Lecture 6

Unit 4 Measuring and Reporting Financial Performance

(continued)

Non Current Tangible Assets

Profit Measurement and the Calculation of Depreciation on Non-Current Tangible
Assets

Depreciation is a measure of that portion of the cost (less residual value) of a fixed asset
which has been consumed during an accounting period

Four factors are considered:

The cost (or other value) of the asset
The useful life of the asset
The estimated residual value of the asset
The depreciation method

The cost of the asset - includes all costs incurred by the business to bring the asset to its
required location and make it ready for use e.g. delivery, installation, legal title, alterations,
improvements etc.

The useful life of the asset - the economic life of the asset determines the expected useful
life of the asset for the purpose of calculating depreciation. The economic life of an asset
ends when the cost of operating or holding the asset exceeds the benefit derived from it.
Economic life may be shorter than physical life in many cases. That is, the business will
estimate what they believe the estimated useful life of the asset will be to the business
usually where the cost exceeds the benefit provided by it. This might not be the same as the
physical life of the asset. For example, a business may determine that the estimated useful
life of a delivery vehicle is 6 years. After the 6 years have passed, the delivery vehicle is still
likely to be operational and work. However it has reached its useful life from the business
perspective and is likely to be sold (or disposed of) or traded in.
Estimated residual value (disposal value): defined as the likely amount to be received on
disposal (or sale) of the asset. Like useful life, estimated residual value can be difficult to
predict.

Depreciation method: Once the depreciable amount (the cost of the asset) has been
estimated, it must be allocated over the useful life of the item. The three common methods
of calculating depreciation expense are:

Straight line method

Accelerated depreciation (reducing balance) method
Units of production (output) method

How Does Depreciation Impact on the Income Statement and the Balance Sheet?
Prior to the preparation of reports, and when adjustments are being undertaken for accrual
accounting, an accounting entry will be used to record depreciation for a non current asset.

The amount of depreciation allocated for a particular year is shown as an expense in the
Income Statement for that year.
The other part of this accounting entry (remembering that there is always a dual effect) is the
use of an account called Accumulated Depreciation. You will find this account in the
Balance Sheet. It is listed underneath the non current asset that the accumulated
depreciation relates to. As the name suggests, accumulated depreciation shows the total
amount of depreciation that has accumulated since the business has had the asset. In
terms of transaction analysis, accumulated depreciation on an asset is considered a
negative asset as it reduces the value of assets but is still shown in the non current assets
section of the Balance Sheet. An example of how accumulated depreciation would be
shown in a Balance Sheet is shown below:

Balance Sheet

Non Current Assets $

Property, plant and equipment 100,000
Accumulated depreciation property, plant and equipment (25,000)
75,000
Note that:
$100,000 represents the original cost of the non current asset
$25,000 represents the amount of depreciation that has accumulated so far
The accumulated depreciation is subtracted from the original cost of the asset
$75,000 is the written down value/book value/carrying value of the non current asset.
This amount does not represent market value. It is simply the value of the non current
asset according to historical cost accounting

We will now look at each of the depreciation methods mentioned earlier.

Straight Line Method

This method allocates the same amount of depreciation each year over the assets useful
life. It is calculated using the following formula:

Total cost of the asset less estimated residual value of asset

Estimated useful life of asset

Accelerated depreciation (reducing balance) method

This method allocates a greater portion of the cost of the asset to the earlier years of the
assets life and therefore, less as the asset gets older. It is calculated using the following
formula.

Fixed percentage rate x written down value of the asset

The written down value of the asset = cost of the asset less any depreciation that has
accumulated so far. Both of these figures are obtained from the Balance Sheet.

The fixed percentage rate is calculated using the following formula:

R
P (1 n ) x 100%
C

where P = the depreciation percentage, n = the useful life (in years), R = the residual value,
and C = the cost of the asset
NOTE: you will not need to use the above formula to calculate the
depreciation percentage in the exam. If you are asked to use the
accelerated depreciation method, the depreciation percentage (P)
will be provided to you.
Units of production (output) method
This method calculates depreciation based on the productive capacity of the asset and its
use over time. It is calculated using the following formula.

Cost of the asset estimated residual value x units of output in the period
Total estimated units over life of the asset

Which method do I choose?

Depreciation methods should be selected to be appropriate to the particular assets and
to their use in the business.
Accounting standard AASB 116 - Property, Plant and Equipment reinforces this view
Depreciation does not provide funds for asset replacement, it is used to calculate net
profit
Depreciation is an example of an accounting process that requires a lot of judgement

Accounts Receivable

Profit Measurement and the Problem of Bad and Doubtful Debts

Bad and doubtful debts are associated with income derived from selling goods on credit
(credit sales). When selling goods on credit there is a risk that the customer (debtor/account
receivable) will not pay the amount due. This can result in a bad debt if the amount is not
paid. Bad debts are classified as an expense. When a business is certain that a debt will not
be received, it must write the debt off. The writing off of a bad debt results in an increase in
expenses and a decrease in accounts receivable. Simply cancelling the sale is not the
correct action to take. Writing off a bad debt can have implications for how the granting of
credit applications is managed in the future and can impact on the evaluation of
management.

There may also be uncertainty about the collection of some debts as well. Recognition of
this uncertainty results in the debts being doubtful debts. The item Doubtful Debts is
recognized in the Income Statement as an expense. The amount of doubtful debts requires
estimation and this can be done by using either the percentage of credit sales or the aged
debtors listing as the basis for the calculation.

Recognition of doubtful debts also results in the recognition of a further item that is shown in
the Balance Sheet an Allowance/Provision for Doubtful Debts. This item is a negative
asset that is subtracted from Accounts Receivable in the Balance Sheet, as shown below:

Balance Sheet

Current Assets $
Accounts receivable 40,000
Allowance for doubtful debts (5,000)
35,000

Approaches to Recording Bad and Doubtful Debts

There are three alternative approaches to recording bad and doubtful debts observed in
practice:
1. Write off bad debt when it is known to be bad. Recognise only on basis of
realised uncollectable amount (customer is bankrupt, deceased etc and business
is certain that the debt will not be paid). This method results in the writing off of a
bad debt when the business knows the debt will not be paid. There is no
recognition given to doubtful debts.
2. Recognise bad debts and doubtful debts separately. The bad debt expense
is always written off against accounts receivable. The doubtful debt recognition
results in the use of a doubtful debt account in the Income Statement and an
Allowance for Doubtful Debts account in the Balance Sheet. Adjustments are
made to the Allowance for Doubtful Debts account each year to represent the
estimated debts in doubt of collection.
3. A combined bad and doubtful debts expense account is used. The value of
doubtful debts can be calculated on either the percentage of credit sales or the
aged debtors listing approach. When a bad debt is written off, accounts
receivable in the Balance Sheet is reduced and the amount is applied to the
Allowance for Doubtful Debts account.

An overall impairment test under AASB 132 may mean changes to the terminology
within the reporting for bad and doubtful debt expenses

Interpreting the Income Statement

How the final net profit figure was derived can be found by:
analysing sales levels - against history and planned sales for the current/future periods
examining the nature and amount of expenses incurred
comparison against history and future
indicator of efficiency of business operations
investigating gross profit levels in relation to sales in similar businesses
helpful in assessing profitability and margins
analysing net profit levels, for example against previous periods and also in relation to
sales.