trial balance is given to you and you have the amount of Debtors and the amount of Bad Debts in the trial balance it means that bad debts have already been deducted from debtors and so you should not deduct it. What you have to do is to find the new provision for bad debts : 1.Debtors* provision % and then 2. deduct from the new provision the old and then 3. add the difference in the bad debts amount.

15 Example 2: Stamp Ltd has opening balances at 1 ST Jan Y12 Debtors €68000 and Provision for Bad Debts €3400. During the year the company made credit sales € and received cash later from the clients € At 31 st Dec Y12 the company find out that €2000 of the clients are Bad Debts and also believes that 5% of the remaining clients will might not pay and since this is not sure the accountant makes a provision for Bad Debts. Required: 1. find the amount of Provision for Bad Debts that will added to Bad Debts amount 2.find the amount of Bad Debts which will go to Profit and Loss 3. Show how Debtors will be presented in the Balance Sheet Lecturer: Chara Charalambous