SYMBIOSIS COLLEGE OF ARTS AND COMMERCE SENAPATI BAPAT ROAD, PUNE 411004

Business Administration

Financial Policies and Practices

M.Com. Part I, Semester II

Financial Policies and Practices

Objectives: 1. To gain knowledge of management and financing of working capital. 2. To understand concepts relating to financing and investment decision. Unit No. 1. Name of the Topic Profit Planning -: Concepts and basics of profit planning, approaches to profit planning Break Even Analysis, Proforma Income statement, Retention of earnings, Depreciation considerations Dividend Policies -: Optimal Dividend policy, variables influencing dividend policy, types of divided policy, forms of divided payment. Implications of Over Capitalization and Under Capitalization Financial Management of Business Expansion -: Business Combination, acquisitions, mergers, Conceptual Aspects, forms, Formulation of Acquisition Strategy, Assessment of Financial Implications of Potential acquisition. Projected Profit & Loss Account statement, BalanceSheet, Cash Flow Statements etc. New Financial Instruments -: Floating rate bonds, Zero Interest Bonds, Deep Discount Bonds, CommercialPapers, P. Notes (Participatory Notes) Financial DerivativesDerivativeMarket Meaning, Benefits, Needs, Types, Features Derivative market inIndia Forwards, Futures and options Securitization of Assets concept,mechanism, utility, growth in foreign countries and in India Leasing Finance and Venture Capital -: Lease Financing nature, types, potentiality of leasing as a source of business finance, Venture Capital Concept, dimensions, its functions Venture capital in developing countries and in India, Operational Highlights, Regulatory Framework in India, Prerequisites for success. International Financial Management -: World monetary system Important Features, Foreign exchange market & rates International parity relationships Financing of foreign operations, Modes and Methods exchange markets: markets and dealings. TOTAL Periods 08

2.

08

3.

08

4.

08

5.

08

6.

08

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UNIT 1: PROFIT PLANNING

Introduction:
Profit planning is setting a profit target for the coming period. It is like a summarized version of estimated income statement. It starts with a forecast of expected sales and desired percentage for gross profit keeping in view the market conditions. In a nutshell, profit planning is a set of steps taken to achieve a desired level of profit. To accomplish this, a number of budgets are prepared. Profit planning is the process of developing a plan of operation that makes it possible to determine how to arrange the operational budget so that the maximum amount of profit can be generated. There are several common uses for profit planning, with many of them focusing on the wise use of available resources. The actual process of profit planning involves looking at several key factors relevant to operational expenses. Putting together effective profit plans or budgets requires looking closely at such expenses as labor, raw materials, facilities maintenance and upkeep, and the cost of sales and marketing efforts. By looking closely at each of these areas, it is possible to determine what is required to perform the tasks efficiently, generate the most units for sale, and thus increase the chances of earning decent profits during the period under consideration. Understanding the costs related to production and sales generation also makes it possible to assess current market conditions and design a price model that allows the products to be competitive in the marketplace, but still earn an equitable amount of profit on each unit sold. Necessary changes that may be uncovered as part of the profit planning process include increasing or decreasing the employee force, changing vendors of raw materials, or upgrading equipment and machinery that are key to the production of goods and services. In like manner, the need to restructure marketing campaigns so that more resources are directed toward strategies that are providing the greatest return, while minimizing or even eliminating allocations to strategies that are not producing significant results, may also become apparent as a result of this type of planning. Even issues such as changing shippers or making slight changes to packaging that trim expenses may be identified as part of the profit planning process. While profit planning is a useful process in any business setting, there are some limitations on what can be accomplished. The effectiveness of the planning is only as good as the data that is assembled for use in the process. Should the data be incorrect or incomplete, the results of the planning are highly unlikely to produce the desired results. In addition, if the findings of the process do not result in the implementation of procedures and changes in the relevant areas of the business, the time spent on the profit planning is essentially wasted. For this reason, profit planning should be seen as a starting point for operations and not simply recommendations of what should be done in order to increase profit margins. Successful business performance requires balancing costs and revenues as illustrated by the following model: Costs of the future (profit) + current costs (expenses) = Average revenue per unit sold x sales volume .

Definition:
Profit planning can be defined as the set of steps that are taken by firms to achieve the desired level of profit. Planning is accomplished through the preparation of a number of budgets, which, when brought through, from an integrated business plan known as master budget. Accounting Dictionary: Process of developing a profit plan that outlines the planned sales revenues and expenses and the net income or loss for a time period. Profit planning requires preparation of a master (Comprehensive) budget and various analyses for risk and what-if scenarios. Tools for profit planning include the Cost-Volume-Profit (CVP) Analysis and Budgeting. Peter Drucker says "Profit is a condition of survival. It is the cost of the future, the cost of staying in business". Process of developing a profit plan that outlines the planned sales revenues and expenses and the net income or loss for a time period.

Advantages of Profit Planning:

Profit planning offers many advantages to your business. The modest investment in time required to develop and implement the plan will pay liberal dividends later. Among the benefits that your business can enjoy from profit planning are the following: 1. Performance evaluation: The profit plan provides a continuing standard against which sales performance and cost control can quickly be evaluated. 2. Awareness of responsibilities: With the profit plan, personnel are readily aware of their responsibilities for meeting sales objectives, controlling costs, and the like. 3. Cost consciousness: Since cost excesses can quickly be identified and planned, expenditures can be compared with budgets even before they are incurred, cost consciousness is increased, reducing unnecessary costs and overspending. 4. Disciplined approach to problem-solving: The profit plan permits early detection of potential problems so that their nature and extent are known. With this information, alternate corrective actions can be more easily and accurately evaluated. 5. Thinking about the future: Too often, small businesses neglect to plan ahead: thinking about where they are today, where they will be next year, or the year after. As a result, opportunities are overlooked and crises occur that could have been avoided. Development of the profit plan requires thinking about the future so that many problems can be avoided before they arise.
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6. Financial planning: The profit plan serves as a basis for financial planning. With the information developed from the profit plan, you can anticipate the need for increased investment in receivables, inventory, or facilities as well as any need for additional capital. 7. Confidence of lenders and investors: A realistic profit plan, supported by a description of specific steps proposed to achieve sales and profit objectives, will inspire the confidence of potential lenders and investors. This confidence will not only influence their judgment of you as a business manager, but also the prospects of your business' success and its worthiness for a loan or an investment.

Limitations of Profit Planning:

Besides profit planning has vast advantages in it but it has some limitations: 1. Profit plans are based upon estimates. Inevitably, many conditions you expected when the plan was prepared will change. Crystal balls are often cloudy. The further down the road one attempts to forecast, the cloudier they become. In a year, any number of factors can change, many of them beyond the control of the company. Customers' economic fortunes may decline, suppliers' prices may increase, or suppliers' inability to deliver may disrupt your plan. 2. The profit plan requires the support of all responsible parties. Sales quotas must be agreed upon with those responsible for meeting them. Expense budgets must be agreed upon with the people who must live with them. Without mutual agreement on objectives and budgets, they will quickly be ignored and serve no useful purpose. 3. Profit plans must be changed from time to time to meet changing conditions. There is no point in trying to operate a business according to a plan that is no longer realistic because conditions have changed.

Break-Even Analysis & Profit Planning

A fundamental of accounting is that all revenues and costs must be accounted for and the difference between the revenues and costs is the profit, or loss, of the business. Costs can be classified as either a fixed cost or a variable cost. A fixed cost is one that is independent of the level of sales; rather, it is related to the passage of time. Examples of fixed costs include rent, salaries and insurance. A variable cost is one that is directly related to the level of sales, such as cost of goods sold and commissions. Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Definition of 'Break-Even Analysis' An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point
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Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point"). In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". Break Even Calculator Example Assume the following: Fixed Costs: Monthly Rent Insurance (RS.6000 per year RS.600/12 months = RS.500) Total Monthly Fixed Costs RS.1000 RS.500 RS.1500

Variable Cost: Materials Labor Total Variable Cost RS.30 RS.40 RS.70

Selling Price: Break Even Point Calculation Break Even Point = Break Even Point = Break Even Point = Break Even Point =

RS.100

Fixed Costs / (selling price - variable costs) RS.1500 / (RS.100-RS.70) RS.1500 / RS.30 50 Units

To break even the company must sell 50 units per month.

Figure 1 For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells more, it will be a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could: Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) Try to reduce variable costs (the price it pays for the tables by finding a new supplier) Increase the selling price of their tables. Any of these would reduce the breakeven point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs. Computation In the linear Cost-Volume-Profit Analysis model, the break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

Where: TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.
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Figure 2 The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs. The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation and multiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Margin over Price) to compute it as:

Break Even Analysis:

By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged, if the firm changes the selling price for its product.

Figure 3 To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal axis and the breakeven price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.

Objectives of Break Even Analysis:

1. To determine the profitability of a product or service: Many things should be considered when finding the breakeven point for a product's profitability. A company's goal is to be profitable as quickly as possible, so it is more effective for a company to run the numbers through a set of break even points to determine where the company will have the optimal chance of making a profit. 2. To set unit prices: Performing break even analysis can also lead to the numbers that will help determine a set price per unit. This is calculated by leaving the cost per unit as the variable in a break even analysis equation. The most effective unit price will bring quick profitability to the company without the company spending too much for production and marketing of the product.

3. To determine the best strategic options: Another use for break even analysis is to use the information from the analysis to help determine the company's financial strategy. If a company's profitability is determined by the success of one or more products, using the breakeven point for each product will provide a timeline for the company. This can be used to choose a better overall financial strategy that fits the projected costs and profits Advantages of Break Even Analysis: 1. Provided detailed and understandable information 2. Profitability of product and business can be known 3. Effects of changing cost and selling price can be demonstrated 4. Cost control can be analyzed 5. Economy and efficiency can be affected 6. Diagonostic tool Application: The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis. Limitations: Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

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Pro-forma income statement:

A Proforma income statement is an estimated or projected income statement. A pro forma income statement is similar to a historical income statement, except it projects the future rather than tracks the past. Pro forma income statements are an important tool for planning future business operations. If the projections predict a downturn in profitability, you can make operational changes such as increasing prices or decreasing costs before these projections become reality. Pro forma income statements provide an important benchmark or budget for operating a business throughout the year. They can determine whether expenses can be expected to run higher in the first quarter of the year than in the second. They can determine whether or not sales can be expected to be run above average in June. The can determine whether or not your marketing campaigns need an extra boost during the fall months. All in all, they provide you with invaluable informationthe sort of information you need in order to make the right choices for your business. In business, pro forma financial statements are prepared in advance of a planned transaction, such as a merger, an acquisition, a new capital investment, or a change in capital structure such as incurrence of new debt or issuance of equity. The pro forma models the anticipated results of the transaction, with particular emphasis on the projected cash flows, net revenues and (for taxable entities) taxes. Consequently, pro forma statements summarize the projected future status of a company, based on the current financial statements. For example, when a transaction with a material effect on a company's financial condition is contemplated, the Finance Department will prepare, for management and Board review, a business plan containing pro forma financial statements demonstrating the expected effect of the proposed transaction on the company's financial viability. Lenders and investors will require such statements to structure or confirm compliance with debt covenants such as debt service reserve coverage and debt to equity ratios. Similarly, when a new corporation is envisioned, its founders will prepare pro forma financial statements for the information of prospective investors. Pro forma figures should be clearly labeled as such and the reason for any deviation from reported past figures clearly explained. Also, banks will request Pro Forma statements in lieu of tax returns for a start up business in order to verify cash flow before issuing a loan or line of credit.

Pro forma gross profit: lets assume that you expect sales to increase by 10 percent next year. You multiply this years sales of RS.10,00,000 by 110 percent to get RS.11,00,000.Then, in this case, you assume there will be no increase in the cost of each item you are selling, but you will need 10 percent more items to sell in order to achieve your sales goals. So, you multiply this years cost of goods sold (lets assume a figure of RS.5,00,000), by 110 percent to get RS.550,000. To figure your pro forma gross profit for next year, subtract the pro forma cost of goods sold from the pro forma sales.RS.11,00,000 minus RS.5,50,000 equals your gross profit, or RS.5,50,000.

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Pro forma total expenses: lets assume salaries and other expenses will increase by 5 percent. So, you multiply your historical salaries of RS.200,000 and your other expenses of RS100,000 by 105 percent each. Your pro forma salaries for next year will be RS.210,000 and your pro forma expenses will be RS.105,000. You then figure your pro forma total expenses by adding pro forma salaries and pro forma other expenses together. In our sample case your pro forma total expenses will be RS.315, 000. Pro forma profit before taxes: Pro forma profit before taxes is figured by subtracting the pro forma expenses from the pro forma gross profit, or RS.315,000 from RS.550,000 for a pro forma profit before taxes of RS.235,000. Pro forma taxes: Pro forma taxes are figured by taking your estimated tax rate, in this case 30 percent, and multiplying it by the pro forma profit before taxes of RS.235,000. This produces a pro forma tax bill of RS.70,500. Pro forma profit after taxes: Pro forma profit after taxes is figured by subtracting the pro forma tax bill of RS.70,500 from the pro forma profit before taxes of RS.235,000. Your pro forma profit after taxes, in this case, would be projected at RS.164,300. Remember that pro form as are essentially best guesses. You should continually update your projections by recalculating your pro form as using any new and actual financial information you have as a base. Doing this on a monthly or quarterly basis will help to assure that your projections are as close to being accurate as possible

Instructions: creating your pro forma income statement:

1. Gather the information you have collected on the market share you expect to gain (forecasted sales) as well as all of the costs of operating your business. Include in your operating costs expenses for the one-year time frame such as rent, salaries, production costs and utilities. 2. Write your business name as the header of your statement. Under it write, "Income Statement," and under that write, "For the year ending (date)." Center the three lines of text. 3. On the left-hand side write "Revenue" under your header as a subject line. Under the word "Revenue" write "Gross Sales." Under that write "Less sales returns and allowances," and under that write "Net Sales." Notice that this is an equation (gross sales minus sales returns and allowances equals net sales). Create two columns to the right of your text. In the first column, write the amount of your revenues. For gross sales use the amount of your projected sales. If your business will not have any returns and allowances, place a zero in the column on that line. Your net sales amount will be the same as your projected sales amount.

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4. Skip a line after "Net Sales" and write "Expenses" as your next subject line. In a list format, write your projected expenses. Write the amount for each expense on the same line in the first of the two columns on the right side of the page. Expenses include rent, costs of inventory, and costs of office furniture, salaries, advertising, bank fees for the business account, postage, transportation, insurance and utility bills. 5. Add all of your expenses to get the total expenses. Write "Total Expenses" below the list. Write this number on the same line in the far-right column. Underline this amount. 6 .Subtract total expenses from net sales to arrive at your projected net operating profit or loss. Skip a line after "Total Expenses," and write "Net Operating Profit (Loss)." Write the amount on the same line in the far-right column. If you arrive at a negative figure, put the loss amount in parentheses. Double underline the amount. 7. If you anticipate no other income, such as the sale of an asset that belongs to the business or interest income, then you are done. If you anticipate either of the two, create a new section called "Other income" under the words "Net operating profit (loss)." In this section include gains or losses from sales of assets or any other income and list the amount in the first column. 8. Add your other income to get your total other income and list the amount in the second column. End by calculating your net income as net operating profit (loss) plus total other income. List "Net Income" on the left-hand side of the form and include the amount in column 2.

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Benefits and Advantages of Proforma Income Statement

1. Business Planning: The budgeting and planning process often precedes the creation of a pro forma income statement. Accounting works with the sales team to determine expected sales. Marketing shares their perception of market conditions. Together, these three departments determine how many products the company will sell and the selling prices. Accounting meets with the production manager to review manufacturing costs and expected increases or decreases in this cost. The impact of capital improvements is considered and final product cost estimates are determined. Accounting collaborates with each operating department to evaluate expected expenses for the period to be reported in the pro forma income statement. Previous year expenses are reviewed and revised as necessary.
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The sales, product costs and operating expenses are combined in the final pro forma income statement. Throughout this process, each department considers its financial position for the following year. Each department creates expectations and goals to meet in that period. 2. Investor Communication: Current investors want to know the company will continue earning money in the future. Successful companies grow their profits and attract new investors. Pro forma income statements communicate the expected profits of the company for the future period. If there are industry changes that will reduce profits or create a net loss, management can explain these conditions and discuss their plan for improving the situation. This prevents investors from unexpected losses since they are aware of the situation and management's plans to address the loss. 3. Impact Assessment: When a company considers increasing the selling prices or discontinuing a product line, they realize this decision will impact their profitability. Pro forma income statements allow management to modify the base information in the financial statement to account for potential changes. An increase in selling price may reduce total sales quantity. Pro forma income statements will demonstrate the impact of this scenario on gross profit. Discontinuing a product line will reduce sales, product cost and operating expenses. This may increase gross profit or decrease gross profit, either of which will be obvious by creating a pro forma income statement. 4. Primary Importance: Pro forma statements are used to create a budget and determine the need of the company for capital. This need can be short-term or long-term with the pro forma statement extending through years of growth. This gives management realistic numbers of cash needs. By anticipating this need, they won't be unprepared when the need is realized. 5. Growth Opportunities: Pro forma statements can demonstrate the areas in which a company can grow by adjusting numbers that deal with distribution to affect the bottom line. By working these numbers and how they affect real costs, a company can judge whether growth is worth the risk and cost. When a company is considering leaping to the next level, it needs to understand that it isn't merely a cost of production and retail cost that affects the net revenues of a company. Increasing production may increase needs for insurance while decreasing the cost of production because materials can be discounted for buying greater bulk. More employees may be needed with more benefits. There are many factors to consider and pro forma statements help review all of them. 6. Capital Investors: When any company, young or old, seeks venture capital or bank financing, it will be required to produce balance sheets and financial statements. If the company is established it will have its records already intact from tax returns and bookkeeping records. New companies will need to create an idea of how the company is going to be profitable. Even established companies seeking growth capital need to show the difference between what they have been
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doing and what they can be doing with new capital influx. This is where pro forma statements help show investors that the company and its management have considered all variables. It gives confidence to investors. 7. Troubleshooting Established companies can take their actual financial statements and make adjustments based on pro forma data assumptions and find areas to cut costs, improve performance and generate more revenues. In doing so, they are able to see the gaps in their current performance and make minor or major adjustments as deemed necessary to rectify any problems. By using pro forma statements to troubleshoot, companies may realize a better way of doing the same thing. 8. Adjustable Projections: Because pro forma statements are estimates, they are flexible and allow for things to be adjusted as needed. Whether they are changes made as suggestions by investors or other ideas that adjust costs, the pro forma statement is dynamic. As the company gets to the implementation stage, actual numbers easily replace the hypothetical assumptions to give an accurate depiction of costs, revenues and returns on investment data. The pro forma statement then easily transfers into becoming a comprehensive financial statement for the company that shows how well their comparisons compare to actual numbers.

RETENTION OF EARNIGS
EARNINGS RETENTION is the proportion of net income that is not paid in dividends. A firm earning Rs.100, 000 after taxes and paying dividends of Rs.20, 000 has a retention rate of Rs.80, 0000, or 80%. A high retention rate makes it more likely a firms income and dividends will grow in future years. Retained earnings means the accumulated net income that has been retained for reinvestment in the business rather than being paid out in dividends to stockholders. Net income that is retained in the business can be used to acquire additional income-earning assets that result in increased income in future years. Retained earnings are a part of the owners' equity section of a firm's balance sheet. Also called earned surplus, surplus, undistributed profits. Most earnings retained are re-invested into the company's operations. Year-on-year tracking of the ratio of undistributed profits to dividends is important to fundamental analysis to investigate whether a company is increasing or decreasing its rate of re-investment. Undistributed profits form part of a company's equity, and are owned by shareholders. They are also called retained earnings, accumulated profits, undivided profits, and earned surplus. Retention Ratio indicates the percentage of a company's earnings that are not paid out in dividends but credited to retained earnings. It is the opposite of the dividend payout ratio, so that also called the retention rate. Earning Retention Ratio is also called as Plowback Ratio. As per definition, Earning Retention Ratio or Plowback Ratio is the ratio that measures the amount of earnings retained after dividends have been paid out to the shareholders. The prime idea behind earnings retention ratio is that the more the company retains the faster it has chances of growing as a business. This is also known as retention rate or retention ratio. There is always a conflict
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when it comes to calculation of Earnings retention ratio, the managers of the company want a higher earnings retention ratio or plowback ratio, while the shareholders of the company would think otherwise, as the higher the plowback ratio the uncertain their control over their shares and finances.Retention Ratio = 1 - Dividend Payout Ratio = Retained Earnings / Net IncomeThe percent of earnings credited to retained earnings. In other words, the proportion of net income that is not paid out as dividends. Calculated as:

DEPRECIATION CONSIDERATIONS
Depreciable assets are tangible assets that are used in a business. Over time, these assets decline in value because of wear and tear, aging, and obsolescence. Depreciation provides a way to match the decline in value with the income that results from using the assets. Generally accepted accounting principles (GAAP) require a rational and systematic approach to depreciation, as well as consistent financial reporting. Accordingly, many decisions must be made to establish depreciation schedules and the proper recording of fixed asset transactions.

Depreciation strategies:
Businessman must keep a record of all depreciable capital assets for his or her business. Known as a depreciation schedule, these list records the date that each asset was placed in service, a calculation for each successive year's depreciation, and accumulated depreciation. An asset remains on a depreciation schedule until the asset becomes fully depreciated or is discarded. A year-end review of fixed assets ensures that your client's business does not keep assets that have been sold or abandoned on the schedules. Before adding assets to depreciation schedules, evaluate these issues: Basis: The basis of an asset is usually its cost. Review invoices carefully to ensure that appropriate costs are included don't forget to include costs such as delivery and setup in the value of the asset. Recovery period: The recovery period of an asset is the number of years you expect the asset to remain in use. Salvage value: The salvage value is the estimated value of the asset at the end of its estimated useful life. If you estimate a salvage value, you depreciate the asset down to the salvage value. Often companies do not estimate a salvage value, possibly because it's difficult to estimate or because some assets, such as computer hardware or software, become obsolete so quickly that they typically have only a negligible value at the end of their depreciable lives. Partial-year depreciation: When an asset is placed in service at some time during the year, a partial depreciation charge is required. If, for example, you start using an item at midyear, you will take depreciation for half of a year in that year and for half of a year in the last year that it is depreciated. Options for handling partial-year depreciation include:
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Half year in the year that the asset is placed in service and also in the final year. Full year in either the year that the asset is placed in service or in the final year. Prorating by the month or quarter that the asset is placed in service, with the remainder of the depreciation taken in the final year. Expensing vs. depreciation: Help to establish a consistent approach for deciding whether the business should expense items that are inexpensive and perhaps not worth adding to the depreciation schedule.

Capital Cost Allowance and Depreciation - Other Depreciation Considerations

All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (due to new technology, for example), and its salvage value may also be affected. Once this happens there is asset impairment. Companies can do two things: 1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time. 2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away. Changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. As a result, there is no need to restate past financial statements.

Other depreciation considerations:

Below are some other important depreciation-related items that you should consider when establishing your accounting policies and procedures. Abandonments: If you dispose of an asset, both the asset and the offsetting depreciation can be written off. Continue to claim depreciation for an asset if it is only temporarily idle. Assets from a lump-sum purchase: if you purchase several assets together, collect an appraisal that provides the fair market value for setting your basis. If you lack adequate information about fair market values for the assets, you must allocate the purchase price among the assets, as dictated by GAAP. Repairs vs. capital improvements: Determine how to allocate repair and improvement costs to assets. Repairs and maintenance occur routinely and should be expensed. Improvements that extend the life of an asset to future periods are depreciable. For example, repairing a machine or replacing short-lived parts within a machine is considered a repair. Totally rebuilding a machine to significantly extend the machine's life is considered a capital improvement.

Depreciation methods:
Depreciation methods vary for financial reporting and tax reporting. Although similar accounting fundamentals underlie both types of reporting, financial reporting emphasizes compliance with GAAP, whereas tax reporting provides various options for minimizing taxes due. Also, some depreciation methods may work better for certain types of business activities, so you need to know whether a particular depreciation method is a common practice within your industry.

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Financial reporting A variety of depreciation methods are available for financial reporting. The type of depreciation method you choose can have a significant impact on your business. Some financial reporting depreciation methods include: Straight-line method: Depreciation charges are spread evenly over the life of an asset. Easy to calculate, the straight-line depreciation method is used by a majority of small businesses. Accelerated methods: Accelerated depreciation methods include sum-of-years' digits and double-declining balance methods. Accelerated methods assume that an asset is used more heavily during the earlier years and loses a majority of its value during the first several years of use. Activity methods: Activity depreciation methods assume that depreciation is a function of use. The life of the asset is valued according to the output the asset provides or the number of units of activity that it produces. Activity methods may provide an excellent matching of expense to income for a machine where the number of produced units can be estimated, but activity depreciation methods do not work for all asset types. Group or composite method: The group depreciation method is appropriate for a large number of similar assets, such as utility telephone poles. The composite depreciation method is used for a group of dissimilar assets, such as a fleet of different types of vehicles. Both methods are based on an average depreciation rate for the group.

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