MANG 6269
Fundamentals of Financial
Accounting
Session 3
Accounting for assets:
• Property, plant and equipment
• inventories
• receivables
Today’s lecture:
• Recap from last time
• Measurement issues and estimates in
financial statements:
– Non current assets and depreciation
– Current assets:
• Inventories
• Receivables
• prepayments
– Current liabilities
• Accruals
NON-CURRENT (OR FIXED) ASSETS
AND DEPRECIATION
• What is a Non Current Asset?
• What is Meant by:
– ‘Property, plant and equipment’
– Intangible Fixed Assets
– Investments held for long term
• What is meant by “Cost” of a fixed asset?
• What is meant by Depreciation?
• Methods of Depreciation
Definitions - Asset
Asset:
A resource controlled by the enterprise and
• There must be an exclusive right of control
• a future economic benefit associated with the
item is expected to flow to the enterprise
• The benefit must have arisen from some past
transaction or events
• the item has a cost or value that can be
measured with reliability
Adapted from International Accounting Committee, Framework for
the Preparation and Presentation of Financial Statements, 1989
Non-current asset
Assets acquired
• for use in the enterprise
• on a continuing basis
• not for resale
Use may be
• in the production or supply of goods or
services
• for rental to others
• or for administrative purposes
IAS16
Examples
• Tangible
• Intangible
Cost of property, plant and equipment
includes:
• its purchase price
– + import duties and non-refundable purchase taxes
– - trade discounts and rebates.
• any costs directly attributable to bringing the
asset to the location and condition necessary for
it to be capable of operating in the manner
intended by management.
• Any obligations for costs to be incurred for
dismantling etc.
Examples of attributable cost
Repairs and improvements
• Cost of Repairs – are charged to the
income statement
.
• Cost of improvements - added to the cost
of a building
.
Depreciation
• Non-current (fixed) assets are gradually used up
in providing goods and services over time.
• Purpose of accounting depreciation is to spread
the cost of a non-current (fixed) asset over its
expected useful life.
• Depreciation is a method of allocating cost.
• Achieves a matching of costs against the
related revenues.
© Weetman
Effect on Accounting Equation
Assets = Liabilities + Owners’ Funds
Depreciation:
• “The measure of the cost or revalued amount of
the economic benefits of the tangible fixed asset
that have been consumed during the period”.
• Consumption includes
the wearing out, the using up or other reduction in the
useful economic life of a tangible fixed asset
whether arising from use, effluxion of time, or
obsolescence through either changes in technology
or demand for the goods and services produced by
the asset.”
• “The fundamental objective of depreciation is
to reflect in operating profit the cost of use of the
tangible fixed assets (. the amount of economic
benefits consumed by the entity ) in the period.
FRS15
• Depreciable amount is the cost of an
asset, less its residual value.”
• “Depreciation is the systematic allocation
of the depreciable amount of an asset over
its useful life.”
IAS16
Note: influence of accruals concept.
• Net book value is
Cost less accumulated depreciation
(. The portion of cost that has not yet
been ‘used up’)
Methods of Depreciation include:
• Straight line
• Reducing Balance
• Machine hours
Example
A machine is bought for £20,000.
Its expected useful life is 3 years or 60,000
machine hours of use, and its estimated residual
value is £8,000.
For the Reducing balance method, use 25%.
Actual hours used:
Year 1 19,000; year 2 21,000; year 3 19,500.
Profit before depreciation in year 1 is £4,500.
What is net profit under each of 3 depreciation
methods?
Example
• A small business buys a machine for
£20,000. The owner expects it to last for
four years and to be scrapped for nothing
at the end of that time. She decides to use
straight line depreciation.
• What will be shown in the Income
statement each year?
• What will be shown in the balance sheet
each year?
Land and Buildings at Valuation
• Most fixed assets are shown in the accounts at
cost (less accumulated depreciation).
• However some companies may choose to
include land and buildings at revalued amount
(less depreciation).
• If a company makes this choice, all the assets in
the category must be revalued, and they must
be revalued at regular intervals.
• Revaluation reserve
• Look out for the accounting policy.
• IAS 16 refers to open market value whereas
FRS 15 required valuation to be at existing use
value,
Impairment
If circumstances change, directors need to review
their non-current assets and see if their value in
the accounts (the net book value) has been
impaired. If necessary, they will need to reduce
the value of the fixed assets to the
• higher of the net realisable value (what it can be
sold for less expenses)
or
• the value in use (the “present” value of
estimated future cash flows).
Inventories
(Stocks and work-in –progress)
• What are inventories?
• Accounting for inventories
• Objectives of inventories valuation
• Normal valuation: Lower of cost and net
realisable value
• What is the cost of inventories?
– cost flow assumptions
– cost of manufactured goods, or of services
• What is net realisable value?
What are inventories? Examples
from different types of business:
• Corner shop
• Crisp manufacturer
• Toy manufacturer
• Builder
• Solicitor
WHAT ARE INVENTORIES?
Assets:
(a) held for sale in the ordinary course of
business;
(b) in the process of production for such sale;
or
(c) in the form of materials or supplies to be
consumed in the production process or in
the rendering of services.
(IAS2)
Common categories:
“a) goods or other assets purchased for resale
b) consumable stores
c) raw materials and components purchased for
incorporation into products for sale
d) products and services in intermediate stages of
completion (Work-in-Progress)
e) long term contract balances
f) finished goods.”
SSAP 9
Accounting for inventories
• inventories is likely to be a very ‘material’
figure . large relative to profit.
• Consider the impact on
A - L = C + Profits
• Example
For a retailer or wholesaler:
Opening inventories + Purchases =
Cost of the inventories available during the year
How much of this cost has been “used up” and
should be charged against profit as Cost of
Sales?
How much of this cost has not been used up and
should be carried forward as closing inventories
with future economic benefit?
Note: Accruals concept: matching sales revenue of
goods sold with cost of goods sold.
Practicalities
• Where there are no detailed records of cost of
sales then:
– Step 1: Physical stocktake
– Step 2: Value at cost
• Where detailed records of cost of sales and
inventories are kept after every sale,
– then Physical stock take (either all at once or a little
at a time) to check records to actual inventories.
– Use inventories figure from the accounting records
Example
• Opening inventory £5,000
• Purchases £60,000
• Closing inventory £8,000
• Cost of Sales?
• Opening inventory £8,000
• Purchases: £90,000
• Cost of sales £88,000
• Closing inventory?
Valuation of inventories
Lower of
• Cost
and
• Net realisable value
• NB Prudence concept
Objectives of inventories valuation
at full cost
• To determine profit
• For financial statements
• basis for ‘cost +’ pricing (sometimes)
Cost:
Comprises:
• All costs of purchase,
• costs of conversion
• and other costs incurred in bringing the
inventories to their present location and
condition.
IAS 2
Cost of purchase
• the purchase price,
• import duties and other taxes
• transport, handling and other costs
• Less Trade discounts, rebates and other
similar items
SSAP 9
Cost Flow Models
• FIFO
• Weighted Average
• LIFO
NB: LIFO is not acceptable under IAS 2
(revised 2003) or SSAP 9
Examples - Widgets
• Jan 10 Bought 200 widgets @ £10 each
• Jan 17 Bought 300 widgets @ £11 each
• Jan 25 Sold 270 widgets
What is the Cost of Sales?
Cost of conversion
• Direct labour.
• Direct expenses
• a systematic allocation of fixed and
variable production overheads that are
incurred in converting materials into
finished goods.
Example 1: Toy Manufacturer
making Teddy Bears
Cost of Finished Bear:
• Direct Materials
(fluffy material, glass button eyes, stuffing etc etc)
£3 per unit
• Direct Labour (piece rate) £4 per unit
• and a share of indirect costs:
– Power: £3,000
– Rent and Business rates 1,800
– Foreman’s salary 2,000
– Depreciation of machines 900
– Other 300
Total for the month £8,000
? per unit
During the month, 1000 bears have been made.
Therefore a reasonable share of production overheads
would be:
8,000 = per unit.
1,000
Cost of Finished Bear:
Direct Materials £3 per unit
Direct Labour (piece rate) £4 per unit
share of indirect costs: per unit
Total per unit
NB The estimates and judgements which have been
used.
Valuation of Partly Made Bear, at
cost:
• A share of production overheads could be
based on direct labour cost:
– Cost of direct labour = 1000 bears at £4 each
=
– Production overhead = £8,000 in the month
– Production overhead / cost of direct labour =
• Costs of partly made bear:
Materials £ Actual
Labour £ Actual at piece rate
Overheads 2 x Direct labour cost
Total
Net Realisable Value:
“The estimated selling price in the ordinary course
of business less the estimated costs of
completion and the estimated costs necessary to
make the sale.” IAS 2
NB
• Normally Cost < NRV. Then inventories is valued at
cost.
Accruals (Realisation) and Prudence concepts
• Occasionally NRV< Cost . Then inventories is valued at
NRV
Prudence concept
Net Realisable Value:
• For a retailer or wholesaler or for the
finished goods of a manufacturer,
normally:
Selling price less selling and distribution
costs.
Example – retailer
Cost NRV Lower of
Cost and
NRV
Line A £5,000 7,000
Line B £2,000 3,000
Line C 200
800
0
1,000
Irreparably
damaged
Line D 1500 750 Out of
fashion
Total 12,500
Net Realisable Value:
For work in progress (or raw materials) of a
manufacturer or of a service industry:
• Normal selling price
• less costs to completion and selling and
distribution costs
in the normal course of business.
Example 3
Valuation of Partly Made Bear:
• Costs so Far (See example 1):
Materials £
Labour £
Overheads £
Total £
• Estimated Costs to Complete:
Further Materials
plus further Labour
plus further Overheads
at 2 x direct labour cost)
Total
• Net Realisable Value:
Selling Price less estimated Costs to
Completion
£25 - £ = £
• Lower of Cost and NRV
= Lower of £ and £ = £
43
Receivables (Debtors)
• These are the amounts of money owed to the
business by its customers.
• Normally, when businesses make sales on
credit, they expect their customers to pay!
– Checks on credit rating BEFORE sale is made
– If they are unsure, may ask for deposits or full
payment in advance.
– Importance of credit control procedures
• Normally it is expected that customers will
pay reasonably promptly, and the receivable
is valued at invoice amount
44
Bad and Doubtful Debts
• Sometimes customers will not pay:
– They may go bankrupt, or have significant
financial difficulties
– They may dispute the debt.
• The debt can only be shown as an asset if there
is an expected future economic benefit
• Therefore, when business knows that a
customer will not pay, the debt is “written off” as
a “bad debt”:
– The account receivable (asset) balance is
reduced to zero
– The bad debt written off is treated as an
expense.
Doubtful Debts – impairment
of receivables
Will the entity get all its money back?
At the end of the accounting period, is there
evidence that the value of the receivables is
impaired? .
• Significant financial difficulty of the debtor
• Late payments
• Probable bankruptcy
• Granting concessions to the debtor .
rescheduling repayments
• Observable data relating to future cash
flows for a group of receivables .
– Increase in rate of Delayed payments or
payments on account
– Unemployment rates in the area going up
Doubtful Debts – impairment
of receivables
If receivables are impaired, Businesses
make an allowance (or provision) for
doubtful debts:
• Deducted from accounts receivable total
on balance sheet
• Increase charged as an expense in the
income statement
Example
• Receivables at invoice value at 31 Dec
2012 amount to £12,500.
• Included in this amount is £3,500 owing
from Bloggs Builders Ltd. This customer
has been very late in its payments and is
in financial difficulty. The company is still
asking for all the moneys but it is
estimated that only half of the debt will be
recovered.
• What amount should be shown in the
balance sheet?
Weir Group plc- accounting
policy
Trade receivables, which generally are of a
short dated nature, are recognised and
carried at original invoice amount less an
allowance for estimated irrecoverable
amounts. Provision is made when there is
objective evidence that the Group will not be
able to recover balances in full. Balances
are written off when the probability of
recovery is assessed as being remote.
Longer term receivables
• . A customer owes £1,000, but the
contract states that the debt is
repayable in 2 years’ time. Current
interest rates are 3%.
• Valued at ‘Fair value or amortised cost’
• Taking into account the ‘time value’ of
money:
Valued in Balance sheet now at £943
Valued in the balance sheet at the end
of year 1 at £971
Receivables and Prudence
Example of a prepayment
• At Jan 1 there is a prepayment of rent of
£700 for two months.
• Four payments for rent of £1,200 each
are paid during the year.
• At the end of the year it is recognised
that of this, £800 is a prepayment
covering rent for the first two months of
the following year.
Example of an accrual
• At Jan 1 the business estimates it owes
£400 for gas.
• During the year payments for gas are
made totalling £3,600.
• At the end of the year, it is estimated that
the business owes £550 for gas.
Estimates and judgements
References :
• IAS 16 International Accounting Standard,
Property, plant and equipment, IASB Dec 2003
(amended 2004)
• FRS 15 Tangible Fixed assets, Financial reporting
standard,
UK Accounting Standard Board 1999
• IAS 2 Inventories (Revised 2003) International
Accounting Standard Number 2, (revised),
International Accounting Standards Board, Dec 2003
• Quotations from SSAP 9: Statement of Standard
Accounting Practice Number 9 , Accounting
Standards Committee, revised 1988)
• Weetman: Pauline Weetman Financial and
Management Accounting 4th edition Pearson 2007
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