UNIT 2

Final accounts

2.1 Final accounts (with adjustments)

Meaning

The final account is the account prepared by the Joint Stock Company at the end of the fiscal year. The purpose of creating a final account is to provide a clear picture of the financial situation of the organization to its management, owners or other users of such accounting information.

Final account preparation involves preparing a set of accounts and statements at the end of the fiscal year.

1. Trading and profit and loss accounts
2. Balance sheet
3. Profit and loss appropriation account
4. Purpose of Final Account preparation

The final account is prepared for the following purposes:

• To determine the profit and loss incurred by the company within a certain financial period
• To determine the financial status of the company
• To serve as a source of information to inform users of accounting information (owners, creditors, investors and other stakeholders) about the solvency of the company.  

Trading account

The results of the purchase and sale of goods are known as the trading account. This sheet is provided to show the difference between the sales price and the cost price. It is prepared to show the trading results of the business i.e.  The total profit or total loss maintained by the business. It records the direct costs of the business company.

According to J. R. Batliboi,

The trading account shows the results of buying and selling goods. When we prepare this account, the general establishment costs are not taken into account and only the transaction of goods is included."

Profit and loss accounts

This account is prepared to check the net profit/loss and fiscal year expenses of the business during the fiscal year. It records the indirect expenses of the business company like rent, salary, and advertising expenses. Profit and loss a/C includes expenses and losses and gains and losses incurred in business other than the production of goods and services.

Balance sheet

The balance statement shows the financial status of the business at a specific date. The financial status of a business is discovered by aggregating its assets and liabilities on a specific date. The excess of assets over liabilities represents the capital sunk into the business and reflects the financial health of the enterprise.

Now it is known as a statement of the financial status of the company.

1. Trading account

Trade and manufacturing operating companies deal with the sale and purchase of goods. Therefore, only the manufacturing and trading entities prepare the trading account. Service providers do not prepare for this.

Advantages of preparing a trading account format

• It is a very important statement from the point of view of the cost of goods. By preparing a trading account, an entity may take a decision to continue or discontinue a particular product, which helps to obtain maximum profit or reduce losses.
• With the help of a trading account, the sales tax authority can, in accordance with the sales tax declaration filed by the business, it also helps the excise duty authorities to assess the excise duty of a business enterprise.
• The management, having in mind the market competition, determines the price of the product with the help of a trading account.                                              

  Items in trading account format

The trading account contains the following details:

1. Details of raw materials, semi-finished goods and finished products, opening stock.
2. Close inventory details of raw materials, semi-finished products, and finished products.
3. Total purchase of goods less purchase return.
4. Total sales of goods less sales return.
5. All direct costs associated with the purchase or sale or manufacture of goods.    

Item of income (Cr.Side)

• Less sales return than total sales of goods
• Close the stock of the product.
• Expenditure item (Doctor) side

Item of expenditure (Dr.Side)

• Opening stock
• Total purchase of goods less purchase return
• All the direct cost like carriage interior & freight cost, rent, electricity and power cost, wages for godown or factory, packing cost, etc. for workers and supervisors.

Notes

1. The trial count will not be displayed on the close. But, firstly, we need to show the amount of closing shares on the income side of the trading account, and secondly, on the balance sheet under current assets.
2. We value closing inventory at either lower cost or market price.
3. On the day of preparation of the trading account, we value the physically available closed shares.
4. However, the trading account can also be prepared in horizontal form, but the content remains the same.

Trading Account Format

2.     Profit and loss A/C

All companies generally prepare profit and loss accounts/statements at the end of the year to gain visibility of income, revenue, expenses, and losses incurred in a certain range of periods. It is important to prepare a profit and loss statement because this information helps organizations make the right business decisions, such as where to cut costs, from where the business can generate more profit, and which parts of the business are suffering from losses.

• Profit and loss accounts / statements
• Types of profit and loss
• Gross profit/gross loss
• Profit / loss

Trading account is prepared to check gross profit/loss while profit and loss account is created to check profit and loss/net loss.

Profit and loss accounts are made to check the annual profit or loss of a business. This account only shows overhead. All items of income and expenses, whether cash or non-cash, are considered in this account.

Only revenue or expenses related to the current period are debited or credited to the profit and loss account. The profit and loss account starts with gross profit on the credit side and, if there is a total loss, appears on the debit side. Items not displayed in the profit and loss account format

Drawing: the drawing is not the company's expense. Therefore, we debit it to capital a/c, and not to profit and loss a/c.

Income tax: for a company, income tax is an expense, but for a sole proprietor, it is his personal expense. Therefore, we debit it to the capital A/C.

Discounts: as we know, discounts are of two types–trade discounts and cash discounts. We deduct the trade discount from the amount charged and therefore do not show it in the account books. On the other hand, if the customer pays the amount on a certain date, a cash discount will be possible. We view cash discounts in account books. Therefore, we debit it to the profit and loss account.

Bad debt: it is because of the customer and the amount he does not pay it. We debit this amount to profit and loss a/c in the event that preparations have already been made for a bet that is worse than it is initially written off from it. When bad loans are recovered, it is again. Now it is not credited to the account of the party, but recovered account should be credited to the bad debt and is written on the credit side of the profit and loss account

Profit and Loss Account Format

3.     Balance Sheet

A balance sheet (also known as a financial statement) is a financial statement that shows the Assets, Liabilities and ownership interests of a business at a specific date. The main purpose of drawing up a balance sheet is to disclose the financial status of the enterprise at a certain date. The balance sheet can be prepared at any time, but it is prepared mainly at the end of the accounting period.

Most of the information about Assets, Liabilities and owner's equity items is taken from the company's adjusted trial balance. Retained earnings are the part of the owner's equity section which is provided by the retained earnings statement.
 

Section of the balance sheet

To be widely considered about the balance sheet of the division part of assets part of liabilities main capital. For each department:

Assets section

 In the balance sheet, assets with similar characteristics are grouped. The mainly adopted approach is to divide assets into current and non-current assets. Liquid assets include cash and all assets that can be converted into cash or expected to be consumed in a short period of time–usually one year. Examples of current assets include cash, cash equivalents, accounts receivable, prepayment costs or prepayment, short-term investments and inventories.

All assets that aren't listed as current assets are grouped as non-current assets. A common feature of such assets is that they continue to provide profit for a long time-usually more than one year. Examples of such assets include long-term investments, equipment, plants and machinery, land and buildings, and intangible assets.

Debt Division

A debt is an obligation to a party other than the owner of the business. They are grouped as current and long-term liabilities in the balance sheet. Current liabilities are obligations that are expected to be met within a one-year period by using current assets of the business or by providing goods or services.

Owner's equity division

The owner's interest is the obligation of the business to its owner. The term owner's equity is mainly used in the balance sheet of a business in the form of a sole proprietor and partnership. In the balance sheet of the company the term “ownership interest “is often replaced by the term “shareholder interest".

When the balance sheet is created, the liabilities section appears first, and the owner's equity section appears later.

Balance sheet format there are two formats on the balance sheet that present Assets, Liabilities and owner's ' equity–the account format and the report format.

In the account form, the balance sheet is divided into the left and right, like the t-account. Both liabilities and the owner's capital are listed on the right side of the balance sheet, while assets are listed on the left. If all the elements of the balance sheet are listed correctly, then the sum on the asset side (that is, on the left) is equal to the sum on the debt and the capital side of the owner (that is, on the right).

BUSINESS CONSULTING COMPANY

BALANCE SHEET

As at December 31, 2015

In reporting format, the balance table element is displayed vertically, the asset section is displayed at the highest, and therefore the liabilities and owner's equity sections are displayed below the asset section.

The example below shows both formats.

Types of adjustment entry for the final account

1. Closing stocks:

The value of the closing stock is checked at the end of the fiscal year, so it is displayed as an adjustment. It must be credited to the transaction a/c and displayed on the asset side of b/S.

The adjustment entry is:

Closing stock a/c ------ Dr.

To trade A / c

Trading account and balance sheet

2.     Unpaid expenses:

These are expenses incurred in the fiscal year,but no payments have been made. Any unpaid or unpaid expenses will be added to such expense a/c in P&L a/c and will be displayed as current liability in b/S.

For example, monthly rent in May 2002Rs. 1,000 remains unpaid. A calendar year is an accounting year.

Adjusting entries:

Rent account Dr. Rs.1000

To Outstanding Rent a/c Rs. 1,000

Profit and loss accounts

Balance Sheet as on 31st December 2002

3.     Prepaid Expenses

These are the costs paid, but part of the amount paid extends to the next year. It is also called “expiring expenses". The prepaid amount paid should be deducted from such expenses and displayed as current assets in the B/S.

For example, Rs premium a total of 2,400 people were paid on July 1, 2002. A calendar year is an accounting year. The annual premium is paid for 1 month, so the 6-month premium concerns half of the current year and the other half the following year.

Hence Rs. 1,200 must be treated as an upfront payment, deducted from the premium paid and displayed as an asset on b/S.

Adjusting entries:

Prepaid insurance a / c Dr Rs. 1, 200

                       To Premium A / c Rs. 1, 200

Profit and Loss Account

Balance Sheet

4.     Accrued income:

It is an income that has already been earned [i.e., the service has already been rendered], but no money has been received. For example, interest on investments accrued Rs. 1,200.

Interest in the current year is due to the end of the year. That amount can actually be received in the next year. Currently, it represents income, which has become accounts receivable or accrued. Therefore, P&L is credited to a/c,IS accounts receivable and appears as an asset in b/S.

Adjusting entries:

Accrued interest a / c Dr. Rs. 1,200

To be interested in a / c Rs. 1,200

Profit and Loss Account

Balance Sheet

5.     Income received in advance:

These are the income received during the current year, but part of the amount received is related to the following year. Such amounts must be deducted from the total amount received in P & L A / C and displayed on the debt side of B / S, which represents the amount that the business is obliged to return.

For example, business concerns have received a three-year apprenticeship premium equivalent to Rs.6, 000. Rs in this amount.2, 000 IE, 1/3 of Rs.6, 000 is for the current year and must be credited to P&L a/c as income. And balance Rs.As business is obliged to return 4, 000 represents responsibility.

 Adjusting entries:

Apprentice premium A / c Dr Rs. 4000

To Apprentice premium received in advance Rs. 4000

Profit and Loss Account

Balance Sheet

6.     Depreciation of assets:

Depreciation implies a decrease or decrease in the value of an asset due to its constant use. It may also occur due to wear and tear, the passage of time and obsolescence. It's a loss to business.

It is usually calculated at a certain percentage to the value of the asset, and so the amount obtained is shown first on the debit side of the P & L A/C, and then subtracted from the original value of the asset of B/s.

For example, a business has furniture worth Rs. At the end of the year 50, 000 it is depreciated by 5%.

Adjusting entries:

Depreciation A / c Dr Rs. 2,500

                                  To Furniture A / c to Rs. 2,500

[5% Rs 50,000 = 2,500]

Profit and Loss Account

Balance Sheet

7.     Bad debts

Debt represents money from the debtor [i.e., the uncollected portion of the credit sale]. When a debt becomes irretrievable, it becomes a bad debt and is treated as a loss. The amount of non-performing loans is debited to P&L a/c and deducted from the various debtors of B/S.

For example, a trader's ledger balance on sundry debtors shows Rs with 20,000. 1,000 are estimated to be unrecoverable.

Adjusting entries:

Bad debts a / c Dr Rs. 1,000

                          To Sundry debtor a / c to Rs. 1,000

a)     Provision for bad and doubtful debt:

Every business has a lot of trading through margin trading. This gives rise to a significant amount of book debts or debtors. But 100% of these debts are rarely recovered.

Therefore, it would be necessary to bring down the balance of the debtor to it true position. The usual practice is to calculate such a bad debt at a certain rate, based on the past experience of the debtor. It is called reserves or reserves for doubtful debts.

However, the allowance for bad loans and bad debt is calculated on good debt, that is, after deducting previously unadjusted bad loans.

For example:

At the end of the year the sundries debtors of traders stood in the Rs.21, 000. It is estimated to be Rs. 1,000 is written off as bad loans and a 5% allowance is created for bad debt.

Adjusting entries:

Bad Debts a/c Dr. Rs. 1,000

To Sundry Debtors a/c Rs. 1,000

                                To Profit and Loss a/c Dr. Rs. 2,000

To Bad Debts a/c Rs. 1,000

To Provision for Doubtful Debts 1,000

Profit and Loss Account

If there is an old provision for doubtful debts, it should be adjusted [deducted] against the new provision.

Balance Sheet

b)    Provision for discounts to debtors:

Cash discounts are allowed to debtors to prompt quick payments. After providing bad loans and bad debts, the debtor's balance represents the debt from a healthy party.

They may pay their dues on time and try to take advantage of the acceptable cash discounts themselves. Therefore, this discount should be expected and offered. It is, therefore, the usual practice in business is to offer debtors discounts at a certain percentage on good debt.

For example:

Suppose a trader has various debtors equivalent to rs.20, 000 and he estimates that a provision for a discount of 5% is desirable, after a provision of 2% for bad debts. Then about healthy debt, i ea provision of 19,000 at 2% has been made as a reserve for debtors ' discounts.

Adjusting entries:

 Profit and Loss a/c Dr. Rs.380

To Reserve for Discount on Debtors a/c Rs.380

Profit and Loss Account

8.     Provision for discounts to creditors:

The creditor represents the amount paid by the business to the supplier of goods on credit. A healthy business concern is the creditor's goodwill and the practice of settling accounts with creditors in time to get the discounts allowed by them.

In that case, the liability for various creditors can be reduced to the extent of the expected discount. Based on past practice, a certain percentage of the balance of receivables is calculated as a reserve for discounts and subtracted from the balance of receivables of B/S, and the same amount is calculated as the gain of P&L A/C.

For example:

Traders had various creditors at Rs. 10,000on31th December2002. It is desirable to *provide 3% for this amount for discounts.

Adjusting entries:

 Discounts on creditors for Reserve a /c Dr Rs. 300

 To Profit and loss a / c Rs. 300

Profit and Loss Account

Balance Sheet

9.     Interest on capital:

Often, interest at the usual rate is allowed to the owner's capital, which is adopted in the business. This is necessary in order to assess the efficiency of the business. Otherwise, the profit will include interest and will be displayed at a higher rate.

So, the interest charged is a loss to the business and a profit to the owner. Thus, it is debited to profit and loss a/c and added to the capital of the balance sheet.

Adjusting entries:

a)     Interest on Capital a/c Dr.

  To Capital a/c

b)    Profit and Loss a/c Dr.

          To Interest on Capital a/c

10. Interest in drawing:

The drawing is the money that the owner has withdrawn from the capital. It charge interest on the drawing so that it allows business interest on capital. It's a profit to the business and a loss to the owner. Thus, it is credited to profit and loss a/c and deducted from the capital on the balance sheet.

Profit and Loss Account

Balance Sheet

Adjustment of special items:

1. Products distributed as free samples:

To promote the products, free samples are supplied to experts in the field. For example, distributed a free sample of a book to a professor, a free sample of medicine to a doctor, etc.

Since it is a promotional activity, the cost of such a sample should be treated as promotional costs, for example, advertising. Free sample distribution is equivalent to a decrease in purchase or sale without a monetary return.

Thus, the adjusted entry is:

The net effect will be the reduction of purchases as promotional costs and the charge to the profit and loss account

2. Goods sold or sold on an approval basis: sometimes goods are sold on an approval basis in order to gain the trust of customers about the quality of the goods. If the customer approves it, it becomes a sale. If the customer does not approve it, the sale is not completed and therefore cannot be treated as a sale. Suppose that at the end of the fiscal year, you have a specific product with the customer that was sent on an approval basis, and you need to pass the necessary entries for reconciliation.

The adjustment entry is as follows: the treatment is as follows:

(A) As a deduction from sales at the selling price on the credit side of the trading account, and in addition to closing the shares at the cost price.

(h) As a deduction from debtors on the asset side, and as the total inventory displayed at the cost on the asset side of the balance sheet (cost+finished stock in stock with authorized customers).

3. About shipping of products by consignment sale:

Since consignment transactions are not sales transactions, they do not directly affect transactions and profit and loss accounts. Another consignment account is opened, and the goods sent to the consignment are debited to the consignment account. When an account sale is received, it is treated as a consignment sale, credited to the consignment account and debited to the consignment account.

The consignment inventory remaining at the consignment is deposited into the consignment account, and after invoicing the consignment cost, the consignment fee, etc., the consignment profit is confirmed. However, the closing stock of the deposit is displayed on the asset side of the balance sheet, and the profit and loss of the deposit is credited to the profit and loss account (if there is a loss of the deposit, it is cancelled).

The transfer input of consignment profit and loss is as follows:

4. Loss of stock due to fire:

If the stock is destroyed by fire, the losses incurred will be treated differently under the following three possible circumstances:

1. if the stock is not insured-the entire value of the stock destroyed by fire is treated as a loss, at the entry –

B.     If the stock is fully insured-when the fully insured stock is destroyed, the company has a claim to the insurance company for the recovery of losses due to the goods destroyed by fire. Therefore, the claim takes precedence in the entry –

In practice, claims against the insurance company are treated as “debtors" and are indicated on the asset side of the balance sheet as payments from the insurance company.

If the insurance company settled the dues, the entry would be

In fact, the account of the insurance company does not appear on the balance sheet, since the cash/bank balance on the balance sheet increases with the settled claims.

C.    if the shares are partially insured-in this case, the total value of the destroyed shares will be credited to the trading account, that portion of the claim settled by the insurance company will be debited to the insurance company account, and the difference between the destroyed shares and the accepted insurance claim will be debited to the profit and loss account as a loss. The entries are as follows –

5. Deferred appropriations: A huge expenditure of the nature of the revenue generated at the initial stage of a business enterprise with the belief that it derives profit from such expenditure during subsequent years is considered a deferred revenue expenditure if the charge of such expenses is spread over the number of years in which the profit is expected to be derived.

Part of such expenditure is charged as revenue for each year, and the rest is capitalized on the basis of the matching concept. For example, huge expenditures on"advertising" occur in the first year of the business and derive profits over an estimated period of ten years. Then one-tenth of that expenditure each year is charged to income over a decade period. The Important point here is that the expenditure that is not charged to the revenue is capitalized and appears as a fictitious asset on the balance sheet.

For example, suppose that the ad cost incurred Rs.2, 00,000 will be able to bring benefits over five year’s term. Then a fifth of two, 00,000, i.e., Rs.40, 000 are going to be charged on revenue for the primary year and therefore the remaining Rs.1,60,000 are shown as fictitious assets. In the second year Rs.40, 000 are charged for earnings and 1,20,000 outstanding are shown as fictitious assets. This process lasts for five years until the full expenditure is written off. Entries passed in the first year are –

6.     Creation of reserve funds: To strengthen the financial situation of the enterprise, a part of the net profit can be transferred to the reserve account by appropriation. The entries for creating a reserve fund are –

7. Committee of managers:

Business companies sometimes offer profit incentives to managers in the form of commissions to motivate people to increase business profits. This fee is given as a percentage of net profit. There are two ways to provide this percentage of net profit.

(a) The percentage of the commission against net profit before charging such fees;

(b) The percentage of fees to net income after invoicing such fees;

8. Specific hidden tweaks:

The adjustments are not given explicitly under the array of adjustments, but they need to be placed and adjusted. For example, the balance displays the subsequent items alongside other items at the top of Dec31, 2009:

                                                                                  DR                      Cr

10% loan January 1, 2009                                       -                        -                               

Interest on loan                                                  3,000                      -

(Paid during the year)

If we carefully observe loans are obtained in March 1, 2009 at a rate of interest of 10%. That is, the interest paid on a one-year loan in December31, 2009 (Rs.50, 000×10/100) rupees.5, 000. But the interest paid is only Rs.3, 000 as shown in the trial balance. This indicates that interest is not paid (Rs.5, 000-3,000-2,000. Therefore, this should be considered as an adjustment. The entry is –

Profit and Loss A/c              Dr                               2,000

TO Interest payable A/c                                        2,000

Here, the total interest charged to the profit and loss account is Rs.Will you be given 3,000 trial balances plus interest expense? 2,000, which is completely equivalent to Rs.5,000. Interest expense Rs.2,000 will appear as liabilities on the balance sheet.

Please note that there are many adjustments to different types of courses and preparations for the final. Their treatment is explained when they appear.

Worksheet

When all the necessary information for financial reporting is ready (that is, information on the trial balance and adjustment, officially aggregated without errors), the accountant prefers to draft a work sheet. The worksheet is a rough work and is not part of the financial statements.

The worksheet is provided for convenience to ensure that the financial statements prepared in the debit and credit columns representing the trial balance, adjusted, adjusted trial balance, trading account, profit and loss account and balance sheet are in order.

Key takeaways:

1. Financial accounting follows either the accrual basis of accounting or the cash basis.
2. Nonprofits, companies, and small businesses use financial accountants.
3. Financial reporting is done by using financial statements in five different areas.                                                                                                                              Accounting records are all documents involved in the preparation of financial statements of the company.
4. Certain regulatory bodies require companies to keep accounting records for several years if they need to be reviewed.
5. Accounting records can be used for audits, compliance checks, or other business-related necessities.
6. Accounting record types include transactions, general ledgers, trial balances, journals, and financial statements.

Problem 1:

From the following ledger balance presented by Sen. on 31st March, 2016 prepare a trading account:

Other information:

1. Closing value of stock for 31st March, 2016. 20,000
2. Unpaid wages reached Rs. 4,000
3. Gas and fuel were paid in advance for Rs. 1,000

Trading account for the year ended 31st March, 2016

Dr                                                                                                                             Cr

Problem 2:

From the following details presented by Thilak for the year 31st March, 2017, we will prepare a profit and loss account.

Adjustment:

1. The unpaid salary reached Rs. 4,000
2. The rent was paid for 11 months
3. Interest expense reached Rs but was not received. 2,000.
4. Prepaid insurance has reached Rs. 2,000
5. Depreciating buildings by 10%
6. Further bad debts reached Rs. over 3,000 of 5%、
7. The fee received in advance reached Rs. 2,000

Solution:

Profit and Loss Account for the year ended 31st March, 2017

Dr.                                                                                                                                       Cr.

Working notes:

Debtors: 40,000

Less: further bad loans: 2,000: 38,000

Allowance for bad and bad debt of 5%: 38,000x5 % =Rs. 1,900

Problem 3:

As of 31st December, 2017, from the balance below, prepare a profit and loss account.

Adjustment:

1. Rent accrued, but not yet received Rs. 500
2. Fire insurance premiums are prepaid in the range of Rs. 1,500
3. Offer the manager's Commission at 10% of the profit before meeting such a commission

Dr.                                                                                                                                        Cr.

Profit and Loss Account for the year ended 31st December, 2017

Dr.                                                                                                                                         Cr.

Working notes:

Manager’s Commission= Net profit before charging commission x Rate of Commission/100

Net profit = 55,500 – (18,000 + 12,000 + 8,000 + 2,500 + 5,000) = Rs. 10,000

Manager’s commission = 10,000x 10/100 = 1,000

Problem 4:

Prepare a trading and profit and loss account from the following balances obtained from Siva books:

Adjustment:

1. Closing value of the stock on 31st December, 2016 Rs 4,500
2. The manager is entitled to receive a commission@5% of the net profit after providing such a commission.

Solution

Dr. Trading and Profit and Loss Account for the year 31st December, 2016 Cr.

Working Note:

Commission= Net profit before charging commissions x Rate of commissions/(100+ Rate of commissions) x 100

Net profit = 14,000 – (3,500 + 1,000+1,200+1,800+1,700+600) = Rs 4,200

Manager’s commission = 4,200 x 5/105 = Rs 200

Problem 5:

From the following details, we have prepared Madhu's balance sheet and finished 31st March, 2018. During the final account creation, the following adjustments were made:

1. Unpaid debt: salary Rs. 10,000; pay Rupees. 20,000; interest on bank overdraft Rs. Bank loan Rs 3,000 and interest. 6,000
2. Provide interest on capital@10%p.a.
3. Bad debts reached Rs. Make provisions for bad debts of 10,000 and@10% to sundry debtors.
4. Closing stock reached Rs. 1,20,000
5. Provide depreciation on car @10%p.a.
6. Net profit for the year reached Rs. 96,000 after considering all the above adjustments.

Solution:

In the book of Madhu

Balance Sheet as on 31st March, 2018

Problem 6:

The following balance was extracted from Thomas's book as of 31st March, 2018 additional information:

1. Close the stock by Rs. 9,000
2. Provide depreciation@10% on machinery
3. Interest accrued on the investment Rs. 2,000

Prepare a trading account, a profit and loss account and a balance sheet.

Solution:

In the book of Thomas

Dr.Trading and Profit  and Loss Account for the year ended 31st March, 2018 Cr.

Balance Sheet as on 31st March, 2018

2.2Depreciation: concept, nature and methods of computing depreciation: straight line method and diminishing balance method. Change in method of depreciation.

The nature of Depreciation

Depreciation can be defined as a measure of the depletion of an asset's lifetime due to any cause during a particular time period. -Spicer and Pegler.

“Depreciation is a measure of the consumption, consumption, or other loss of value of a depreciable asset resulting from use, time wasted, or obsolescence due to changes in technology or market. During that time, you will be assigned to charge a significant portion of the depreciation amount for each accounting period. Depreciation expense includes the depreciation of assets with a predetermined useful life. "

-Accounting Standard-6 (revised), issued by ICAI.

Depreciation features:

(I) Depreciation is a decline in the value of fixed assets (excluding land). The decline in the value of an asset is inherently permanent. Once shrunk, it cannot be restored to its original value.

(Ii) Depreciation is a gradual and continuous process because the value of an asset decreases due to the use of the asset or the expiration of time.

(Iii) It is not an asset valuation process. This is the process of allocating the cost of an asset to its lifetime.

(Iv) Depreciation reduces the book value, not the market value of an asset.

(V) Depreciation is only used for property, plant and equipment. It is not used to waste intangible assets such as amortization of goodwill and depletion of natural resources.

Causes of depreciation:

1. Normal physical wear and tear:

The normal use of an asset causes it to physically deteriorate, resulting in a decrease in the value of the asset.

2. Time outflow:

Certain intangible assets, such as trademarks, patents and copyrights, have a fixed lifespan. The value of these assets diminishes over time, whether or not they are used by a company.

3. Obsolescence:

R & D brings innovation in the form of better, technologically advanced machines that dispose of older machines, even if they can be physically performed.

In that case, the market price of certain assets such as computers and automobiles may fall permanently. This reduces the value of older machines. Obsolescence is the loss that results from aging an existing asset and replacing it with a new and improved model of that asset.

4. Accident:

Accidental destruction or damage can reduce the value of an asset.

The accounting concept of Depreciation

Fixed assets are long-term assets. They help produce goods and services. However, when an asset is in use, normal wear, time spills, and obsolescence reduce the value of the asset. This reduction in the value of fixed assets is known as depreciation. Understand the concept of depreciation.

Assets owned by a company for the production and supply of goods and services, expected to be used for more than a fiscal year, and have a limited useful life are called depreciable assets.

When you purchase a fixed asset, it is recorded in your books at its original cost or purchase price. Organizations use this fixed asset to earn or generate revenue for several fiscal years before selling or discarding the asset.

Therefore, you must allocate a portion of your purchase or acquisition costs by fiscal year until you use it. This allocation of costs is called depreciation. Depreciation is an organizational expense.

For example, a Setu company buys a machine for £ 2,000,000, uses it for 10 years and then sells it for £ 400,000. Therefore, the cost of a machine for business use is £ 1600,000 (£ 2000000-400000). Now, for every 10 fiscal years you've been using this machine, you need to allocate this £ 1600,000 cost as a project cost. This cost is a depreciation cost of £ 160,000 (1600000/10).

In other words, the concept of depreciation is the cost of getting a service from the use of an asset. You need to match the depreciation cost of a fixed asset with the revenue for the year in which it was used. Therefore, depreciation is charged as an income statement expense.

Methods of computing depreciation: straight line method and diminishing balance method

Straight line method

What is the straight-line method?

The straight-line method is the default method used to evenly recognize the carrying amount of fixed assets over their useful lives. This is used when there is no particular pattern in how an asset is used over time. The straight-line method is the easiest depreciation method to calculate and is highly recommended for use as it causes few calculation errors. The procedure for flat-rate calculation is as follows.

1. Determines the initial cost of an asset recognized as a fixed asset.
2. Subtract the estimated residual value of the asset from the amount recorded in the books.
3. Determines the estimated useful life of an asset. It is easiest to use thestandard useful life for each class of asset.
4. Divide the estimated useful life (yearly) by 1 to calculate the depreciation rate using the straight-line method.
5. Multiply the depreciation rate by the cost of assets (minus salvage value).
6. Once calculated, depreciation expense is recorded in accounting records as a depreciation expense account and a credit to the accumulated depreciation account. Accumulated depreciation is against assets. That is, it is paired with the fixed asset account and the depreciation is reduced.

Formula:

Depreciation = (Asset Cost – Net Residual Value) / Service Life

Depreciation rate = (annual depreciation cost x 100) / cost of capital

Straight-line Journal Entries:

1. Purchase of Assets A / c Dr. xx

To cash / bank / creditor A / cxx

(Purchasing assets)

2. Depreciation of assets A / c Dr.xx

To asset A /cxx

(Assets are subject to depreciation)

3. Transfer depreciation gains / losses A / c Dr. xx

To depreciation of asset A / cxx

(Asset depreciation is transferred to the profit and loss account)

Example 1

Pensive Corporation will purchase a Procrastinator Deluxe machine for $ 60,000. It has an estimated salvage value of $ 10,000 and a useful life of 5 years. Pensive calculates the machine's annual flat-rate depreciation as follows:

Solution

$ 60,000 Purchase Cost – $ 10,000 Estimated Residual Value = $ 50,000 Depreciable Asset Cost

1/5-year useful life = 20% annual depreciation rate

20% depreciation rate x $ 50,000 depreciation asset cost = $ 10,000 annual depreciation

Diminishing Balance Method

The various depreciation methods are based on mathematical formulas. This formula is derived from a study of asset behaviour over a period of time. One such depreciation method is the depreciation method. Learn more about this method.

According to the depreciation method, depreciation is charged at a fixed percentage of the book value of the asset. It is also known as depreciation or depreciation because its book value decreases each year.

Since the book value decreases every year, the depreciation amount also decreases every year. This way, the value of the asset never goes to zero.

If you plot the depreciation amount billed this way and the corresponding period on the graph, the line will move down.

This method was previously based on the assumption that the cost of repairing an asset is low and therefore more depreciation costs must be charged. In addition, depreciation costs will decrease as repair costs increase in later years. Therefore, this method puts an equal burden on profits each year for the life of the asset.

However, this method may not provide full depreciation at the end of the asset's useful life if the applicable depreciation rate is not appropriate.

In addition, when applying this method, it is necessary to consider the period of use of the asset. If the asset is used for only two months in a year, depreciation will only be charged for two months.

However, if the asset is used for more than 180 days for income tax purposes, you will be charged full-year depreciation. Income tax rules also allow you to depreciate using the depreciation method.

The formula is:

Amount of depreciation=Book Value x Rate of Depreciation

100

Change in method of depreciation

Accounting policies and principles need to be applied consistently when recording financial transactions. This is the principle of consistency.

At the end of each fiscal year, management should consider depreciation methods. If there are significant changes in the pattern of future economic returns from the asset, the depreciation method will also need to change.

Accounting Standard 1-According to the disclosure of accounting policies, changes in depreciation methods are changes in accounting estimates. Therefore, footnote quantification and full disclosure are required. You also need to disclose the legitimacy of the change and its economic impact.

Therefore, the depreciation method can be changed without or with a retroactive effect. The lack of retroactive impact means that no adjustments have been made to past entries and only future depreciation will be billed in the new way. While having a retroactive effect, it means that the depreciation amount charged will be adjusted from the date of purchase of the asset.

Key takeaways

1. According to accounting matching principles, depreciation links the value of employing a tangible asset with the profits gained over its useful life.
2. There are differing types of depreciation, including the straight-line method of depreciation and various sorts of accelerated depreciation.
3. Accumulated depreciation is that the sum of all depreciation recorded on an asset up to a specific date.
4. The value of an asset on the record is that the acquisition cost minus all accumulated depreciation.
5. The carrying amount of an asset in any case depreciation has been made is named its salvage value.
6. The straight-line method of depreciation may be a method of calculating depreciation and is that the process of paying an asset for a extended period of your time than when it had been purchased.
7. Straight-line bases are popular because they're easy to calculate and understand, but they even have some drawbacks.

References

1. Gupta R.L. and Radhaswamy. M, Sultan chand & Sons, New Delhi.
2. Shukla M. C. Grewal T. S and Gupta S.C., S. Chand & Sons. New Delhi.
3. Shukla S. M., Sahitya Bhawan Publication, Agra.
4. Murti Guru Prasad, Himalaya Publishing House, Mumbai.
5. Jain and Narang, Kalyani Publisher, New Delhi.
6. S. N. Maheswari, Vikas Publishing House, New Delhi.
7. Sharma and Gupta, RBD Publishing House, Jaipur.
8. Khatik S. K., Jitendra Saxena K, Extol Publication, Bhopal.
9. Gangwar Sharda, Himalaya Publishing House, Agra.