Depreciation Methods

Depreciation, contrary to popular belief, does not measure the decline of an asset's market value nor its physical deterioration. Rather, it is the allocation of the asset's cost to its expense throughout its useful life. There are three primary methods employed by companies to calculate and produce a schedule of depreciation. These are commonly known as the Single-Line Method, Units-of-Production Method, and Double-declining-balance. Each will be described in more detail below.


Single-Line Method
The single-line method recognizes the same amount of expense to each period of the asset's useful life. The first step in this method is to calculate the cost to be depreciated, found by subtracting the salvage value from the total cost of the asset (NOTE: total cost includes ALL expenses incurred throughout the process of getting the asset ready to be put into use). Next, this cost to be depreciated is divided by the number of accounting periods in the asset's useful life.

For example, if we have purchase a tractor for $5,000 and used for the entirety of its predicted 10 year useful life when it is realized that a salvage value of $200 exists, the depreciation will be calculated as follows:

(5,000-200)/10 = $480/year


Units-of-Production Method
The Units-of-Production Method charges a different amount for each period of the useful life depending on how many units are produced - the asset's usage. There are also two steps to this process as well. The first is to find the depreciation per unit - how much the asset is to be depreciated with each unit of production - which is calculated by dividing the cost to be depreciated (described above) by the expected total units of production at the end of the asset's useful life. Next, this depreciation per unit is to be multiplied by the units produced in the specific period of needed calculation.

Example: (Consider the situation about the tractor above) This tractor is expected to mow 10,000 fields in it's useful life. In its third year, it mows 800 fields. The depreciation for the third year is computed as follows:

(5,000-200) / 10,000 = $0.48 per field
0.48 x 800 = $384 (depreciation in year 3)



Double-declining-balance Method
The double-declining-balance uses a depreciation rate that is double the straight line rate and applies it to the beginning-of-period book value of an asset. The three steps of this method are as follows:

1. Calculate Straight-line rate  (100% / useful life periods)
2. Calculate Double-declining-rate (SL rate x 2)
3. Multiply Double-declining-rate by the beginning period book value

To employ this method, it is advisable to produce a double-declining-balance schedule which charts the beginning-of-period book value, depreciation rate, depreciation expense, accumulated depreciation, and book value for each respective period of the asset's useful life. The depreciation expense of each period is subtracted from the beginning-of-period book value to find the beginning-of-period book value of the next period.



It is important to note that all of these methods will produce the same amount of total depreciation at the end of the asset's useful life will be the same. This is ensured by only depreciating as much as needed in the final period of depreciation.







With that, there are now 21 days until Christmas.

Reporting Cash Flows

At this point in my Accounting 201 class, we are preparing for the end of the semester...which means finals. Since this is an introductory level course, we are only covering certain topics that will be covered in later classes, including Finance and higher level accounting classes. Therefore, our final topics will be cash flow statements and how to analyze other financial statements.

For the subject of this blog post, I will discuss the importance and how to go about producing a report of cash flows. The statement of cash flows reports cash receipts and payments involved in operating, investing, and financing activities. These statements are especially important to a business that is monitoring and analyzing change throughout a business period or deciding whether or not to make a decision.  It will help answer the following questions:

What explains the change in the cash balance?
Where does a company spend its cash?                                 
Why do income and cash flows differ?
How much is paid in dividends?
How does a company receive/disperse its cash?
Is there a cash shortage/surplus?
(Questions derived from "Financial and Managerial Accounting: Information for Decisions" by John J. Wild)

The statement of cash flows, as mentioned, are broken into three categories, if you will: Operating, Investing, and Financing.

Operating Activities
Operating activities include transactions that ultimately determine net income. Examples include the production/purchase of inventory, sale of goods and services, and other operating expenditures. When producing this section, the accountant must also consider depreciation expense, loss/gain, current assets, and current liabilities. The majority of these factors can be found in the balance sheet and income statement. The prepared operating statement will be produced as follows:

Net Income (+) or (-)
Depreciation Expense (+)
Loss (+) or Gain (-)
Current Assets Increase (-) or Decrease (+)
Current Liabilities Increase (+) or Decrease (-)
Cash flows from operations..............................net of the above


Investing Activities
Investing activities include transactions that affect long-term assets. Specifically, these activities will be the purchase and sale of short-term investments as well as the lending and collecting of money for notes receivable. In the report, one will generally find the purchase and sale of equipment. This section will be prepared as follows:

Purchase of equipment (-)
Sale of equipment (+)
Cash flows from investing..................net of the above


Financing Activities
The financing activities include transactions that affect long-term liabilities and equity. When a company obtains cash from issuing debt and repays borrowed amounts or receives cash from or disperses cash amongst owners. This section will be prepared as followed:

Issuance of Stocks (+)
Cash Paid to Settle Notes Payable (-)
Cash Paid to Retire Bonds Payable (-)
Dividends Paid (-)
Cash flows from financing..................net of the above


As you can see, the preparation of a statement of cash flows is vital to the success of a business.






There are now only 28 days till Christmas!!!

Stocks

Stocks are often thrown around as an easy, sure fire way for anyone to make some easy money. At least, that's what I previously thought about them. In short, a stock grants an individual or group a certain amount of ownership in a corporation. Those who partake in such ownership are known as stockholders. These individuals invest cash or other assets in a corporation in exchange for common stock. The stockholder actually does have significant influence on the success of the corporation in that they elect a board of directors who directly vote on the actions the business will take. A stockholder is also known as an investor because when a corporation issues capital stock, they are seeking to obtain capital as an exchange. Therefore, investors are literally investing assets into the good of the company. 

For the sake of this blog post, I won't get too complicated, but stock can be issued in a number of ways depending on the market at that time and the value of certain stock. Stock can be issued based on its par value (an amount assigned per share by the corporation) at par, below par (discount), or above par (premium). The journal entry for such issuances involve the debit of cash or other asset along with the credit of common stock and that of an account known as "Paid-In Capital of Excess of Par Value, Common Stock" OR "Discount on Common Stock". Each of these credited accounts is dependent on the difference between the issuance price and par value. In accordance to the natural laws of accounting, the credits will always equal the credits in the exchange of stock.

Cash                              x                Cash                                                x+y             Cash                                      x+y

       Common Stock            x                Common Stock                                 x              Common Stock                        x

                                                              Paid-In Capital of Excess of             y             Discount on Common Stock      y

                                                                  Par Value, Common Stock 

Stock can also be issued with a No-Par Value, meaning that the share is not assigned a stated value. Any amount that the corporation receives is legal capital and recorded as common stock. All proceeds from the issuance is credited to a "No-Par Stock" account.

Cash                                                       x 

       Common Stock, No-Par Value             x

Lastly, no-par value stock can be issued at a stated value. When received, the proceeds become legal capital and are credited to a stated value stock account. Usually, the stated value stock is issued at an amount in excess of the stated value.

Cash                                                                                                      x+y

        Common Stock                                                                                    x

        Paid-In Capital in Excess of Stated Value, Common Stock                y

Stock is issued at par 88% of the time, at no-par 9%, and with a stated value 3% of the time. It is also important to know that a corporation can receive other assets rather than cash in exchange for stock, but it can also assume liabilities on such assets. 

That's my brief explanation of the recording of issued stocks. On that note, there are only 3 days till Christmas.

3-3A Worksheet

The following is the worksheet for Problem 3-3A.

"The name's Bond..."

Another important factor in a business' financial well-being is the issuing of bonds. Investors purchase bonds with cash after they are issued by a corporation. Essentially, a bond creates a long-term debt for a company as they borrow money. Those who purchase the bonds are considered lenders and/or bondholders.

As with most transactions, the issuing and paying off of bonds requires accurate accounting of interest that accrues throughout the bond's life until maturity. Interest is typically paid every six months (semiannually). Thus, if a corporation issues a bond to be paid at maturity in three years, it will make a total of six interest payments. Upon the maturity date of the bond, the issuer will pay the investor its final interest payment as well as the bond's principal amount.

A bondholder's claim to these interest payments is NOT a form of equity; the investor is not granted any form of the corporations ownership. Thus, the corporation that issues the bond does not make any entry to the equity accounts. Rather, upon issuing the bond, it will debit the amount of cash received and debit 'Bonds Payable'. This establishes a liability that will be paid at the bond's maturity date. When interest payments take place, the journal entry will be recorded as such with 'Bond Interest Expense' and 'Bond Interest Payable'.

Bonds can be issued with a Premium or Discount. A Premium is issued when the investor is willing to pay more than the principal amount proposed by the corporation. A discount, therefore, is issued when the investor purchases the bond at a price lower than par value. Both Discounts and Premiums are amortized accordingly at each semiannual interest payment and at the date of maturity.

Straight-Line Amortization and Effective Interest are two useful methods that effectively compute the reduction of a premium or discount throughout the life of the bond.

There is so much more to discuss regarding bonds and why they are so vital to the success of a business. As an aspiring entrepreneur, I have taken significant interest (no pun intended) in the importance of bonds. Lenders and investors are especially important to the success and survival of a start up industry. I have no interest in becoming an accountant, but I have definitely learned a lot of vital information regarding the financial endeavors and management for a business.

As of November 13, we have a new president and 42 days till Christmas.

Working on the worksheet

A few weeks ago, my professor assigned us a scenario from our workbook and instructed us to complete a worksheet with it. In the worksheet, we are to provide all of the account titles, an unadjusted trial balance, adjustments, an adjusted trial balance, the income statement, and a balance sheet. At the beginning of this semester, I would have looked at this assignment and notified my parents of my immediate withdrawal from the university. However, I took this project on with great confidence for a few reasons:

1. Accounting is easy.
          Yeah. I said it. The stereotype of this career being easy is absolutely true. Literally, all it's about is remembering a few little tips and tricks about manipulation of transactions, grabbing a calculator (or abacus if you prefer), and crunching away at some numbers until you can produce a valid number of statements regarding the business for which you account. In fact, all you really need to do is play around with Microsoft Excel until you've produced a professional looking report with some numbers and lines, and maybe even colors.
           I completed this assignment, due at the end of the semester, in a matter of roughly 30 minutes. I spent more time making style adjustments than I did actually computing and organizing data. What's magic about Excel is that it does the work for you.

2. Accounting is fun...relatively speaking.
          Who doesn't love playing with numbers. As lame as it sounds, accounting is just a matter of making sure everything matches up (or at least makes sense). This is really cool, especially in that this concept is vital in the coherency and accuracy of a worksheet. For example the debits and credits on the unadjusted and adjusted trial balances had to equal; the difference between total debits and credits on the income statement gives you the net income or loss; and the difference between debits and credits on the balance sheet also gives you net income or loss. [The contrast between balance sheet and income statement net income or loss is that the balance sheet is a reflection of that business' current financial standing as an aggregative report of previous periods' retained earnings and other permanent accounts (see previous posts) while the income statement is more often referred to as the observed result from a period's revenues and expenses.]
           So yes, accounts are just professional number crunchers, but I think that's totally cool. Numbers don't make sense to everyone, so if you can get the rules and regulations of accounting down, you can easily earn your CPA and PEOPLE WILL GIVE YOU MONEY to, if relative, have fun playing with numbers!

3. I have confidence in what I have learned about accounting thus far.
          I have recently been able to say with complete honesty that I have learned more from this class and my economics class than I did in my four years of high school combined. I'm not just saying this as a typical teen who said "screw high school"; I have legitimately learned so much and feel like the world of business is the place for me and my career. In fact, I have become so eager and excited to take on my own business, that I have neglected to focus on my other, far less important classes such as biology and French culture (in both of which I have an A...no worries) and have immersed myself as fully as I can in everything business.
           That being said, this passion that I have developed has made learning very easy. I wouldn't say it's very fun reading my accounting textbook, but I always feel so satisfied when I can put what I've learned into practice and build upon it over time. And because everything builds on everything else, I am pretty much always confident in what I am doing.

So, I'm not telling my group that I've already done the project because I don't want them just taking the answers. But I'll be a good sport and help them out.




The next time I write, we will have a new president. If you read this before November 8, let's vote to make America great again, for the sake of the business world if nothing else.


FYI....49 days till Christmas.

Economists vs Accountants (profit)

I am an economics student at the University of Louisville. Why? Because I love business. Well, actually, because I disliked the idea of becoming an engineer. See, I originally went to UL as a mechanical engineer major, but about 2 months before classes started, I gave my future a little thought and decided that these hands weren't made to be an engineer. Rather, I have been given the mind to pursue business and entrepreneurial endeavors.  That being said, understand that although I have a bias towards the practice of economics, the following is not a persuasive argument about which practice is better. Instead, I am just going to give you a few examples of how they are slightly (very) different in their ways of analyzing business.

Profit is calculated in a way that yield very different results, usually with accounting recognizing an overstatement of profit due to an understatement of expense. Expenses can be broken down into two primary categories: EXPLICIT and IMPLICIT. Explicit costs are the more obvious, cash/asset-related expenditures that the company partakes in order presumably to increase revenue. Implicit costs, however, is generally known as OPPORTUNITY COST, what you give up in order to produce x number of units. If you have looked into either accounting or economics at least a little, it should be clear based on these definitions which practice analyzes which costs. Well, accounting only uses explicit, monetary, costs in their computation of profit. Economics uses both explicit and implicit. Profit in general is computed by subtracting expenses from your total revenue. The processes for both practices are as follows:

Economics      Profit = Total Revenue - Explicit Costs - Implicit Costs
Accounting     Profit = Total Revenue - Explicit Costs

This difference will, more often than not, produce recorded profits that are strikingly different. For example, assume Company A had a good year of sales and made $200,000 in total revenue. Throughout the year, they purchased $150,000 worth of equipment (an explicit cost), but had observed an opportunity cost of $60,000 (an implicit cost). Well, the accounting profit would be $50,000 and the economic profit would be -$10,000. As you can see, these numbers are totally different, as the economic profit was actually negative, meaning the company lost money.

Here's another example, assume Company A had total revenue of $200,000 and that they noted $170,000 worth of explicit costs and $30,000 of implicit costs. The accounting profit would be $30,000 while the economic profit would be $0. Typically, a profit of $0 seems bad, but this is actually considered a success in the business world and is known as NORMAL PROFIT, meaning you didn't lose anything. Good job, Company A.

Many other differences exist, but when it comes down to it, comparing accountants and economists is like comparing apples to oranges; they both provide a way to examine and manipulate business strategies based on statistics and trends over a certain financial period. Both are important (utterly vital) to the life of a company and must be utilized efficiently in order to guarantee survival in the world of business.

To close, I'd like to note that Christmas is only 54 days away as of November 1.