Accounting bases are methods used for calculating information for financial statements. The two most commonly used bases are the straight line basis and the declining balance method. It generally depends on the item with regard to which basis is used. The purpose of using different bases is to allocate the cost of the asset over the agreed number of years applying it to each year independently. This accounting basis divides the net cost of the asset equally over the expected number of years of its working life.
With regard to depreciation it assumes that the value of the asset will decline equally over the number of years that are deemed to be how long it will be of use to the company. Instead of an even division every year, the declining or reducing balance method takes into consideration that an item like a vehicle depreciates in value more quickly in the first year than in subsequent years of its useful life. Therefore the depreciation amount for the first year is calculated and then for each subsequent year a percentage of the value of the asset is deducted.
This method is most commonly used for motor vehicles, for example if a truck was
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They are specific accounting bases (Glautier & Underdown 1995) giving an explanation of how the figures in the financial statements have been attained. It is the company’s choice as to which accounting basis is most appropriate to use in preparing the financial information and in accordance with FRS18, it must be stated which Accounting Policy is used in order to give a true and fair reflection of all financial transactions. All tangible assets apart from freehold land have allowance made on them for depreciation.
Each year these assets are stated on the balance sheet at cost price less the accumulated depreciation. The purpose of this is to write off the cost over a certain number of years according to its useful life. In practise certain assets are given a fixed number of years before they are subject to depreciation, e. g. generally vehicles depreciate over a period of four years or what is deemed to be their estimated life. Buildings are usually anywhere between 30 – 50 years. (Ramsden 2003). The Colefax Group outlines how depreciation is calculated using the straight line method, e.
g. it states that the residual value – the amount that the item is deemed to be worth at is time of replacement – is subtracted from the price that it was bought for and this figure is then divided by the number of years that the company will use it for before it is replaced. A list is then provided showing this. Any assets that are being manufactured are not subject to depreciation New Look states that tangible fixed assets are recorded at cost less depreciation. Cost includes any extras charged. Freehold land does not depreciate.
Depreciation exists to write off the cost less anything that it is worth at the end of its life. The accounting policies refer to stock as being valued at either cost price or the net realisable value, as stated by (Black 2002). The pricing method used in calculating the value of stock is the first in first out (FIFO) basis and this includes logistical and finishing costs according to (Holmes & Sugden 1990). The first items that have been bought in are the first to be sold. New Look states that stock is valued at cost price or net realisable value, whichever is the lower amount.
There is no mention of the pricing method so this could make a difference on the profits attained. If the reducing balance method was used to calculate depreciation a different amount would show on the P&L account and the balance sheet each year. In the case of motor vehicles with an original cost of i?? 383,000 and a residual value of i?? 27,000, at the end of the 4 years the figures would be the same, but over years 1-3 the amount that is accounted for can affect the Net Profit figures quite dramatically.
In summary, the annual provision amount on the P&L account if the straight line method is used in year 1, will be 97,140 less than if the reducing balance method is used, as stated by (McKenzie 1994) some companies prefer this way of calculation as it is more akin to ‘real’ depreciation. If the reducing balance method is used, it would be prudent to analyse the accounts over the 4 year period, as looking at year 1 or year 4 in isolation may give a distorted view. The way an accounting policy is presented can alter the amount the company reports its profits.
If there is a low charge for depreciation, then the asset value of an item appears to be higher, this also makes the profits to appear higher in the P&L account. If the P&L account is read without reading the explanation then a false view can be given. As suggested by (McKenzie 1994) a different method in calculating value is by using the average cost. This is when deliveries are received which are priced differently and therefore an average price is taken over the year.
This is not entirely accurate and as stated by (Holmes & Sugden (1990), stock needs to be valued consistently because a slight difference in price can affect the reported profits quite dramatically. In the case of New Look, where we don’t know how they have valued their stocks, if the stock is valued higher at year end, this could mean that the cost of the goods could have been very low and a greater profit was realised. (Holmes & Sugden (1990)