ACCT accrual and depreciation

Recognition of Revenue and Expenses

• You add revenue as part of financial statement when it is realized

• Revenue is recognized when revenue is earned

Matching principle

• Expenses recognized in the same period as the revenues they helped generate

Conditions for recognition

• Transfer of risk and reward

• Seller does not have control over transferred good  - when you buy a product, seller no longer owns it

• Invoice is reasonable assurance for cash collection/revenue

• Revenue amount can be measured reliably

• Probable that revenue will be received

• Ownership and control must pass onto buyer

• When revenue is earned it is recognized - Accrual

Advance Payments

• Advance payment should be recognized as a current liability and not a revenue

• Known as differed revenue

• Cash accounting states that revenue should be recognized only when the cash is collected and not when the goods are sold.

• Revenue is first item on income statement

Long term contracts

• We compromise on faithful representation and

• Should offset expenses from each period with some revenue

• If wait until end, final period would have a jump in revenue - because revenue earned in earlier period would be considered in last period

Services

• If cash comes before a service - it is a liability and becomes revenue once the cash has been earned (income increase as liabilities decrease once cash has been earned)

• If cash comes after a service

Accrual basis of accounting

• Opposite is cash accounting

• Recognize revenue when cash is received = cash accounting

Recognition of Expenses

•  expenses should be aligned with revenues they relate to and be recognized in the same period in which the revenue is recognized earned

• when expenses are recognized = when expenses are incurred

Accrued benefit = used up the benefit but not yet payed for it

Accrued expense = we owe but not yet payed

Example = electricity - used the electricity but not yet payed for it

Depreciation

• Non current assets apart from land are used up

• Become no longer useful overtime (depreciation)

• Depreciation is the attempt to measure the value lost of the asset overtime

• Intangible assets is amortization

4 factors to calculate depreciation

The fair value of the asset (value)

• All costs required to bring the asset to its required location and to make it ready for use and improving altering the asset - transportation etc..

The useful life of asset

• Physical wear and tear (can be extended through maintenance)

• Economic - benefits of the asset to the owner

• Useful life - depends on the economic benefit of the owner

Estimated residual life of asset

• The end of the useful life there is still residual value of the asset

Depreciation method - straight line

Cost - residual value (depreciable amount)/ useful life = depreciation

Measuring expenses

• Assets leave business through expense

Depreciation expenses

• Retained depreciation = depreciation of assets total over number of years

• Managers need to choose the best depreciation method which best matches the depreciation expense to the income generated by the asset being generated

• Unit of use depreciation - depreciation increases when the asset is utilized more

• Easier to compare and match when keeping same depreciation method

• Straight line method good for fixed assets/PPE - buildings, vehicles, machinery etc.

• Be prudent when analyzing carrying amount - if carrying amount is higher than market value, you need to estimate down

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Accumulated depreciation (contra asset)

• Accumulated depreciation is not an expense it is a negative asset - find out why

Depreciation issues

• Need to check for drop in value

• Depreciation reduces profit in the business - reduces expense

Inventory expense

• Inventory assets leave business through COGS

• Deferred expense (its an asset until sold)

• Service firms have no inventory

• Retail firms  - goods available to sell

• Manufacturing firms - raw materials, work in progress, finished goods

• Cost of inventory =

• FIFO - earliest inventories held are the first to be used/sold

• LIFO - latest inventories are first to be used (not allowed in NZ/AUS)

• Specific identification -

• Weighted average - average cost of inventories

• Perpetual inventory system - measures inventory and COGS continuously through each sale and transaction

• Periodic inventory system - not updated continuously but updated at end of accounting period through a stock take

Net realizable value = estimated selling price - cost to complete sales

• Prudence requires inventory to be valued at lower of cost and NRV

Bad and doubtful expense

• Bad debts expense (cannot be collected)

• Doubtful debts is a liability (unlikely to be collected)

• Revenue is recognized when goods are passed to customer (accrual basis)

• Bad debts must be written off - reduced accounts receivable and increased expenses (doubtful debts)

Income Statement

• Statement of financial performance summarizes the transactions for the period affecting income and expenses

• End of period, the profit or loss is transferred to retained profits

• The wealth generated by the business over a period of time (normally 1 year)

• Notes

• Highlights Comparative information

• Income and expenses are key elements

• Profit (or loss) is the difference between the two

• Links with Balance sheet

Income

• Increases in economic benefit

• Increases in OE is an increase in income

• An inflow of assets or a reduction in liabilities

• Income = revenue and other gains/ losses

• Revenue = earned from ordinary operating activities

• Gains = inflows from non operating activities. - gain in fair value of PPE or the sale of PPE

Expense

• Decrease in economic benefit

• Reduction in asset/ increase in liability leading to decrease in equity (other than owners

• equity relation  - withdrawals/dividends)

• Firms reduce compensation in order for more profit (less expense)

Format

• Brackets used to show a deduction

Opening inventory + purchase - closing inventory = COS/COGS