So far...we have learned how to analyse business transactions, record these in T-Accounts, prepare a trial balance, income stmt and balance sheet. We have also been introduced to the concept of accrual accounting vs cash accounting (accounts receivable and accounts payable) We have been accounting for transactions as they occur, however during the accounting period other changes take place End of Period Adjustments
<ul><li>Changes that take place during the accounting period that have yet to be entered into the accounting system include: </li></ul><ul><li>Pre-paid insurance is being used up </li></ul><ul><li>Supplies are being used up </li></ul><ul><li>Equipment is wearing out </li></ul><ul><li>Employees are earning wages that have not yet been paid </li></ul><ul><li>As these events have not yet been recorded, adjusting entries must be made prior to the preparation of the financial statements. </li></ul><ul><li>The matching principle in accounting requires that revenues earned during an accounting period are matched with expenses incurred in the production of that revenue. </li></ul>End of Period Adjustments cont..
The income stmt reports earnings for a specific time period (1qtr, 1yr etc) The balance sheet reports the assets, liabilities and owners equity on a specific date (as at 31 Dec 20xx) Therefore to follow the matching principle, accounts in the trial balance must be adjusted before financial statements are prepared. The matching principle
<ul><li>Assets are resources or items of value owned by the business which will generate future income . </li></ul><ul><li>Examples of assets include cash at bank, accounts receivable, buildings.. </li></ul><ul><li>Assets are classified on a time basis (liquidity): </li></ul><ul><li>Current Assets – those that will be consumed or converted into cash within the accounting period - normally 1 year </li></ul><ul><li>Non Current Assets (also known as Fixed Assets) - those that will be held onto for a long period of time </li></ul>Definition of an Asset
Current vs Non Current Assets Balance Sheet Current Assets: Within the financial year: Cash - Expected to produce revenue Accounts receivable - Can be used to meet short term / day to day obligations Prepaid Insurance - Generally can be liquidated (converted to cash within 1 yr) Inventories Non Current Assets: (Fixed Assets) Office Furniture - Tend to remain in the business for a longer period of time Motor Vehicles - Indirectly generate income Buildings - Can not be liquidated instantly for cash Land - Suject to depreciation Total Assets = Current + Non Current Assets
Prepaid expenses <ul><li>A pre-paid expense occurs when a business pays for an item in advance and not all of the cost has been used at balance day. </li></ul><ul><li>Example: - Prepaid Insurance </li></ul><ul><li>A company pays an annual insurance bill up front - $1,200 </li></ul><ul><li>The entries are: </li></ul><ul><li>DR – Asset – Pre-paid Insurance $1,200 </li></ul><ul><li>CR – Asset – Cash $1,200 </li></ul><ul><li>Why is the asset debited? Does the insurance policy provide future benefit? </li></ul><ul><li>The company prepares monthly accounts, how should we adjust prepaid insurance to accurately report the income stmt and balance sheet? </li></ul>
Prepaid expenses cont. <ul><li>Example: - Prepaid Insurance - Adjustment </li></ul><ul><li>Since the premium covered 12 months, the cost of the expired coverage is $100 per month ($1,200 / 12 mths) </li></ul><ul><li>The monthly adjusting entry is: </li></ul><ul><li>DR – Expense – Insurance Expense $100 </li></ul><ul><li>CR – Asset – Pre-paid Insurance $100 </li></ul><ul><li>After 3 months, what will be the balance of prepaid insurance? & Insurance expense? </li></ul>
Prepaid expenses cont. <ul><li>Other examples of pre-paid expenses include: </li></ul><ul><li>Rent paid in advance </li></ul><ul><li>Supplies / Inventory / Stock remaining unused at the end of the period. </li></ul><ul><li>Wages paid in advance </li></ul>Cash Prepaid Insurance Insurance Expense (1,200) 1200 (100) 100 (100) 100 (100) 100 1200 (300) balance (1,200) balance 900 300 balance
Non-current assets such as vehicles, equipment etc cannot be included as expenses in an income statement because they are not used up in one reporting period. A delivery van for example will be useful to a company for a number of years, during which time it helps the company earn revenues by delivering goods. Under accrual accounting, revenue for a reporting period must be Matched with the relevant expenses for that period. Depreciation is the process of allocating (or writing off) the cost of a non-current asset over its useful life . What is Depreciation?
An assets useful life is the period of time that asset is expected to help produce revenues. Depreciation is the recognition of a decline in value of an asset due to wear and tear. Depreciation is an expense account. When depreciation is recognized as an adjusting entry at the end of the accounting period, an expense is charged – a debit entry is made to depreciation expense. Where does the credit entry go? Adjusting Entries - Depreciation
Under the ‘historical cost’ principle, assets are recorded at their actual cost. (regardless of whether the firm got a good buy or over paid for them.) When we made an adjustment for pre-paid insurance, the asset accounts were credited to show that they had been consumed. However assets that are expected to provide future benefits for more than 1 yr require a different approach. The business must maintain a record of the actual cost of an asset. The credit side of the adjusting entry therefore goes to an asset – contra account called ‘Accumulated Depreciation’ Accumulated Depreciation
The depreciation adjusting entry is: DR Depreciation Expense (P/L) CR Accumulated Depreciation (B/S – contra asset account) Accumulated depreciation is also known as Provision for depreciation Accumulated Depreciation cont.. Balance Sheet Income Statement Assets: Expenses: Delivery Equipment 3,600 Depreciation Expense 100 less: Accumulated depreciation (100) Net Book Value 3,500
<ul><li>Straight-line method </li></ul><ul><li>- the most common method of depreciating assets in financial statements </li></ul><ul><li>- the depreciation for each full year is the same amount. </li></ul><ul><li>Example: </li></ul><ul><li>On July 1, 2009 a company purchases equipment having a cost of $10,500. </li></ul><ul><li>The company estimates that the equipment will have a useful life of 5 years. </li></ul><ul><li>At the end of its useful life, the company expects to sell the equipment for $500. </li></ul><ul><li>The company wants the depreciation to be reported evenly over the 5–year life. </li></ul>Calculating Depreciation Straight Line Depreciation: Original cost – Salvage Value = Depreciable Cost Depreciable Cost Estimated Useful Life = Depreciation Exp
If a company's accounting year ends on December 31, but the purchase of the asset was 1 July, what will the depreciation schedule look like? What is the cash outlay? How will the company report the depreciation expense on the company's income statement? Why is depreciation expense regarded as a non-cash expense? Depreciation Example cont.
Depreciation Estimates <ul><li>Salvage Value – can also be referred to as disposal value, scrap value, or residual value. This is the amount the company estimates it will receive on disposal of an asset at the end of its useful life. Often the salvage value can be zero. </li></ul>2. Useful life - an estimate of how long the asset will be used (as opposed to how long the asset will last). For example, a graphic artist might purchase a computer in 2009 and expects to replace it in 2011 with a more advanced computer. Hence the graphic artist's computer will have an estimated useful life of 2 yrs. An accountant purchasing a similar computer in 2009 expects to use it until 2013. The accountant will use an estimated useful life of 4 yrs when computing depreciation.
Your turn <ul><li>Depreciation drill – Accounting Coach (do not do Q 12, Q 15 or Q 20) </li></ul><ul><li>VCE – depn exercises 18.7 & 18.8 </li></ul><ul><li>Richmond Rugs Exercise </li></ul><ul><li>Chapter 5 – Book questions </li></ul>