Financial Accounting

We will cover the following topics in this chapter:

1. Trial Balance

2. Financial Statements

3. Depreciation and its roles

Trial Balance

Trial balance is a summary of all the debit and credit balances of ledger accounts. The total of debit side and credit side of trial balance should be matched. Trial balance is prepared on the last day of the accounting cycle.

Trial balance provides us a comprehensive list of balances. With the help of that, we can draw financial reports of an organization. For example, the trading account can be analyzed to ascertain the gross profit, the profit and loss account is analyzed to ascertain the profit or Loss of that particular accounting year, and finally, the balance sheet of the concern is prepared to conclude the financial position of the firm

Format:

Financial Statements

Financial statements are prepared to ascertain the profit or loss of the business, and to know the financial position of the company.

Trading, profit & Loss accounts ascertain the net profit for an accounting period and balance sheet reflects the position of the business.

All the above has almost a fixed format, just put all the balances of ledger accounts into the format given below with the help of the trial balance. With that, we may derive desired results in the shape of financial equations.

Owner’s Equity

The equation of equity is as follows:
Owner Equity = Assets – liability
The owner or the sole proprietor of a business makes investments, earns some profit on it, and withdraws some money out of it for his personal use called drawings. We may write this transaction as follows:
Investment (capital) +- Profit or Loss – drawings = Owner’s Equity

Current Asset

Assets that are convertible into cash within the next accounting year are called current assets.
Cash in hand, cash in bank, fixed deposit receipts (FDRs), inventory, debtors, receivable bills, short-term investments, staff loan and advances; all these come under current assets. In addition, prepaid expenses are also a part of current assets.
Note: Prepaid expenses are not convertible into cash, but they save cash for the next financial or accounting year.

Current Liabilities

Like current assets, current liabilities are immediate liabilities of the firm that are to be paid within one year from the date of balance sheet.
Current liabilities primarily include sundry creditors, expenses payable, bills payable, short-term loans, advance from customers, etc.

Depreciation

Depreciation reduces the value of assets on a residual basis. It also reduces the profits of the current year.

Depreciation indicates reduction in value of any fixed assets. Reduction in value of assets depends on the life of assets. Life of assets depends upon the usage of assets.

There are many deciding factors that ascertain the life of assets. For example, in case of a building, the deciding factor is time. In case of leased assets, the deciding factor is the lease period. For plant and machinery, the deciding factor should be production as well as time. There can be many factors, but the life of assets should be ascertained on some reasonable basis.

Why Do We Need to Account for Depreciation?

Here is why we need to provide depreciation:

a)  To ascertain the true profit during a year, it is desirable to charge depreciation.

b)  To ascertain the true value of assets, depreciation should be charged. Without calculating the correct value of assets, we cannot ascertain the true financial position of a company.

c)  Instead of withdrawal of overstated profit, it is desirable to make provisions to buy new assets to replace old asset. The accumulated value of depreciation provides additional working capital.

d)  Depreciation helps in ascertaining uniform profit in each accounting year.

e)  Depreciation allows to take the advantage of tax benefit.
 

Accounting Entries Related to Assets and Depreciation
Let us see the accounting entries related to assets and depreciation:

Method of Depreciation

Depreciation can be calculated using any of the following methods,

• Straight Line Method
• Written Down Value Method
•  Annuity Method
• Insurance Policy Method
• Machine Hour Rate Method
• Depletion Method
• Revaluation Method
• Depreciation Fund Method

 However the most popular methods is  Straight Line Method

Straight-Line Method

Under the straight-line method, equal depreciation expense is charged in each period of the asset’s useful life. Straight-line method is appropriate for assets which are expected to be equally productive in all periods of its useful life.

Depreciation expense under the straight-line method is calculated by dividing the depreciable amount by the total useful life of the asset. Depreciable amount equals historical cost minus salvage value.

Example  Whole-Year Depreciation in Year of Purchase

On 1 Jan 2001, Company A purchased a vehicle costing $20,000. The company expects the vehicle to be operational for 4 years at the end of which it can be sold for $5,000. Calculate depreciation expense for the year ended 31 Dec 2001, 2002, 2003 and 2004.

Solution:

Depreciable amount of the vehicle is $15,000 ($20,000 cost minus $5,000 salvage value). Useful life is 4 years.

Depreciation expense for year ended 31 Dec 2001 = $15,000 ÷ 4 = $3,750 per year.

Depreciation expense shall remain the same over the useful life. Hence, an amount of $3,750 shall be the depreciation expense for year ended 31 Dec 2002, 2003 and 2004.