CHAPTER
2
Principles of
Accounting
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CHAPTER 2 OUTLINE
2.1 Basic Principles in Accounting
2.2 Financial Statements
2.3 Analysis of Financial Statements
2.4 Basic Principles of Depreciation
2.5 Depreciation Methods
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Professor R. Jassim
2.1
Engineering Economy
BASIC PRINCIPLES IN ACCOUNTING
Principles
• Record only facts that are expressed in monetary value
• A business is an entity that is independent of its shareholders’ personal wealth
• The value of the business is based on the assumption that it is a going concern,
i.e. it will operate indefinitely
• The value of the assets is recorded at cost; the value of capital assets must be
adjusted for use and deterioration
• Revenues must be matched with associated operating expenses for each
accounting period
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Professor R. Jassim
2.1
Engineering Economy
BASIC PRINCIPLES IN ACCOUNTING
Accounting
•
The process of estimating and recording financial changes in an organization along
with subsequent monitoring and analysis of this information.
Financial Accounting
•
Concerned with recording and analyzing the financial data of a business. The
object is to provide information to both internal management and external parties
who wish to make decisions about an enterprise.
Investors
•
Anyone who currently owns or may invest in the organization will use accounting
information to ask questions about the profitability of the company.
Creditors
•
A person or group to whom the organization is indebted (e.g. bank, supplier).
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Professor R. Jassim
2.1
Engineering Economy
BASIC PRINCIPLES IN ACCOUNTING
Assets
•
Goods owned by the business (e.g. cash, inventory, real estate, machinery).
Liabilities
•
Elements owed by the business (e.g. accounts payable, taxes payable, bank
loans, mortgages).
Shareholders’ Equity
•
•
•
Net worth of the business to its owners. Consists of:
Amount received by issuing shares “capital”, original value is “par value”
Past profits reinvested into the business, “accumulated retained earnings”
Assets = Liabilities + Shareholders’ Equity
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Professor R. Jassim
2.1
Engineering Economy
BASIC PRINCIPLES IN ACCOUNTING
Revenue
•
Generated from the sale of products and/or services.
Operating Expenses
•
Expenses incurred in fabricating products and/or providing services to
appropriate markets; generally associated with the purchase of consumable
items used to generate revenue over the current accounting period, i.e. the
short-term.
Profits
•
•
•
Net amount available for:
Distribution to shareholders as “dividends”
Reinvesting in the business (retained earnings)
Profits = Revenues – Operating Expenses
Capital Expenditures
•
Expense generally associated with the purchase of non-consumable items used to
generate revenue over several accounting periods, i.e. the long-term.
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Income Statement
The Income Statement shows all revenues and operating expenses associated
with a specific accounting period. The Income Statement is also known as the
Statement of Earnings. It summarizes revenues, expenses, profits before taxes,
taxes paid and profits after taxes.
Figure 2.1
Income Statement
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Income Statement
Revenue Items
Sales
Other
• dividends received from other companies
• interest on investments
• proceeds from the sale of assets
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Income Statement
Operating
Expense Items
Cost of
goods sold
•
•
•
•
raw materials
labour
power
depreciation
Other
• administrative and marketing expenses
• insurance
• property taxes
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Statement of Earned Surplus
The Statement of Earned Surplus (also known as the Statement of Retained
Earnings) shows the changes in the (Accumulated) Retained Earnings account
from the end of the previous accounting period to the end of the current period.
Add:
Less:
Balance at start of current period
Net Income (Loss) of period
Dividends declared during period
Balance at end of period
Example 2.1- Major Electric Company (Fig. 2.1)
Earned Surplus at Nov. 2009
174 700
Add:
Net Income for 2010
304 200
Less:
Withdrawals for 2010
286 500
Source
Use
Earned Surplus at 31 October $ 192 400
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Balance Sheet
The Balance Sheet is a snapshot of a firm’s financial position at a particular point
in time, i.e. the end of the current accounting period. It summarizes assets,
liabilities and owner equity.
It is a list of the business’ assets as well as the claims against those assets by:
• Creditors – the liabilities
• Owners – the Shareholders’ Equity
Assets
Current assets typically can be converted into cash within one year. Examples are:
• Cash
• Accounts receivable
• Inventory
Fixed assets (or, capital assets) have a life greater than one year. Examples are:
• Plant and equipment
• Buildings and land
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Liabilities
Current Liabilities are those that are normally paid within a year. Examples are:
• Accounts payable
• Taxes or wages payable
• Bank loan payable
Long-term liabilities are money owed later than in the current year. Examples are:
• Loans
• Mortgages
Shareholders’ Equity
Capital Stock – Value at par of stock issued to shareholders
Preferred Stock – “Par” value (original issue price) of preferred stock issued to
shareholders
(Accumulated) Retained Earnings – Accumulated profits reinvested in the
business, i.e. those not distributed to the shareholders in the form of dividends.
Also referred to as Earned Surplus.
Book Value per Share =
Net worth - Preferred stock
# common shares
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Figure 2.2
Balance Sheet
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Cash Flow Statement
The Cash Flow Statement shows the sources and the uses of cash over the current
accounting period
Sources
•
•
•
•
•
Net Income
Depreciation
Decrease in assets
Increase in liabilities
Increase in capital (shares)
Uses
•
•
•
•
•
Loss
Increase in assets
Decrease in liabilities
Repurchase of shares
Dividends
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Example 2.2
Assume a net income of 3 840 and a withdrawal of 2 500.
Assets
Year 1
Year 2
Change
Cash
4 440
5 560
X
Accounts Receivable
1 500
750
Source 750
150
414
Use 264
Savings Bond
3 000
4 000
X
Prepaid Rent
800
1 200
Use 400
9 890
11 924
6 000
9 500
Use 3 500
600
1 550
Source 950
5 400
7 950
$15 290
$19 874
Current Assets
Stationary Supplies
Total Current Assets
Fixed Asset
Equipment at Cost
Less Accumulated Depreciation
Total Net Fixed Assets
Total Assets
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Example 2.2
Liabilities & Shareholders’ Equity
Year 1
Year 2
Change
4 000
200
Use 3 800
250
Source 250
2 560
Source 1 444
750
Source 750
Current Liabilities
Accounts Payable
Wages Payable
Income Taxes Payable
1 116
Prepaid Consulting Fees
Total Current Liabilities
5 116
3 760
Long-term Liabilities
Bank Loan
4 600
Total Long-term liabilities
Source 4 600
4 600
Shareholders’ Equity
Capital Stock
10 000
10 000
0
174
1 514
X
Total Shareholders’ Equity
10 174
11 514
Total Liabilities & Shareholders’ Equity
$15 290
$19 874
Accumulated Retained Earnings
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Example 2.2
Operating Activities
Net Income
3 840
Depreciation
950
Accounts Receivable
750
Increase in other current assets
Accounts Payable
Increase in other current liabilities
-264 + -400 = (664)
(3 800)
2 444
3 520
Financing Activities
Bank loan
Withdrawal
4 600
(2 500)
2 100
Investment Activities
Purchase of fixed assets
(3 500)
Change of Cash = 3 520 + 2 100 -3 500 = $2 120
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Example 2.3- Accumulated Retained Earnings
Accumulated retained earnings, end of 19X1
(20 000)
Accumulated retained earnings, end of 19X2
50 000
Dividend paid in 19X2
10 000
What was the Net Income in 19X2?
Change in accumulated retained earnings:
50 000 - (-20 000) = +70 000
Change in accumulated retained earnings = Net Income (Loss) - Dividend
Net Income = 70 000 + 10 000 = 80 000
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Example 2.4- Net Fixed Assets
Net fixed assets, end of 19X1
540 000
Depreciation claimed in 19X2
40 000
Fixed assets purchased in 19X2
100 000
What was the value of Net Fixed Assets at the end of 19X2?
Net fixed assets, end of 19X2 = Net fixed assets, end of 19X1 Depreciation claimed in 19X2 +
Fixed assets purchased in 19X2
Net Fixed Assets, end of 19X2 = 540 000 - 40 000 + 100 000 = 600 000
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Professor R. Jassim
2.2
Engineering Economy
FINANCIAL STATEMENTS
Example 2.5- Change in Cash Position
Decrease in inventory
140 000
Source
Decrease in accounts payable
100 000
Use
Increase in long-term debt
Increase in accounts receivable
50 000
200 000
Source
Use
Classify each item as either a source or use of cash...
Based uniquely on these items, what was the change in the cash position?
Change = Sources - Uses
= 140 000 + 50 000 - (100 000 + 200 000)
= (110 000) i.e., the amount decreased
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Financial Indicators
•
Four categories of measures (known as financial indicators and/or ratios) are
used to assess the financial health of a company.
Liquidity
•
Measures the ability of the firm in meeting its short-term financial obligations, i.e.
the company’s short-term solvency.
Leverage
•
Measures the extent to which a business is financed by debt as opposed to equity.
Activity
•
Examines the firm’s effectiveness in using its fixed resources.
Profit
•
Examines the firm’s effectiveness in generating profit.
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Liquidity
Working Capital
•
Funds available to sustain a business’ short-term activities
Working Capital = Current Assets - Current Liabilities
Current Ratio
•
Indicates the short-term liquidity of the business.
Current Ratio =
Current Assets
Current Liabilities
Quick Ratio
•
More rigorous assessment of the short-term liquidity of a business. Liquid assets
exclude less liquid assets such as inventories and prepaid expenses.
Quick Ratio =
Liquid Current Assets
Current Liabilities
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Leverage
Debt Ratio
•
Indicates the dependency of the firm on creditors; i.e. the amount of non-equity
funds invested in the assets
Debt Ratio =
Liabilities
Liabilities + Shareholders’ Equity
Equity Ratio
•
Measures the financial strength of the firm; it is the complement of the Debt Ratio.
Equity Ratio =
Shareholders’ Equity
Liabilities + Shareholders’ Equity
Debt to Equity Ratio
•
Compares the amount of long-term debt liabilities to equity capital
Debt to Equity Ratio =
Long-term Debt Liabilities
Shareholders’ Equity
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Leverage
Times-Interest-Earned Ratio
•
Measures the firm’s ability of paying interest on long-term debt, i.e. the coverage
of interest payments.
Times-Interest-Earned
Before-Tax Profit + Interest Expenses
=
Ratio
Interest Expenses
•
Numerator is also referred to as ``Earnings before interest and taxes`` or EBIT.
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Activity
Inventory Turnover Ratio
•
Measures adequacy of inventory level.
•
•
=
Inventory Turnover
Ratio
Cost of Goods Sold
Avg. Inventory of Finished Products
If Cost of Goods Sold is not available, use net sales.
To calculate average: (beginning balance + ending balance)/2
Average Collection Period
•
Measures promptness in collecting receivables.
Average Collection
Average Accounts Receivable
=
Period
Average Daily Credit Sales
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Activity
Fixed Asset Turnover Ratio
•
Measures the sale generating capacity of the fixed assets.
Fixed Asset
Net Sales
=
Turnover Ratio
Average Net Fixed Assets
Total Asset Turnover Ratio
•
Measures the sale generating capacity of all assets.
Total Asset
Net Sales
=
Turnover Ratio
Average Total Assets
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Profit
Operating Cost Ratio: Operating Margin
•
Before-tax cost of generating one dollar of sales
Operating
Operating Expenses (Excluding Taxes and Interest Expenses)
=
Cost Ratio
Net Sales
Profit Margin
•
Before-tax profit generating capacity of one dollar of sales.
Profit Margin = 1 - Operating Ratio
Net Profit Ratio
•
Measures the profit generating capacity of one dollar of sales.
Net Profit Ratio = Net Profit
Net Sales
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Profit
Return on Total Assets
•
Accounting measure of the return on investment
Return on Total Assets =
Net Profit
Average Total Assets
Return on Equity
•
Accounting measure of the return on equity.
Return on Equity =
Net Profit (less preferred dividend)
Average Common Shareholders’ Equity
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6- PASCO Limited
Income Statement for the Second Quarter of 1980 (values in ‘000 $)
Net Sales
Other Income
Cost of sales and operating expenses
Selling, general and administrative expenses
Research and development
Exploration expenses
Interest, net of amount capitalized
Currency translation adjustments
720 953
7 259
728 212
487 547
72 349
12 945
6 079
41 506
8 882___________
629 308
Income before income and mining taxes
Income and mining taxes
Net Income
98 904
52 782
46 122
Dividends on preferred shares
Net Income application to common shares
Earnings per common share ($)
6 592
39 530
0.53
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Balance Sheet as of 30 June, 1980 (values in ‘000 $)
Assets
Current Assets
Cash and Securities
71 824
Accounts Receivable
558 232
Inventories
Prepaid Expenses
1 287 310
25 439
Total Current Assets
1 942 805
Property, plant and equipment, net
2 517 057
Cost in excess of net assets acquired (Goodwill)
28 145
Other assets
94 332
Total Assets
4 582 339
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Liabilities
Current Liabilities
Notes payable
374 968
Accounts payable
436 811
Current taxes payable
112 658
Total Current Liabilities
924 437
Long-term Liabilities
Long-term debt
1 015 160
Deferred taxes
453 000
Other long-term liabilities
70 231
Total Liabilities
2 462 828
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Shareholders` Equity
Shareholders` Equity
Preferred Shares
346 948
Common Shares
116 016
Retained Earnings and Capital Surplus
1 656 547
Total Shareholder`s Equity
2 119 511
Total Liabilities
2 462 828
Total Liabilities and Shareholders` Equity
4 582 339
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Liquidity
Working Capital = Current Assets - Current Liabilities
(WC)
= 1 942 805 - 924 437
Should be positive
= 1 018 368
Current Ratio =
(CR)
Current Assets
Current Liabilities
= 1 942 805
924 437
= 2.10
Should be above 2.0
Quick Ratio = Liquid Current Assets
(QR)
Current Liabilities
= 1 942 805 - 1 287 310 - 25 439
924 437
= 0.68
Should be above 1.0
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Leverage
Debt Ratio =
(DR)
Liabilities
Shareholders’ Equity + Liabilities
= 924 437 + 1 015 160 + 453 000 + 70 231
4 582 339
= 2 462 828
4 582 339
Typically ranges from 0.2 to 0.4
= 0.54
Equity Ratio =
(ER)
Shareholders’ Equity
Shareholders’ Equity + Liabilities
= 1 - DR
= 0.46
Typically ranges from 0.6 to 0.8
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Leverage
Debt to Equity Ratio = Long-term Debt Liabilities
(D/E)
Shareholders’ Equity
=
1 015 160
346 948 + 116 016 + 1 656 547
= 1 015 160
2 119 511
Above unity is risky
= 0.48
Times Interest Earned Ratio = Before Tax Profit + Interest Expenses
(TIER)
Interest Expenses
= 98 904 + 41 506
41 506
= 3.4
Around 10 is good, but
at least 3 to 4
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Activity
Inventory Turnover Ratio =
(ITR)
Cost of Goods Sold
Average Inventory of Finished Products
=
487 547
1 287 310
= 0.38 / quarter
= 1.5 / year
Average Collection Period =
(ACP)
Typically between 5 and 10
Average Accounts Receivable
Average Daily Credit Sales
= 558 232 (91)
720 953
= 70.5 days
Industrial average ~ 60 days
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Activity
Fixed Asset Turnover Ratio =
Net Sales
(FTR)
Average Net Fixed Assets
=
720 953
2 517 057
= 0.29 / quarter
= 1.2 / year
Total Asset Turnover Ratio =
(ATR)
Typically between 5 and 6
Net Sales
Average Total Assets
=
720 953
4 582 339
= 0.16 / quarter
= 0.64 / year
Industrial average ~ 2
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Profit
Operating Cost Ratio =
(OR)
Total Operating Expenses (excl. interest on debt and income taxes)
Net Sales
= 629 308 - 41 506
720 953
= 0.82
Profit Margin = 1 - OR
(PM)
= 1 - 0.82
= 0.18
Typically between 0.85 and 0.95
Complement of OR
Net Profit Ratio = Net Profit
( P/S)
Net Sales
=
46 122
720 953
= 6.4%
Typically around 2%
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Profit
Return on Total Assets =
(RTA)
Net Profit
Average Total Assets
= 46 122 (4)
4 582 339
= 4.0 %
Return on Equity =
(ROE)
Typically around 5%
Net Profit (less preferred dividends)
Average Common Shareholders’ Equity
= 39 530 (4)
1 772 563
= 8.9%
Typically around 9%
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Professor R. Jassim
2.3
Engineering Economy
ANALYSIS OF FINANCIAL STATEMENTS
Example 2.6
Summary
WC
CR
QR
1 018 368
2.10
0.68
OK
OK
LOW, not enough liquid assets
DR
D/E
TIER
0.54
0.48
3.4
A little HIGH, too many liabilities
OK
LOW, not enough flexibility
ITR
ACP
FTR
ATR
1.5
70.5
1.2
0.6
LOW, inventory too high
A little HIGH, lax collection policy
LOW, fixed-asset intensive business
LOW, asset intensive business
OR
P/S
RTA
ROE
0.82
6.4%
4.0%
8.9%
OK, better than average, good profit margin
OK, much better than average, efficient business
OK, slightly lower than average (low FTR and ATR)
OK, keeping shareholders satisfied
40 of 57
Professor R. Jassim
2.4
Engineering Economy
BASIC PRINCIPLES OF DEPRECIATION
Depreciation
•
•
Depreciation is the process of allocating over time the cost of long-term assets
(i.e. capital expenditures). The period of time over which an asset is
depreciated typically corresponds to its useful life or period of use.
Depreciation is recorded as an expense on the income statement and thus,
reduces the net income reported in any given accounting period. The value of
the long-term assets on the balance sheet is reduced by an equivalent amount.
The remaining value of these assets (i.e. net fixed assets) is referred to as their
book value.
Types of Depreciation
•
•
Depreciation charges recorded in the income statement
Depreciation used for tax purposes
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Professor R. Jassim
2.4
Engineering Economy
BASIC PRINCIPLES OF DEPRECIATION
Depreciation charges recorded in the income statement
•
•
Accounting practice provides for the recovery of capital expenditures, thereby
reflecting the true costs of production over time
Method chosen by company accountants and approved by the shareholders
Depreciation used for tax purposes
•
•
•
The income before provision for income taxes shown in financial statements is
seldom the actual tax base used to determine tax liability
As in the case of accounting practice, the government allows the recovery of
capital expenditures over time, i.e. only a fraction of an asset`s value can be
declared as an expense in any given year
Method prescribed by income tax act
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Professor R. Jassim
2.4
Engineering Economy
BASIC PRINCIPLES OF DEPRECIATION
Accounting Practice versus Tax Purposes
•
•
An asset cannot be depreciated for more than its net cost, i.e. [IC - SV].
The depreciation method establishes the depreciation charges over the period of
use.
Accounting practice: the total amount to be depreciated over the period of use of the
asset, i.e. TDC, is set to: IC – SV (This represents the net cost of the asset)
• This yields a terminal book value (book value at end of period of use) equal to
the salvage value.
• Should the actual salvage value differ from the one anticipated at the time of
purchase, an adjustment is made to the books at the time of disposal.
Tax purposes: the amount to be depreciated over the period of use of the asset is
set to: IC (i.e. the full cost of the asset)
• This is meant to produce a terminal tax book value of zero
At the time of disposal:
•
If TDC exceeds (IC-SV), the excess is TAXED by the government
•
If (IC-SV) exceeds TDC, the excess is written off as a loss
•
No adjustment is necessary when the two amounts are equal
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Professor R. Jassim
2.4
Engineering Economy
BASIC PRINCIPLES OF DEPRECIATION
Effect of Depreciation on Net Income
Revenue
1000
1000
- Operating
Expenses
400
400
- Depreciation
•
•
•
•
+ 100
100
Taxable Income
600
500
- Tax @ 40%
240
-40
200
NET INCOME
360
- 60
300
Deduction increased by 100
Decrease taxable income by 100
Tax saving of 40
Decrease net income by 60
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Professor R. Jassim
2.4
Engineering Economy
BASIC PRINCIPLES OF DEPRECIATION
Consideration
•
•
•
•
Initial Cost = IC
Estimated Salvage Value = SV
Period of Use = n years
Rate of Usage = constant or variable
Terminology
•
•
•
•
Depreciation charge in year j = DCj
Accumulated depreciation charges up to year j = ADCj
Book Value (end-of-year j) = IC-ADCj = BVj
Total depreciation charges claimed over period of use = TDC
Amount to be Depreciated
•
•
Accounting Practice: IC-ADCj
Tax Purposes: IC
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Professor R. Jassim
2.4
Engineering Economy
BASIC PRINCIPLES OF DEPRECIATION
Example 2.7
•
•
•
Initial Cost of Asset = $ 80 000
Estimated Salvage Value = $ 10 000
Period of Use = 5 years
Year
DC
ADC
BV
1
10 000
10 000
70 000
2
15 000
25 000
55 000
3
10 000
35 000
45 000
4
20 000
55 000
25 000
5
15 000
70 000
10 000
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Straight-Line Depreciation (SLD)
•
•
Depreciation charge is constant
Specify depreciation rate ( r) per year or depreciation period (n)
• R = 1/n
• When r is specified, n is not necessarily a whole value
e.g. 30% per year
Depreciation rate of 30% in years 1,2,3 and 10% in year 4
Example 2.8
•
IC = $ 1000
SV = $ 200
n = 8 years
Year
DC
ADC
BV
1
100
100
900
2
100
200
800
3
100
300
700
4
100
400
600
5
100
500
500
6
100
600
400
7
100
700
300
8
100
800
200
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Example 2.8
Figure 2.3
Straight Line Depreciation
48 of 57
Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Declining-Balance Depreciation (DBD)
•
•
•
•
•
Depreciation charge is a proportion of the asset`s current value,
Government established depreciation rate ( r) per year
Annual depreciation charge is determined by multiplying book value by
depreciation rate
As the depreciation rate fixes the terminal book value, this value may not
correspond to the estimated salvage value.
DBD is an anomaly, NOT for accounting purpose, see below for illustration, this is common
error, only tax purpose. However asset market price of assets at disposal is another issue,
will be dealt with in Ch 7
Example 2.9
•
Year
DC
ADC
BV
IC = $ 5500
SV = $ 500
n = 5 years
Dep rate =
30%
1
1 650
1650
3850
2
1155
2805
2695
3
808.5
3613.5
1886.5
4
565.95
4179.45
1320.55
Accounting:
Taxation:
5
820.55
5000
500
5
396.165
4575.615
924.385
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Professor R. Jassim
2.5
DEPRECIATION METHODS
Solving for r
•
Engineering Economy
IC = $ 5500
SV = $ 500 n
= 5 years
Trend of DBD
5500 (1 - r)5 = 500
(1 - r)5 = 500 / 5500 = 0.0909
r = 0.381 or 38.1%
This is only for algebraic illustration –
illegal for Government
Figure 2.4
Declining Balance Depreciation
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Sum-of-the-Years`-Digits Depreciation (SYDD)
•
•
•
Depreciation charge decreases over time
Specify depreciation period
Depreciation rate changes every year
rj =
n − j +1
n
j
1
•
The full net cost of the asset (IC-SV) is depreciated
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Example 2.10
• IC = $ 5500
• SV = $ 500
• n = 5 years
Sum = 1 + 2 + 3 + 4 + 5 = 15
r1 = 5 / 15 DC1 = 5/15 (5000) = 1666.67 BV1 = 3833.33
r2 = 4 / 15 DC2 = 4/15 (5000) = 1333.33 BV2 = 2500
r3 = 3 / 15 DC3 = 3/15 (5000) = 1000
BV3 = 1500
r4 = 2 / 15 DC4 = 2/15 (5000) = 666.67 BV4 = 833.33
r5 = 1 / 15 DC5 = 1/15 (5000) = 333.33 BV5 = 500
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Unit of Production Depreciation (UPD)
•
•
•
Depreciation charge varies with intensity of use, i.e. they are proportional to
production
Specify use in total units produced or hours operated rather than in years
Depreciation rate is given per unit produced or hour operated
r=
•
IC-SV
Total units produced or hours operated
The full net cost of the asset (IC-SV) is depreciated
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Example 2.11
•
•
•
IC = $ 5500
SV = $ 500
n = 5 years
Production
Yr 1 – 3000
Yr 2 – 2000
Yr 3 – 2000
Yr 4 – 1500
Yr 5 – 1500
Total production: 10 000
Net cost: 5500 - 500 = 5000
r = 5000 / 10 000 = 0.50 / unit
DC1 = 3000 (0.50) = 1500
BV1 = 4000
DC2 = 2000 (0.50) = 1000
BV2 = 3000
DC3 = 2000 (0.50) = 1000
BV3 = 2000
DC4 = 1500 (0.50) = 750
BV4 = 1250
DC5 = 1500 (0.50) = 750
BV5 = 500
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Example 2.12
Comparison of depreciation methods
IC: 200 000
Terminal book value: 25 000
n: 10 years
Straight-line rate: 1 / 10 = 0.1 or 10%
Declining-balance rate: 1 − 10 25 / 200 = 0.1877 or 18.77%
This is only for algebraic illustration – illegal for Government
Sum-of-the-years’-digits rates:
S j, j = 1,10 = 55
r1 = 10 / 55
r2 = 9 / 55
r3 = 8 / 55
…
r10 = 1 / 55
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Example 2.12
DEPRECIATION CHARGE ('000 $)
40
Declining-balance
30
Sum-of-the-years'-digits
Straight-line
20
SLD – constant
SYDD – linear decrease
10
0
1
2
3
4
5
6
7
8
9
10
YEAR
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Professor R. Jassim
2.5
Engineering Economy
DEPRECIATION METHODS
Example 2.12
200
BOOK VALUE ('000 $)
Straight-line
150
Sum-of-the-years'-digits
100
SLD – linear decrease
Declining-balance
50
0
At
1
purchase
2
3
4
5
6
7
8
9
10
YEAR
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