So, in this article, I (Nick Craggs) want to give a recap of some key aspects of both sides of accounting.
The first subject, and one of my favourites (if you can have a favourite accounting concept) is depreciation. Depreciation is a provision for a fall in value of your assets. Over time generally, most assets you buy will be worth less than what you paid for them due to things like wear and tear, or your asset becomes outdated by newer models. We want to show in our accounts the cost to the business of these assets falling in value. What we don’t want is to keep the asset in the accounts at what we paid for it many years ago and then when we sell it, we find that it has fallen in value and that huge drop in value appears in the accounts of the year that it is sold, when in fact it has been falling in value over many years. This is where depreciation comes in. This is our estimate as to how much we think these assets have fallen by each year. We are unlikely to know exactly how much the asset has fallen by each year. After all, we only know what someone is willing to pay for an asset when it is sold. We will enter a provision for what we think it has depreciated by each year and then if there is an over or under provision as to what it has actually fallen by when we do come to sell it we will deal with it later.
So how do we depreciate an asset in the accounts? Well, that depends on the asset. There are a number of ways you can depreciate an asset. The simplest is to depreciate it by the same amount each year, this is known as straight line depreciation. Back when I was in practice, we would depreciate computer equipment over 3 years and assume that after 3 years it was worthless. If you purchased a computer for £900, you would depreciate it by £300 each year. After 3 years you will have depreciated it by £900 in total and the asset is now not worth anything in the accounts.
You may decide that your asset is going to fall more in value in the first few years, and then as time goes on it will fall in value by less and less. This is reducing balance depreciation. A good example of where this is a sensible depreciation method to use is with cars. As anyone who has purchased a brand new car knows, it falls in value as soon as you drive it off the forecourt. Whereas when I was driving around in a 10 year old Rover 75 (I still miss that car) what is another year going to make to what it is worth when it is that old anyway? Reducing balance works by taking a percentage of what the asset is worth at the start of the year, and taking this off the value of the asset that year. For example, so you have a car that is worth £10,000 and you are going to depreciate it at 25% reducing balance in year one. The car will fall in value by £2,500 so it is now worth £7,500; this is known as the net book value. When we come to the second year we are going to depreciate it by 25% again, but this is going to be based on the value at the start of this year of £7,500. Therefore, in the second year, the depreciation is going to be £1,875. Over time, the depreciation charge each year gets less and less.
These two depreciation methods are the most common, but there are others. Going back to my farming roots, the value of a tractor isn’t really based on how old it is, but how much it has been used. So, you may want to depreciate your tractor based on how many hours it has been used.
Net Present Value
Another concept that deals with time is calculating the Net Present Value of a project. As we all know inflation can drastically change what something is worth now vs what it will be worth in the future. For example, £100 worth of shopping doesn’t get you as much as it did this time last year! In Management Accounting we may use a net present value calculation to estimate what we will get from a project valued in today’s money. To do so we will discount the future cashflows more and more the further it is in the future using what is known as discount factors. This takes into account the fall in value of the money received but can also take into account risk, as having to wait 3 years is more risky than getting the money today for a number of reasons.
Discount factors are usually given to you in your AAT exam, but you can calculate them, and they are freely available on the internet. You may decide to discount a project by 12% over 3 years. The discount factors at 12% are 0.893, 0.797 and 0.712 for years 1, 2 and 3 respectively. If the 3 year project returns £50,000 each year the discounted net present value of that project will be £120,050 (£50,000 x 0.893 + £50,000 x 0.797 + £50,000 x 0.712). In effect, you would be equally happy if someone gave you £120,050 now, or £50,000 each year for three years at a discount rate of 12%.
Moving back to Financial Accounting, another unfortunate fact of life is that some people will owe you money and they won’t pay you. Under the concept of prudence, we may need to put in a provision for the amount of money we think we won’t get paid to give a more realistic figure that we will get paid in the future. We will put in a provision for bad debts. A bad debt provision can be split into two categories; a specific provision and a general provision. A specific bad debt provision is where you have an idea of who it is who isn’t going to pay you and how much they are not going to pay you. Whereas a general provision is where history has taught you some of your customers who owe you money will not pay you, but you don’t know who.
If you have a specific bad debt, you know who it is and how much it is, it could be someone who you know is struggling financially, or they have owed you this money for a long time. You don’t want to write the debt off, after all there is a chance they might still pay you. You don’t want them to know you think they might not pay you, as then they definitely won’t pay you! To enter a specific bad debt, we debit the bad debt expense account and then credit the bad debt provision account. The bad debt provision account offsets the debit of the trade receivables account to come to what you think you will actually receive. However, you still have the full amount owing in the trade receivables account, as you still want to chase it up even if you think you won’t get the money. Once you have dealt with all the specific bad debts you can deal with the general bad debt provision, and it is important you do it in that order.
Let’s pretend that over the last few years of the amount of money that you have been owed, 3% of that amount goes bad. All things being equal you would expect that going forward 3% of what you are currently owed will go bad. You don’t know who, but again being prudent, you need to reflect this in your accounts. Obviously, the more you are owed the more debts will ‘go bad’. Let’s take an example where you are owed £20,000. Historically you know 3% will go bad, so you need to enter a provision of £600 as this is the amount of the £20,000 that you think you will not receive. It probably isn’t the exact amount but it is a reasonable assumption. We will debit the bad debt expense account and credit the bad debt provision account, which will then offset the trade receivables to show a more likely amount that you will receive.
Sounds relatively straight forward right? However, it gets a little bit more complicated the following year. Again, we will need to work out the amount of our trade receivables that we won’t receive. However, we already have a provision in place. Such is life, the amount that people owe us goes up and down, therefore the amount of the provision for bad debts needs to go up and down. Following on from our previous example in the following year we are owed £16,000 now in total. Nothing has changed in our credit control procedure so we still think that 3% of our debts will go bad. Our general bad debt provision now needs to be £480 (£16,000 x 3%). However, we already have a provision of £600. We don’t need to enter a new provision, but we will adjust the existing provision to what we now want it to be. In this case, we will reduce it by £120, down from £600 to £480. We debit the bad debt provision account by £120 to reduce it, and then credit the bad debt expense account with £120. If we had found that we needed to increase our bad debt we would debit out bad debt expense account and credit the bad debt provision to further increase the provision.
Finally, let’s switch back to Management Accounting one last time. I think I have made it clear as to which side of the Management Accounting vs Financial Accounting divide I lie on, however, I have to say cost behaviour is my guilty pleasure from Management Accounting. Basically, this looks at if and how costs go up and down as production levels go up and down. The easiest cost is a fixed cost, which is a cost that stays at the same amount no matter how many units of production you make. An example of this would be your rent for your factory. Your landlord isn’t going to reduce your rent if you produce fewer items than you did last year, nor would you accept your landlord putting your rent up because you sold more units than you did last year for the same factory. Your rent is going to stay at the same amount no matter how many units you sell, provided you don’t get a second factory.
The next cost behaviour I would like to talk about is variable costs. These are costs that go up directly in line with production. These are typically costs that go directly into the products that you sell. Say you are a production manager for a factory that sells wooden tables and imagine your CEO shouting at you because the amount of money you have spent on wood has doubled since last year. It would be perfectly fair that the cost has doubled if the number of tables you have made during the year has doubled as well because you can’t make tables without wood! If you make tables that take 2 metres of wood (I have never made a table, can you tell?) and each metre costs £10 you would expect each table to cost you £20 in wood. If you make 100 tables you would expect the total wood cost to be £2,000, and if you made 200 tables you would expect the total wood cost to be £4,000.
A mixture of the two above cost types is a semi variable (or mixed) cost. This a cost which has one element which stays at the same level no matter what level of production you are at and then another element that goes up directly in line with production. A very good example of this is a phone bill. You have a line rental that you will have to pay even if you don’t make a single call during the year. Then there is the call cost element which as the busier you get, the more calls you make and therefore your total call costs increase. Looking at another example if your line rental is £1000 for the year, and per unit you sell you will incur call costs of 50p per unit. If you sell 500 units your phone costs will be £1,250, which is the £1000 line rental and 500 units at 50p in call charges. Then if the following year the sales double to 1,000 units, your line rental is still going to be £1,000 but now your variable cost will now be 1,000 units at 50p, giving a variable cost of £500 and a total cost of £1,500. Whilst the production has doubled the cost has increased but it hasn’t doubled.
Check your understanding
1, If you have a piece of machinery that you purchase for £30,000 and you are going to depreciate it by 30% reducing balance, what will be the net book value of this machinery after 3 years?
2, What will be the net present value of a project which has the following cashflows, which will be discounted at 10%, using the below discount factors?
|Year 1||Year 2||Year 3|
3, You have a trade receivables figure of £25,000, there is a specific bad debt of £2,000 provision to be entered and then you want a general bad debt allowance of 3%. Will you increase or decrease the general bad debt provision and by how much if you have an existing bad debt provision of £750?
4, Finally, you are calculating the cost of car hire for a tax firm. The cars have a fixed lease fee of £5,000 each and 10p per mile for every mile travelled. What will be the total cost of two cars, one which drives 40,000 miles in the year and the other 45,000 miles?