MEASUREMENT OF INCOME – VALUATION OF ASSETS AND ALLOCATION OF COSTS

1. MEASUREMENT OF INCOME –VALUATION OF ASSETS AND ALLOCATION OF COSTS By h. O ondigo School of busIness, UNIVERSITY Of nairobi 2012

2. Why value assets? • To reflect their realistic value • The value of certain assets (For example, accounts receivable, inventory) is a function of some future events and or development • To comply with the constraint of prudence

3. Why estimate the value of some assets? • For accounts receivable, estimates must be made of uncollectible amounts. • For inventory, decline in market value from cost may imply that the historical cost is not recoverable

4. Why allocate the cost of assets? • To comply with the “matching” principle

5. Why allocate the cost of assets?... • Certain assets( Property, plant and equipment) have an operating life cycle of more than one accounting period. • The cost of such assets have to be allocated to the periods that will benefit from such assets

6. Why allocate the cost of assets?.. Property, plant and equipment – Statement of Financial Position) category/term used to record many non-current assets with useful lives exceeding one accounting period.

7. Property, plant and equipment cont… • The capital expenditures for these assets are matched against the revenues that the assets help to produce through the provision of depreciation.

8. Depreciation Defined • It is a systematic and rational allocation of the cost of a plant asset over its estimated useful life. • Common Methods of depreciation include: • Straight–line method • Reducing balance method • Sum of years’ digit method • Unit of output method • Valuation method

9. Depreciation Models (2) Straight Line (SL) • It writes off capital investment linearly over n years. • The estimated salvage value is always considered. • This is the classical, non-accelerated depreciation model. Declining Balance (DB) (also known as fixed percentage or uniform percentage method) • The model accelerates depreciation compared to straight line. • The book value is reduced each year by a fixed percentage. • The most used rate is twice the SL rate; called double declining balance (DDB). • It has an implied salvage that may be lower than the estimated salvage.

10. Straight Line -Example • If an asset has a first cost of $50,000 with a $10,000 estimated salvage value after 5 years, • Calculate the annual depreciation. Solution

11. Double Declining Balance (DDB) • A fiber optics testing device is to be DDB depreciated. It has a first cost of $25,000 and an estimated salvage of $2500 after 12 years. • (a) Calculate the depreciation and book value for years 1 and 4. • (b) Calculate the implied salvage value after 12 years. Solution • The DDB fixed depreciation rate is d = 2/n = 2/12 = 0.1667 per year. • Year 1: D1 = (0.1667)(25,000)(1 - 0.1667)1-1 = $4167 • BV1 = 25,000(1 - 0.1667)1 = $20,833 • Year 4: D4 = (0.1667)(25,000)(1 - 0.1667)4-1 = $2411 • BV4 = 25,000(1 - 0.1667)4 = $12,054 • Implied S = 25,000(1 - 0.1667)12 = $2803 • Since the estimated S = $2500 is less than $2803, the asset is not fully depreciated when it reaches its 12-year expected life.

12. Depreciation…. • To record depreciation charge for a period: Dr. Depreciation expense xx Accumulated depreciation xx • Accumulated depreciation is a contra asset account. • Accumulated depreciation is deducted from the cost of the relevant asset account to determine the un-depreciated account balance (net book value)

13. Statement of financial position presentation Example… Non-current assets Building at cost or valuation XX Accumulated depreciation (xx) Net book value XX

14. Accounts receivable The recoverability of debts from credit customers is a question that accountants must address since the concept of prudence requires that losses should be recognized when anticipated.

15. Accounts receivable… For accounting purposes debts may be grouped into three categories: • Good debts • Doubtful debts • Bad debts

16. Accounts receivable… Where evidence exists that the recoverability of a debt is impossible, a loss should be recognized in the income statement and the accounts receivable balance should be reduced by the amount of uncollectible debts.

17. Accounts receivable… The question of doubtful debts as distinct from bad debts is usually examined at the end of each accounting period. After bad debts are eliminated, there is a possibility that of the remaining accounts receivable some may prove to be ultimately bad. The concept of prudence requires that this possibility be provided for.

18. Accounts receivable… The practice: • to create an allowance or a provision for doubtful debts out of the current year’s profits without seeking to identify particular debts as being doubtful of recovery. • provision reviewed at the end of each accounting period and adjustments are made to adjust the account to the appropriate level.

19. To create allowance for uncollectible debts

20. Presentation…. Current assets Accounts receivable (net) 2201 Note. 1 Accounts receivable 240 Allowance for uncollectible debts (20) 220

21. To increase allowance for uncollectible debts

22. To decrease allowance for uncollectible debts

23. To write off uncollectible debts

24. To reinstate recovered uncollectible debts

25. To record collection of cash

26. Inventory • Losses may take the form of pilferage, wastage, damage, theft, obsolescence or inability to recover the carrying value of inventory.

27. Inventory adjustment for losses… The entry to account for losses in the value of inventory is as follows: Dr. Loss in value of inventory xx Inventory xx

28. END OF PART 2 • THANK YOU