Chapter 11 - Constructing Accounts

Question 1

Define depreciation.

Answer 1

The measure of the wearing out, consumption or other reduction in the useful economic life of a non-current (fixed) asset, whether arising from:
- the passage of time, or
- obsolescence through technological or market changes.
Depreciation adjustments are not attempts to reflect the market value of non-current assets in the statement of financial position.

Question 2

Describe the straight-line basis of depreciation.

Answer 2

This method charges equal amounts every year as follows:
(Cost - Estimated residual value) / Estimated useful life

Question 3

Describe the reducing-balance method of depreciation.

Answer 3

This method charges a fixed % of ‘book value’ (i.e. cost less depreciation to date) each year so that the whole cost is charged over the life of the asset.
The depreciation cost is calculated as follows:
1 - n^ root(estimated residual value / cost) where n is the estimated useful life in years.

Question 4

List the three sources of equity capital.

Answer 4

1. Sale of shares to shareholders.
2. Adjustments, such as the revaluation of non-current assets.
3. Retention of profit after tax.

Question 5

Describe the revaluation reserve.

Answer 5

A non-current asset such as a property would typically be held in the accounts as its ‘book value’ of cost less accumulated depreciation. If the realisable value is considerably higher or lower than the book value, the book value can be adjusted to make it more realistic.
Any up-valuation would be added to the revaluation reserve in the equity capital section of the company accounts and reported as a profit in the ‘other comprehensive income’ section. If revaluation losses are crystalised, they will reduce any existing revaluation gains in respect of that asset where these exist, but will be treated as a loss in the P&L if no revaluation gains exist.
Once revalued, the depreciation rate on the asset will be applied to the higher (or lower) value from then on. The company may simultaneously reassess the useful life of the asset.

Question 6

Explain the purpose of the retained earnings reserve.

Answer 6

Normally the aggregate amount of profits earned during the lifetime of the company, less amounts paid out of profits for tax and dividends.
Company law limits dividends by restricting the maximum payout to the retained earnings reserve in order to protect the interests of creditors.

Question 7

Describe a trial balance and its use in the preparation of a company’s statement of profit or loss and statement of financial position.

Answer 7

The trial balance records a company’s transactions during the year.
The trial balance is used to prepare the statement of profit or loss and statement of financial position.
Every figure in the trial balance is used once in the preparation of either the statement of profit or loss or the statement of financial position.
Notes to the trial balance may also be provided. This information may need to be used (twice) in the preparation of either the statement of profit or loss or the statement of financial position if it is relevant and has not yet been incorporated in the trial balance entries.

Question 8

Describe how depreciation information provided in a trial balance is used in the construction of a company’s financial statements.

Answer 8

The depreciation figure for each non-current asset in the main trial balance may be:
- the accumulated depreciation as at the year start
- the accumulated depreciation as at the year end.
Exam tip - it may not always be clear whether the depreciation figure is as calculated at year start or year end. If there is:
- information to enable you to calculate the last year’s depreciation, then it is likely the figure in the trial balance is at the year start
- no information to enable you to calculate the last year’s depreciation, then it is likely the figure in the trial balance is at the year end. A figure in the trial balance names ‘cost of sales’ or ‘cost of goods sold’ is then expected to include the last year’s depreciation. There should be no further depreciation adjustments for you to make.