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Chapter Introduction to Accounting and Business Objectives Describe the nature of a business Describe the role of accounting in business Describe the profession of accounting Summarise the development of accounting principles and relate them to practice • State the accounting equation and define each element of the equation • Describe the financial statements of a sole proprietorship and explain how they interrelate • • • • Content • • • • • • Nature of a business What is accounting? Profession of accounting GAAP Accounting equation Financial statement VuongPM Nature of a business • In general, a business is an organisation in which basic resources (inputs) are assembled and processed to provide goods or services (outputs) to customers • Each business has its own objective!!! Nature of a business • Types of businesses: Manufacturing Trading Service Manufacturing VuongPM Trading Service Types of Business Organisation • Sole proprietorship • Partnership • Company VuongPM What is accounting? • Accounting provides information for stakeholders • Accounting = Gathering, Processing and Communicating 10 Providing Information to Stakeholders Identify stakeholders Internal/External Stakeholders Assess their information needs Record economic data about business activities Accounting Information System Design the AIS 11 Stakeholder • Internal: – Manager – Employee • External: – Bank – Tax authority 12 VuongPM Stakeholders’ information needs • • • • Managers? Investors? Creditors (such as Bank)? Government? 13 Profession of accounting Accountant Private accountant Public accountant Accounting Fields Financial Accounting Managerial Accounting 14 GAAP GAAP (Generally Accepted Accounting Principles) US GAAP UK GAAP * Accountants follow GAAP in preparing reports By this, these reports could be compared from one business to another 15 VuongPM GAAP Accounting concepts developed from GAAP         Business Entity Concept Historical Cost Accounting Period Going Concern Consistency Materiality Money measurement concept … 16 Accounting equation Assets = Liabilities + Owner’s Equity * All business transactions can be stated in terms of changes in the elements of the accounting equation 17 Assets • Resources controlled by the business 18 VuongPM Assets • • • • • • Cash Property, Plant and Equipment Stock (Inventory) Patent right Land usage right Money in bank account 19 Liabilities • Debts owed to outsiders (creditors) 20 Liabilities • • • • • Loans Advance payment from customer Bank overdraft Payable to supplier Tax payable 21 VuongPM Owner’s Equity • Owner’s right to the asset of the business 22 Owner’s Equity • Contributed capital investment • Reserves • Retained earnings 23 Business Transactions and the Accounting Equation • Deposit in bank account for initial capital investment ($1,000) • Purchase a machine by cash ($300) • Borrow money from your family ($400) • Sell goods to customer and receive cash ($200) 24 VuongPM Financial statement • • • • • Profit and loss statement Statement of owner’s equity Balance sheet Statement of cash flows Notes of FS 25 Profit and loss statement Revenues Expenses 26 Statement of owner’s equity Summary of the changes in the owner’s equity 27 VuongPM Balance sheet A list of assets, liabilities and owner’s equity 28 Statement of cash flows A summary of the cash receipts and cash payment 29 Notes of FS • List of note to accommodate user of FS with additional information      Accounting policies Detailed information Contingency liabilities Events after reporting date Transactions with related parties 30 VuongPM 10 Effect on PL and BS Whatever the cost method apply, it will affect both PL and BS results as it affects:  COGS  Inventory ending balance 25 25 Which costing method to choose from? It depends on company’s policy LIFO is not permitted in a number of countries This is an accounting policy, therefore, it requires a consistency 26 26 Which costing method to choose from? During a period of inflation or rising price, applying FIFO would give a higher gross profit and higher ending inventory balance as compared with other two methods 27 27 VuongPM FIXED ASSET Chapter 1 Objectives  Compute depreciation, using the following methods: straight – line method, units-of-production method, and declining-balance method  Journalise entries for the disposal of fixed assets  Describe how depreciation expense is reported in a profit and loss statement and prepare a balance sheet that includes fixed assets 2 Contents  Fixed Assets  Purchase of Fixed Assets  Depreciation  Accounting for Depreciation  Disposal of Fixed Assets  Financial Reporting for Fixed Assets 3 VuongPM Fixed assets  They could be machines, plants, properties, etc 4 Fixed assets  Main characteristics:  Permanent  Duration Used to earn Revenue 5 Purchase of PPE  Fixed assets maybe purchase with cash, bank or on credit (on account) Dr PPE Cr Cash/Bank/Account payable 6 VuongPM Purchase of PPE  Other costs included in the cost of PPE:  Irrecoverable  Installing tax (import duties) cost  Transportation cost 7 Depreciation  As time passes, fixed assets (except land) lose their ability to provide useful services In other words, when they get older, they may spoil, and not work as well as before  Depreciation:  Decrease in usefulness Recorded as expenses 8 Depreciation  Fixed assets are presented on the BS at their Net Book Value (Cost of Fixed Assets – Accumulated Depreciation) 9 VuongPM Accounting for Depreciation  Fixed asset’s cost: all amounts spent to get it to the business’ premises and ready for use  Expected useful life: how long the fixed asset can be used by the business  Residual value: what the fixed asset item is worth at the end of its expected useful life 10 10 Accounting for Depreciation Fixed asset’s cost Residual value Depreciation Cost 11 11 Accounting for Depreciation  Three methods of depreciation: Straight-line Units-of-production Declining-balance 12 12 VuongPM Straight-line Depreciation 13 13 Straight-line Depreciation  This method provides for the same amount of depreciation expense for each year of the asset’s useful life Depreciation Cost Annual Depreciation Expense Estimated useful Life 14 14 Straight-line Depreciation  Example:  Assume that the cost of an asset is $40,000, its estimated residual value is $4,000, and its estimated life is 10 years  Annual Depreciation Expense = ???????? 15 15 VuongPM Straight-line Depreciation The amount of depreciation could be calculated for less than one accounting period  Example:   An asset is bought at cost of $40,000 on 1st of March 20X0, its estimated residual value is $4,000, and its estimated life is 10 years What is its depreciation expense for the year ended on 31st December 20X0? 16 16 Units-of-Production Depreciation  This method is used when the usage of fixed asset varies from year to year  The idea is that the more depreciation should be recorded when the machine is used for more hours (or for more units produced) 17 17 Units-of-Production Depreciation  The useful life of fixed asset is now expressed in terms of estimated number of hours used or estimated number of units produced Depreciation Cost Depreciation For a unit-ofproduction Estimated Number of hours used (or estimated number of units produced) 18 18 VuongPM Units-of-Production Depreciation  Example: A machine with a cost of $100,000 and an estimated residual value of $5,000 is expected to produce 200,000 units during its useful life time What is the depreciation expense of this machine? Given that, during the accounting period, this machine produced 35,000 units 19 19 Declining-Balance Method  This methods provides for a declining (reducing) depreciation expense over the useful life of the asset  The highest amount of depreciation is recorded on the first year 20 20 Declining-Balance Method  Depreciation amount:  For the first year = cost of asset X declining-balance rate  After the first year = the net book value X declining-balance rate 21 21 VuongPM Declining-Balance Method  Example: The cost of an asset is $40,000, its estimated residual value is $4,000, and its estimated life is years Declining-balance rate is 40% Compute the depreciation for this asset Assume that the asset is purchased at the beginning of the year 22 22 Declining-Balance Method Year Cost (A) $40,000 $40,000 Accum Depre (B) Open Net Rate Book (D) Value (C=A - B) Depre for Year (E=C*D) Close Net Book Value (F= C – E) $40,000 40% $16,000 $24,000 $16,000 $24,000 40% $9,600 $14,400 $40,000 $25,600 $14,400 40% $5,760 $8,640 $40,000 $31,360 $8,640 40% $3,456 $5,184 $40,000 $34,816 $5,184 $1,184 $4,000 23 23 Disposal of Fixed Assets  When fixed assets are no longer used:  Discarded (thrown away)  Sold  Traded  in (exchanged) Accounting treatment for above situation? 24 24 VuongPM Discarding Fixed Assets  The fixed asset could be fully depreciated Dr Accumulated Depreciation Cr Fixed Asset 25 25 Discarding Fixed Assets  If the fixed asset is not fully depreciated  Remember:  To calculate and include depreciation for the period prior to removing date net book value would be recorded as Loss on Disposal of Fixed Assets Dr Depreciation Expense Cr Accumulated Depreciation  The Dr Accumulated Depreciation Dr Loss on Disposal of FA Cr Fixed Asset 26 26 Discarding Fixed Assets  Example: Assume that equipment costing $20,000 is depreciated at a straight-line rate of 10% In addition, assume that accumulated depreciated at the beginning of 20X0 is $5,000 and the asset is discarded on 30th June 20X0 How would this transaction be recorded on 30th June 20X0? 27 27 VuongPM Selling Fixed Assets  If the selling price: < Net Book Value: Make a loss = Net Book Value: No gain no loss > Net Book Value: Make a profit  And as always, take off the Accumulated Depreciation 28 28 Selling Fixed Assets  Example: Assume that equipment costing $20,000 is depreciated at a straight-line rate of 10% In addition, assume that accumulated depreciation at the beginning of 20X0 is $5,000 and the asset is sold on 30th June 20X0  How would this transaction be recorded if:  Selling price is $12,000  Selling price is $14,000  Selling price is $16,000 29 29 Selling Fixed Assets Step 1: Determine the depreciation expense prior selling point Depreciation = (6/12*$20,000*10%)= $1,000 Step 2: Find the Net Book Value of the equipment: Net Book Value = $20,000 – ($5,000 + $1,000) = $14,000 Step 3: Compare NBV with selling price and record the transaction 30 30 VuongPM 10 Selling Fixed Assets Selling price is $12,000 < NBV: make a loss ($14,000 - $12,000 = $2,000) Dr Cash $12,000 Dr Accumulated Depreciation $6,000 Dr Loss on Disposal $2,000 Cr Equipment $20,000 31 31 Selling Fixed Assets Selling price is $14,000 = NBV: no gain or loss ($14,000 - $14,000 = $0) Dr Cash $14,000 Dr Accumulated Depreciation $6,000 Cr Equipment $20,000 32 32 Selling Fixed Assets Selling price is $16,000 > NBV: make a profit ($16,000 - $14,000 = $2,000) Dr Cash $16,000 Dr Accumulated Depreciation $6,000 Cr Equipment $20,000 Cr Profit on Disposal $2,000 33 33 VuongPM 11 Exchanging Fixed Assets  Old equipment could be traded in for new equipment Seller allows the buyer an amount for the old equipment traded in  This amount is called the trade-in allowance In addition, trade-in allowance could be > or < NBV of the old equipment 34 34 Exchanging Fixed Assets Example:   Assume that equipment costing $20,000 is depreciated at a straight-line rate of 10% In addition, assume that accumulated depreciated at the beginning of 20X0 is $17,000  The equipment will be traded in for a new equipment (cost $15,000, cash pay) on 1st Jan 20X0 and receive a trade-in allowance  How this transaction would be recorded if the trade-in allowance:  A) $2,000  B) $4,000 35 35 Exchanging Fixed Assets  A) Trade-in allowance is $2,000 New equipment $15,000 Trade-in allowance $ 2,000 Cash paid $13,000 Old equipment $20,000 Accumulated depreciation $17,000 NBV $ 3,000 Trade-in allowance $ 2,000 Loss on exchange $ 1,000 36 36 VuongPM 12 Exchanging Fixed Assets  A) Trade-in allowance is $2,000 Dr Accumulated Depreciation $17,000 Dr New Equipment $15,000 Dr Loss on Exchange $ 1,000 Cr Old Equipment $20,000 Cr Cash $13,000 37 37 Exchanging Fixed Assets  B) Trade-in allowance is $4,000 > NBV of old equipment: No gain is recognised for the exchange However, this unrecognised gain could be used to reduce the cost of new equipment Old equipment $20,000 Accumulated depreciation $17,000 NBV $ 3,000 New equipment (List price) $15,000 Unrecognised gain (4,000-3,000) $ 1,000 Cost of new equipment $14,000 38 38 Exchanging Fixed Assets  B) Trade-in allowance is $4,000 Dr Accumulated Depreciation $17,000 Dr New Equipment $14,000 Cr Old Equipment $20,000 Cr Cash (15,000 – 4,000) $11,000 39 39 VuongPM 13 Financial Reporting for Fixed Assets  PL:  Depreciation  Profit/Loss  expense on Disposal of Fixed Assets BS:  Fixed Assets Cost  Accumulated Depreciation 40 40 VuongPM 14