Engineering Management Accounting Lecture 3

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Engineering ManagementAccounting Lecture 3
ELE 2EMT
George Alexander G.Alexander_at_latrobe.edu.au http/
/www.latrobe.edu.au/eemanage/
10 August, 2007
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Last week

• Financial Accounting
• Balance Sheet (Financial Position)
• Profit and Loss Statement (Financial Performance)
• Brief look at assets/depreciation

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This week

• A closer look at why we classify certain
  expenditure as capital expenditure - assets
• The importance of accurately valuing assets
• The role of depreciation and how it works
• Types of Depreciation
• Depreciation Terminology
• Straight Line Depreciation
• Declining Balance Depreciation

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Definition of Assets (Bazley)

• Assets Future economic benefits controlled by
  the entity as a result of past transactions or
  other past events
• Fixed assets held for the purpose of
  generating income over a number of years.
• Current assets cash or cash-equivalent,
  expected to be realised within 12 months of the
  reporting date.

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Types of Assets

• Fixed Assets
• Buildings
• Plant
• Equipment
• Current Assets
• Stock (inventory)
• Cash on hand
• Accounts receivable
• Short-term investments
• Intangible assets e.g. patents, goodwill

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Liabilities

• What the firm owes as a result of past
  borrowings or expenditure
• Current
• Short-term borrowings e.g. overdraft
• Accounts payable
• Taxes
• Non-current
• Long term borrowings
• Other future commitments

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Owners Equity Assets Liabilities
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Valuing non-fixed assets

• Often, these are recorded as cash amounts, so the
  value is quite clear.
• Current assets such as stock can prove a problem
  if it is subject to deterioration or
  obsolescence.
• Some areas such as intangibles, and provisions
  for future liabilities, can be difficult to
  estimate and are usually closely audited.

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Why capitalise/depreciate?

• Capital assets have an estimated useful lifetime.
• Consequently, it would be misleading to account
  for the associated expenditure in just one
  accounting period.
• As a result, the expenditure is accounted for
  over the assets lifetime through depreciation.
• This also provides a basis for valuing the asset.
• ATO requires that the asset expense deduction is
  claimed over the assets lifetime.

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Depreciation - an introduction

• Capital investment in tangible assets -
  equipment, computers, vehicles, buildings, and
  machinery - are commonly recovered through
  depreciation.
• Depreciation also referred to as capital recovery
  (US) and capital allowance (ATO)
• Refer ATO Guide to Depreciating Assets 2006-07
• http//www.ato.gov.au/individuals/content.asp?doc
  /Content/00096847.htm
• The depreciation amount itself is not an actual
  cash flow, but may provide cash flow benefits.

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Introduction - cont.

• The process of depreciating an asset accounts for
  the decrease in an assets value because of age,
  wear, and obsolescence.
• Depreciation is a tax-allowed deduction included
  in tax calculations.
• Taxes (income - deductions)(tax rate)

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Types of Depreciation

• Depreciation
• Depreciation is the reduction in value of an
  asset.
• It does not represent an actual cash flow.
• It does not necessarily reflect the actual usage
  pattern.
• Book Depreciation
• Used by a corporation or business for the purpose
  of internal financial accounting.
• Tax Depreciation
• Used by a corporation or business for the purpose
  of tax calculations as per government regulations.

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Book Depreciation

• Used for internal managerial decision making.
• Management is free to use any method they so
  choose to compute book depreciation amounts.
• Any method can be used
• Straight Line,
• Declining Balance
• Sum-of-the-years digits
• Other.
• Defines the reduced investment in an asset based
  upon usage pattern and an assumed life.

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Tax Depreciation

• Must follow the current federal law pertaining to
  acceptable methods for computing depreciation for
  income tax purposes.
• It may have nothing to do with the actual life
  of the asset or the usage pattern.

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Depreciation Terminology - cont.

• Salvage Value
• The estimated trade-in or market value at the end
  of the assets useful life.
• Market Value
• The estimated amount realisable if the asset was
  sold on the open market.
• The market value and book value may be
  substantially different.
• Book Value
• The remaining, undepreciated capital investment
  on the books after subtracting all depreciation
  to date.

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Book Value v Time - General Case
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Depreciation Terminology - cont.

• Recovery Period
• Recovery period is the depreciable life n of
  the asset in years.
• Depreciation Rate
• Depreciation rate or recovery rate is the
  fraction of the first cost removed by
  depreciation each year.
• First Cost - unadjusted basis
• The purchase price of a new asset including
  delivered and installed cost and any other
  depreciable cost.

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Depreciation Terminology - cont.

• First Cost - adjusted basis
• The term adjusted basis is used when the asset is
  not new and some depreciation has been charged.
• Real Property
• It includes real estate and all improvements -
  office building, manufacturing structure, test
  facilities, warehouse, apartments and other
  structures.
• Land itself is considered real property but it is
  not depreciable.

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Different Depreciation Methods
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Straight Line Depreciation

• The book value decreases linearly with time.
• The depreciation rate, d 1/n, is the same each
  year of recovery period n.
• It is considered the standard against which any
  depreciation model is compared.
• The annual SL depreciation is determined by
• (first cost - salvage value) d

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Example
B 50,000 n 5 years S 10,000 at t
5 Dt for each year is (50,000 - 10,000)/5
8,000/year
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Solution
using
d 1 / n Dt (B -S) d (B - S) / n
Book value BVt B tDt
Notation (to be followed herein) t the year (t
1,2, , n) Dt Annual depreciation charge, B
The first cost or unadjusted basis, S Estimated
Salvage Value at t n, n The Recovery
Period, d The Depreciation Rate 1/n
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Table of Results
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Plot of SL Book Value
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Accelerated Depreciation

• SL book values decline in a linear fashion down
  to a specified salvage value.
• Declining Balance (DB) method allows the book
  value to accelerate faster.
• Per ATO web site, rate 150/n for zero residual
  value. (200/n for acquisitions after 10/5/2006)
• The SL method writes off the asset in equal
  amounts over the recovery period.
• The DB method permits greater depreciation
  amounts in the early years, and hence reduces the
  book value faster than the SL method.

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Accelerated Depreciation - cont.

• More depreciation in the early years means more
  tax savings sooner.
• Assumes a profitable firm.
• Tax savings early in the life of an asset has a
  greater present value than tax savings out in
  time.
• Larger depreciation amounts early on result in
  increased present worth of future tax savings to
  the firm.

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What it means for the firm ?

• If the firm is profitable, then more depreciation
  amounts in the early years means
• Lower tax liability
• Pay less taxes more available for
  reinvestment!
• The firm can retain more after-tax funds if the
  depreciation is accelerated in the early years of
  an assets life.
• Thus, more depreciation early on are better!

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Previous example SL vs DB
Test using ATO calculator at http//calculators.
ato.gov.au/scripts/axos/axos.asp?CONTEXT KBSDep
reciating_assets.XR4gook
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Refer ATO web site

• Refer description/examples on link below
• http//www.ato.gov.au/individuals/content.asp?doc
• /Content/00096847.htm
• Note ATO terminology
• DB Diminishing Value
• SL Prime Cost Method

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References

• Bazley, Hancock, Berry, Jarvis Contemporary
  Accounting, Thomson
• Australian Taxation Office website
• www.ato.gov.au

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Thanks for your attention