MGT101 Final Term Notes 2025
Fixed Assets and Depreciation
Depreciation involves spreading the cost of a physical asset over the
period it is expected to be used. Essentially, it involves spreading out the
expense of an asset across the number of years it is expected to be used
effectively. Vu Expert Solutions Rather than recording the entire expense in the year the asset was
purchased, depreciation allows a portion of the cost to be matched with the
revenue generated each year, this allocation is shown in the profit and loss
statement.
When a company incurs an expense, it is typically recorded in the profit
and loss account of the same accounting period in which it was incurred.
However, fixed assets are long-term investments that provide value over many
years. To ensure the expense of the asset is allocated appropriately, the
expected useful life is estimated. This useful life represents the period
during which the asset is expected to contribute positively to the business.
For example, if a piece of equipment is estimated to be efficient for 10 years,
the total cost of that equipment is divided by 10 to calculate the annual
depreciation expense. This amount, known as “depreciation for the year,” is
then recorded in the profit and loss account. Simultaneously, it is deducted
from the asset’s total cost to arrive at the “written down value,” which
represents the asset’s current book value after accounting for depreciation.
Presenting Depreciation in Accounts
The method of charging depreciation in the profit and loss account depends
on how the asset is used within the organization. Let’s consider an example of
computers in a business. If these computers are used by the management team for
administrative work, the associated depreciation expense is charged under
“Administrative Expenses.” However, if computers are directly involved in the
production process such as computerized machinery in a factory the depreciation
of these computers is added to the “Cost of Goods Sold” because they are
directly linked to manufacturing. Likewise, if the computers are used by the
sales department, the depreciation expense is allocated to “Selling Expenses.”
This ensures that depreciation is accurately matched to the department that
benefits from the asset’s use.
Disposal of Fixed Assets
At some point, a fixed asset may be sold or otherwise disposed of before it
reaches the end of its useful life. When this occurs, an accounting entry must
be made to reflect the disposal. Since the final salvage value of an asset is
only an estimate, the sale price may not match the book value when the asset is
sold. To determine whether a gain or loss occurs, the book value calculated by
subtracting accumulated depreciation from the asset’s original cost is compared
to the amount received from the sale. If the sale price exceeds the book value,
the result is a profit; if it falls short, it results in a loss. Any gain or
loss from the sale must be reported in the profit and loss account.
Capital Work in Progress (CWIP)
Sometimes, an asset is not ready for use by the time the balance sheet is
prepared. In such cases, all costs incurred up to that date are transferred to
a “Capital Work in Progress Account.” This account is shown separately in the
balance sheet, below the fixed assets section. The Capital Work in Progress
Account includes all expenses related to the construction or development of an
asset until it is ready for use. When the asset is finally completed and put
into operation, these accumulated costs are transferred from the Capital Work
in Progress Account to the respective fixed asset account, ensuring the total
asset cost includes every expense made to bring the asset to a usable state.
Depreciation on Assets Under Construction
It is worth noting that depreciation does not apply to assets that are
still under construction and not yet ready for their intended use. Until the
asset is completed, all costs are tracked in the Capital Work in Progress
Account. Until the asset is ready for use, all expenses are recorded in the
Capital Work in Progress Account.
Solution
When preparing a company's
financial statements, the balance sheet is typically shown first, followed by
the profit and loss account. However, the balance sheet cannot be created
without first preparing the profit and loss account. That’s why we make the
profit and loss account first and then prepare the balance sheet.
Creditors Turnover Ratio
The creditors turnover ratio
shows how quickly or how often a company pays its suppliers. Timely collection
of payments from customers is important because without cash inflow, the
company cannot pay its creditors on time. Delayed payments harm the company’s
reputation. Like the debtor’s turnover ratio, the creditors turnover can be
expressed either in terms of the number of times payments are made in a year or
the average number of days it takes to pay creditors.
Return on Capital Employed Ratio (ROCE)
This ratio is important for
shareholders as it shows the company's profitability relative to the capital
invested. You find this ratio by dividing the profit before taxes by the
average amount of capital the company uses. Shareholders expect a return higher
than the current market rates; if the company offers a lower return, investors
might prefer to put their money elsewhere.
Earnings Per Share (EPS)
EPS tells you how much profit the
company makes on each share owned by shareholders. Shareholders are keen to
know this figure because it reflects their potential earnings. A smaller EPS
value generally means a better return for the shareholder. The EPS is
calculated by dividing the net profit after tax (before any appropriations) by
the total number of shares.
Debt to Equity Ratio
This ratio shows how much money
the company borrowed versus how much it invested itself to buy its assets.
Different projects have different acceptable ratios. In Pakistan, the
recommended ratio is 60:40, meaning 40% of assets should be financed by the
company's own capital and 60% by loans. If the debt ratio exceeds this, it
suggests the company may face difficulties paying its liabilities because its
assets might not cover its debts. To find this ratio, you divide the company’s
long-term loans by its own funds (equity).
Conclusion
In summary, depreciation is an essential tool in accounting for the wear
and tear of fixed assets, helping to distribute their cost over their useful
lives. The treatment of depreciation in financial statements depends on how the
asset is used within the organization, ensuring accurate financial reporting.
Additionally, proper handling of assets under construction and disposal of
assets ensures transparency and accuracy in the company’s financial records.
Through systematic depreciation, businesses can better plan for future
investments and maintain a realistic view of their asset values.
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