You are employed in a management role by HappyDaze Limited. The company is considering offering bonuses to employees in the form of shares in the company. The employees recently attended a seminar on the understanding of financial statements. The feedback provided by the employees was very negative and almost all of the attendees stated they did not understand the subject matter.
The document should provide answers to the following questions. An appropriate heading should be provided for each question. Advice is given below.
1. Why do accountants depreciate some non-current assets?
2. What is the difference between the reducing balance and the straight line methods of depreciation? State examples, with explanations, of when the reducing balance or straight line methods should be used.
3. What is a statement of financial position?
4. What is capital?
5. Why are assets always equal to capital and liabilities?
6. Why does the date of the statement of financial position begin with ‘as at’ whereas the date of the income statement begins with ‘year ended’?
1. Depreciation of Non-current Asset
Non-current assets refer to the fixed assets, intangible assets and the long term investment of the company. Depreciation is calculated for the non-current asset which is used for more than one year. Generally the non-current assets are capitalized by the business and consequently its value starts declining (Weygandt, Kieso and Kimmel, 2003). For example, a machine has a useful life of ten years and in the beginning year the value of the asset will be same as the cost of acquiring the machine. Net year onwards the value of the asset will decline as it will be capitalized over the useful life. Not consideration of depreciation of the non-current asset may lead to overestimation of asset and it can inflate the financial position of the company. Hence, the accountants consider depreciation of the non-current asset (Harrison and Horngren, 2001).
2. Difference between Reducing Balance and Straight Line Method
Reducing balance and straight line methods are the two approaches for calculating depreciation on the non-current asset. Reducing balance method estimates depreciation at a greater rate in the earlier period. The amount of the depreciation will decline as the life of the asset progresses (Elliott and Elliott, 2008).
Depreciation per annum = (Net Book Value – Residual Value) * Rate of Depreciation
On the other hand, in straight line method, depreciation is calculated by following formula:
Depreciation per year = (Cost of Acquisition – Residual Value at the end of life) / Useful Life
It means that in straight line method, the amount of depreciation remains same every year (Adah, 2014). In contrast, in case of the reducing balance method, depreciation rate remains the same but the amount of depreciation changes as it calculated on the residual value of the asset each year.
3. Statement of Financial Position
Statement of financial position provides the relevant information regarding asset, liability and equity of the business on a particular date. It is also referred as balance sheet and significantly contributes in analyzing the current financial position of the business (Pratt, 2000). Elements which are owned by the company for deriving economic benefits are listed under the asset category. Liability includes the short term as well as log term obligation of the business which is owed to someone and can be settled through monetary transactions. Equity includes the share capital and retained earning held by the business (Libby, Libby and Short, 2004).
In simple terms, capital refers to accumulated wealth of the business firm. Basically, capital includes all the financial resources available to the business which can be utilized for conducting business activities. Capital indicates that amount invested by the business owner. There are two major type of capital in business: fixed capital and working capital. Fixed capital is utilized for acquiring long term assets and meeting the long term obligations. On the other hand, working capital is used for undertaking the day to day activities of the business (Needles and Powers, 2004).
5. Assets are Equal to Capital and Liabilities
From the basic accounting equation it can be found that assets are equal to the capital and liabilities of the business. Capital refers to the total wealth of the organization. Liabilities indicate the obligations which need to be satisfied by the business firm. Assets refer to the entities which are capitalized for deriving economic advantages. Hence it can be stated that capital and liabilities are the sources of fund or the total resources that are utilized for acquiring assets and retained for future business activities. Hence, assets are equal to capita and liabilities (Pratt, 2000).
6. Statement of Financial Position Start with ‘as at’ and the Date of Income Statement with ‘year ended’
It has been observed that financial position starts with ‘as at’ and the date of income statement starts with ‘year ended’. The financial position of the business changes over the time on the basis of asset, liability and equity. Hence, the statement of the financial position illustrates the financial position on that particular date. On the other hand, income statement is associated with providing relevant information regarding the revenue, profit and expenditure of the business firm. This information is specific for that particular year and will not be changed. Hence, the income statement starts with the ‘year ended’ in order to depict the net income of the business (Weygandt, Kieso and Kimmel, 2003).
Adah, A. (2014). Straight Line Method of Depreciation and Financial Information Quality of Nigerian Service Companies. IJFAS, 2(2), pp.1-7.
Elliott, B. and Elliott, J. (2008). Financial accounting and reporting. Harlow: Financial Times Prentice Hall.
Harrison, W. and Horngren, C. (2001). Financial accounting. Upper Saddle River, NJ: Prentice Hall.
Libby, R., Libby, P. and Short, D. (2004). Financial accounting. Boston: McGraw-Hill/Irwin.
Needles, B. and Powers, M. (2004). Financial accounting. Boston: Houghton Mifflin.
Pratt, J. (2000). Financial accounting in an economic context. Cincinnati, Ohio: South-Western College Pub.
Weygandt, J., Kieso, D. and Kimmel, P. (2003). Financial accounting. New York, NY: Wiley.