Engineering ManagementEngineering ManagementAccounting – Lecture 8Accounting – Lecture 8

Revision(1)Revision(1)

ELE 22EMTELE 22EMT

George AlexanderG.Alexander@latrobe.edu.auhttp://www.latrobe.edu.au/eemanage/

15 October, 2004

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Accounting for Engineers - becauseAccounting for Engineers - because

• Engineers invariably operate in a managed business environment.

• Accounting provides a means of measuring the viability and performance of organisations.

• Accounting is closely linked to Engineering Economics in that it provides many of the analytical tools and data required for analysis.

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So what is accounting?So what is accounting?

• “The process of identifying, measuring and communicating economic information to permit informed judgement and decisions by users of the information.”

Bazley et al

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Financial AccountingFinancial Accounting

“That part of an accounting system that tries to meet the needs of various external users”.

Bazley et al

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Management AccountingManagement Accounting

“That part of an accounting system that tries to meet the needs of management and internal users”.

Bazley et al

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TopicsTopics

• Financial Accounting– Profit and Loss Statement– Balance Sheet – Cash Flows

• Capital assets/depreciation• Management Accounting

– Budget Process– Organisation Structure– Product Cost Calculation

• Business Ratios

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TransformationProcess

InputsOutputs

Resources:HumanMaterialsEquipmentFinancialInformation

managerial:PlanningOrganisationLeadingControllingTechnology

Outcomes:Products & servicesProfit & lossemployees growth & satisfaction

Bartol – Management: A Pacific Rim Focus, McGraw-Hill, 2001

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The Firm –a simple modelThe Firm –a simple model

The Firm

Owners

Lenders

Client

Suppliers

Government

Reserves

Capital

Profit

Dividends

Revenue

Goods/Services Goods/Services

Expenditure

Tax

Infrastructure

Loans

Interest

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Balance SheetBalance Sheet(Statement of Financial Position)(Statement of Financial Position)

• Records the financial position of the organisation at a given point in time.

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Telstra Balance SheetTelstra Balance Sheet

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Profit and Loss StatementProfit and Loss Statement(Statement of Financial Performance)(Statement of Financial Performance)

Reports receipts and expenditure over the period in question – the accounting period.

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Telstra Profit and Loss StatementTelstra Profit and Loss Statement

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Cash Flow StatementCash Flow Statement

Is an indicator of the organisation’s ability to survive in the short term

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Telstra Cash Flow StatementTelstra Cash Flow Statement

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Money Flows - INMoney Flows - IN

• Equity capital (Owners)

• Debt capital (Lenders)

• Revenue from sales (Customers)

• Interest on reserves (Financial Institutions)

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Money Flows - OUTMoney Flows - OUT

• Dividends (Owners)

• Repayments/Interest (Lenders)

• Purchases of assets (Suppliers)

• General expenditure (Suppliers/employees)

• Taxes/charges (Government)

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Definition of Assets Definition of Assets (Bazley)(Bazley)

• Assets – “Future economic benefits controlled by the entity as a result of past transactions or other past events”

• Fixed assets – “… held for the purpose of generating income over a number of years.”

• Current assets – “… cash or cash-equivalent, expected to be realised within 12 months of the reporting date”.

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Types of AssetsTypes of Assets• Fixed Assets

– Buildings

– Plant

– Equipment

• Current Assets– Stock (inventory)

– Cash on hand

– Accounts receivable

– Short-term investments

• Intangible assets e.g. patents, goodwill

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Other ExpenditureOther Expenditure• Salaries and wages• Rent and other building-related expenses• Insurance• Taxes and charges • Marketing and advertising• Communications• Motor vehicles and travelling• Entertainment

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LiabilitiesLiabilities

What the firm owes as a result of past borrowings or expenditure –

• Current– Short-term borrowings e.g. overdraft– Accounts payable– Taxes

• Non-current– Long term borrowings

• Other future commitments

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Owners Equity/Net WorthOwners Equity/Net Worth= =

Assets - LiabilitiesAssets - Liabilities

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Relationship – Balance Sheet/ P&L statementRelationship – Balance Sheet/ P&L statement

Balance Sheet (Beg)

+

Revenue/Expenditure/Depreciation

during accounting period

=

Balance Sheet (End)

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Why capitalise/depreciate?Why capitalise/depreciate?

• Capital assets have an estimated useful lifetime.• Consequently, it would be misleading to account

for the associated expenditure in just one accounting period.

• As a result, the expenditure is accounted for over the asset’s lifetime through depreciation.

• This also provides a basis for valuing the asset.• ATO requires that the asset expense deduction is

claimed over the asset’s lifetime.

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Depreciation - an introductionDepreciation - an introduction• Capital investment in tangible assets -

equipment, computers, vehicles, buildings, and machinery - are commonly recovered through depreciation.

• Depreciation also referred to as capital recovery (US) and capital allowance (ATO)

• Visit www.ato.gov.au - search for depreciation.

• The depreciation amount itself is not an actual cash flow.

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Introduction - cont.Introduction - cont.

• The process of depreciating an asset accounts for the decrease in an asset’s value because of age, wear, and obsolescence.

• Depreciation is a tax-allowed deduction included in tax calculations.

Taxes = (income - deductions)(tax rate)

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Book DepreciationBook Depreciation

• Used for internal managerial decision making.• Management is free to use any method they so

choose to compute book depreciation amounts.• Any method can be used:

– Straight Line,– Declining Balance;– Sum-of-the-years digits;– Other.

• Defines the reduced investment in an asset based upon usage pattern and an assumed life.

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Tax DepreciationTax Depreciation

• Must follow the current state and federal law pertaining to acceptable methods for computing depreciation for income tax purposes.

• It may have nothing to do with the actual life of the asset or the usage pattern.

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Different Depreciation MethodsDifferent Depreciation Methods

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Straight Line DepreciationStraight Line Depreciation

• The book value decreases linearly with time.

• The depreciation rate, d = 1/n, is the same each year of recovery period n.

• It is considered the standard against which any depreciation model is compared.

• The annual SL depreciation is determined by:

(first cost - salvage value) d

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ExampleExample

B = $50,000;B = $50,000;

““n” = 5 years;n” = 5 years;

S = $10,000 at t = 5;S = $10,000 at t = 5;

DDtt for each year is: for each year is:

($50,000 - $10,000)/5 = $8,000/year($50,000 - $10,000)/5 = $8,000/year

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10,0008,0005

18,0008,0004

26,0008,0003

34,0008,0002

$42,000$8,0001

BVtDtt

Table of ResultsTable of Results

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Plot of SL Book ValuePlot of SL Book Value

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Accelerated DepreciationAccelerated Depreciation

• SL book values decline in a linear fashion down to a specified salvage value.

• Declining Balance (DB) method allows the book value to accelerate faster.

• The SL method writes off the asset in equal amounts over the recovery period.

• The DB method permits greater depreciation amounts in the early years, and hence reduces the book value faster than the SL method.

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Accelerated Depreciation - cont.Accelerated Depreciation - cont.

• More depreciation in the early years means more tax savings sooner.

• Assumes a profitable firm.• Tax savings early in the life of an asset has a

greater present value than tax savings out in time.

• Larger depreciation amounts early on result in increased present worth of future tax savings to the firm.

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What it means for the firm ?What it means for the firm ?

• If the firm is profitable, then more depreciation amounts in the early years means:– Lower tax liability;– Pay less taxes – more $$ available for

reinvestment!– The firm can retain more after-tax funds if the

depreciation is accelerated in the early years of an assets’ life.

– Thus, more depreciation $$ early on are better!

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Refer ATO web siteRefer ATO web site

• Refer description/examples on link below

• http://www.ato.gov.au/individuals/content.asp?doc=/content/42787.htm&page=8#H23

• Note ATO terminology –– DB =‘Diminishing Value’– SL = ‘Prime Cost Method’

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Thanks for your attention Thanks for your attention