UNIVERSITY OF ZIMBABWE

LLB PART III, 2018

ACCOUNTING FOR LEGAL PRACTITIONERS

EXPENSE RECOGNITION - INVENTORY & DEPRECIATION

1. EXPENSE RECOGNITION
Under the accrual method of accounting, expense recognition is based
on the matching principle whereby expenses to generate revenue are
recognized in the same period as the revenue. Inventory provides a good
example. Assume inventory is purchased during the first half of the year
2018 and sold during the second half of the year 2018. Using the
matching principle, both the revenue and the expense (cost of goods
sold) are recognised in the second half of the year 2018, when the
inventory is sold, not the period in which the inventory was purchased.
Not all expenses can be directly tied to revenue generation. These costs
are known as period costs. Period costs, such as administrative costs,
are expensed in the period incurred.

2. INVENTORY EXPENSE RECOGNITION

If a firm can identify exactly which items were sold and which items
remain in inventory, it can use the specific identification method. For
example, a car dealer records each vehicle sold in inventory by its
vehicle identification number (VIN).

2.1 First-in-first-out (FIFO) Method – under the FIFO method, the

first item purchased is assumed to be the first item sold. The cost
of inventory acquired first (beginning inventory and early
purchases) is used to calculate the cost of goods sold (COGS) for
the period. The cost of the most recent purchases is used to

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 calculate ending inventory. FIFO is appropriate for inventory that
has a limited shelf life. For example, a food products company
will sell its oldest inventory first in order that it keeps fresh
inventory on hand.

2.2 Last-in-first-out (LIFO) Method – under the LIFO method, the

last item purchased is assumed to be the first item sold. The cost
of inventory most recently purchased is assigned to the COGS for
the period. The costs of beginning inventory and earlier
purchases are assigned to ending/closing inventory. LIFO is
appropriate for inventory that does not deteriorate with age. For
example, a coal distributor will sell coal off the top of the pile.

2.3 The weighted average cost Method – this method makes no

assumption about the physical flow of the inventory. It is popular
because of its ease of use. The cost per unit is calculated by
dividing cost of available goods by total units available, and this
average cost is used to determine both COGS and closing
inventory. Average cost results in COGS and ending inventory
values that are between those of LIFO and FIFO.

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The table below summarises the effects of the various inventory methods: -

Method Assumption COGS consists Closing stock

of: consists of:
FIFO Items first First purchased. Most recent (last)
purchased are purchases.
first to be sold.
LIFO Items last Last purchased. Earliest
purchased are purchases.
first to be sold.
Weighted average Items sold are a Average cost of Average cost of
cost mix of all items. all items.
purchases.

Exercise: Inventory Costing

Use the inventory data in the table below to calculate the COGS and closing
stock under each of the 3 methods of inventory recognition.
Inventory Data: -
1st January 2018 20 units @ $2 per unit = $40
(Opening inventory)
8th January purchase 30 units @ $3 per unit = $90
22nd January purchase 50 units @ $50 per unit = $250
Cost of goods available 100 units = $380
Units sold during 70 units
January 2018

Solution: -
(a) FIFO COGS – value the 70 units sold using the unit cost of first units
purchased. Start with the opening inventory and the earliest units
purchased and work done as illustrated in the following table: -

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FIFO COGS Calculation
From Opening Inventory 20 units @ $2 per unit $40
From 1st purchase 30 units @ $3 per unit $90
From 2nd purchase 20 units @ $5 per unit $100
FIFO COGS 70 units $230
Ending Inventory 30 units @ $5 per unit $150

(b) LIFO COGS – value the 70 units sold using the unit cost of last units
purchased. Start with the most recently purchased units and work up
as illustrated in the following table: -

LIFO COGS Calculation

From 2nd purchase 50 units @ $5 per unit $250
From 1st purchase 20 units @ $3 per unit $60
LIFO COGS 70 units $310
Ending Inventory 10 units @ $3 per unit $30
+ 20 units @ $2/unit + $40 = $70

(c) Weighted Average COGS Calculation

Average unit cost $380/10 units $38
Weighted average COGS 7 units @ $38 per unit $266
Ending inventory 3 units @ $38 per unit $114

(d) Summary: -
Inventory Method COGS Ending Inventory
FIFO $230 $150
LIFO $310 $70
Average Cost $266 $114

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 3. DEPRECIATION EXPENSE RECOGNITION
The cost of long-lived assets must also be matched with revenues. Long-
lived assets are expected to provide economic benefits beyond one
accounting period. The allocation of cost over an asset’s life is known
as depreciation (tangible assets), depletion (natural resources) or
amortisation (intangible assets). Most firms use the straight-line
depreciation method for financial reporting purposes. The straight-line
method recognises an equal amount of depreciation expense each
period. However, most assets generate more benefits in the early years
of their economic life and fewer benefits in the later years. In this case,
an accelerated depreciation method is more appropriate for matching
the expenses to revenues.

In the early years of an asset’s life, the straight-line method will result
in lower depreciation expense as compared to an accelerated method.
Lower expense results in higher net income. In the later years of the
asset’s life, the effect is reversed, and straight-line depreciation results
in higher expenses and lower net income compared to accelerated
methods. Depreciation is charged to the Income Statement as an
expense.

3.1 Straight-line (SL) Depreciation – allocates an equal amount of

depreciation each year over the asset’s useful life as follows: -
SL depreciation expense = [Cost – Residual Value] / Useful Life

Example 3.1: Calculating straight-line depreciation expense

Justinian Company recently purchased a machine at a cost of
$120,000. The machine is expected to have a residual value of $20,000
at the end of its useful life in 5 years. Calculate the annual depreciation
expense using the straight-line method.
Answer:
The annual depreciation expense will be:
[Cost – Residual value] / Useful life

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 = [$120,000 - $20,000] / 5 = $20,000

3.2 Accelerated Depreciation – speeds up the recognition of

depreciation expense in a systematic way to recognise more
depreciation expense in the early years of the asset’s life and less
depreciation expense in the later years of its life. Total
depreciation expense over the life of the asset will be the same as
it would be if straight-line depreciation were used.

3.3 Declining Balance (DB) Method – applies a constant rate of

depreciation to an asset’s (declining) book value each year. The
declining balance method is also known as the diminishing
value method. The most common declining balance method is
double-declining balance (DDB), which applies two times the
straight-line rate to the declining balance. If an asset’s useful life
is ten years, the straight line rate is 1/10 or 10%, and the DDB
rate would be 2/10 or 20%.

DDB dprn = [2/useful life][cost – accumulated depreciation]

Example 3.3: Calculating DDB depreciation expense

Justinian Company recently purchased a machine at a cost of
$120,000. The machine is expected to have a residual value of $20,000
at the end of its useful life in five years. Calculate depreciation expense
for all five years using the double declining balance method.
Answer: -
The depreciation expense using the double declining balance method
is:
Year 1: [2/5][$120,000] = $48,000
Year 2: [2/5][$120,000 - $48,000] = $28,800
Year 3: [2/5][$120,000 – ($48,000+ $28,800)] = $17,280

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 In years 1 to 3, Justinian Company has recognised cumulative
depreciation expense of $48,000 + $28,800 + $17,280 = $94,080. Since
the total depreciation is limited to $100,000 ($120,000 - $20,000
salvage value), the depreciation in year 4 is limited to $100,000 -
$94,080 = $5,920 rather than [2/5][$120,000 - $94,080] = $10,368
using the DDB formula.
Year 5 depreciation = 0 since the asset is fully depreciated.
NB – the rate of depreciation is doubled (2/5) from straight-line, and
the only thing that changes from year to year is the base amount (book
value) used to calculate annual depreciation. Please also note that while
we have been discussing the “double” declining balance method, which
uses a factor of 2 times the straight-line rate, firms can compute
declining balance depreciation based on any factor e.g., 1, 1.5, double,
triple, etc, etc.

4. PROVISION FOR DEPRECIATION

Ii must be emphasised that depreciation is an estimate. For that reason,
the modern practice is to treat it as an estimate by opening a Provision
for Depreciation Account. No entry is made in the Asset Account but
instead, the Net Book Value (NBV) is shown in the Balance Sheet where
the accumulated depreciation is deducted from the cost of the asset.
Using the above example (Justinian Company), if the cost of the
machine ($120,000) is depreciated using the straight-line method, the
annual depreciation expense will be:
[Cost – Residual value] / Useful life
= [$120,000 - $20,000] / 5 = $20,000
At the end of the 1st year, the Depreciation Account will be debited
with $20,000 while the Provision for Depreciation Account will be
credited with $20,000. The machine would accordingly continue to be
reflected in the Ledger at its cost price of $120,000 since the credit
would have been posted to the Provision for Depreciation Account.
However, in the Balance Sheet, the Provision for Depreciation Account
is not shown as a liability but is deducted from the cost of the machine

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 which would then give its net book value (NBV) of $100,000 i.e., its cost
of $120,000 minus the accumulated depreciation of $20,000. At the
end of the 2nd year, a further $20,000 would be debited to the
Depreciation Account while the Provision for Depreciation Account is
credited with the same amount. The Balance Sheet at the end of the 2nd
year would reflect an NBV of $80,000 i.e., its cost of $120,000 minus
the accumulated depreciation of $40,000.

See the table below with the appropriate entries and balances: -

Depreciation Accumulated Asset NBV

Depreciation
End of 1st Year $20,000 $20,000 $100,000
End of 2nd Year $20,000 $40,000 $80,000
End of 3rd Year $20,000 $60,000 $60,000
End of 4th Year $20,000 $80,000 $40,000
End of 5th Year $20,000 $100,000 $20,000

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 TUTORIAL EXERCISES

1. Ms. Grotius depreciates her motor vehicles at 10% per anum using
the diminishing balance method. On 1st January 2009, she
purchased a Land Rover Discovery for $100,000 cash. On 1st
January 2010, she purchased her second vehicle, a Mercedes GLE
for $150,000 cash. She then sold the Land Rover Discovery on 1st
January 2011 for $80,000 cash.
(a) Show the ledger accounts for the motor vehicle account, the
depreciation account, provision for depreciation account, the
asset disposal account, the cash account and the Profit & Loss
account.

2. Mr. Pacioli’s books reflected that his motor vehicles cost $150,000
and that the provision for depreciation of motor vehicles had
accumulated $60,000. One of the motor vehicles, a Toyota Camry is
involved in an accident and is sold for $5,000. The Toyota Camry
had been bought for $30,000 and had been depreciated $5,700.
(a) Make the necessary entries in the Motor Vehicles Account, the
Provision for Depreciation Account and the disposal of the Toyota
Camry Account.

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