General Policies and Financial Policies
Before discusing Financial Policies, we start first to define Policy as the set of principles and concepts established by the higher levels of the organization to guide other management levels when carrying out their activities and making their decisions.
Policies are considered a constitution for action because they are the permanent framework that defines and directs thought and shows what should be done and what behavior or actions should be refrained from. Policies take the form of orders or instructions that are accompanied by penalties imposed on violators.
We must clearly differentiate between policy and rules of action. Policy is characterized by commonness and generality, and only specifies the general direction in which the enforcers operate. As for the rules, they mean what should be done and what behavior or actions should be refrained from.
The objectives of the policies are summarized among the following objectives:
- Economy in effort and time.
- Accelerate the achievement of goals.
- Assisting in developing plans for the branches.
- Linking the administrative units to each other.
On the other hand, a good policy is one that is characterized by the qualities that ensure its effectiveness and stability. Therefore, policy must meet the following conditions:
- To proceed from the goals, and at that time lead to their achievement if they are put into practice.
- To be convincing for all levels.
- Policy should be realistic and feasible.
- Be flexible.
- To be clear.
- Be specific.
- To be written.
- Stems from the reality of the environment in which the institution operates.
- To be characterized by consistency and stability.
- To review constantly to protect it from obsolescence.
Financial Policies Basis
The financial policies are based on the same foundations upon which the general policies of the institution are based. The senior management lays down their broad foundations, and the financial manager undertakes the work to achieve those policies.
It is necessary to review the forms and features of capital expenditures and address the criteria for distinguishing between capital expenditures and revenue expenditures with some explanation, before talking about financial policies. Within the financial policies, we will address the policies related to the following three matters, even some of them will be re-examined when talking about asset management later:
- Asset lease or purchase policy
- Consumption policy
- Sales and distribution Policy
Criteria for distinguishing between revenue capital expenditures
Capital expenditures are defined as those expenditures in order to obtain assets that have a permanent character and those that increase the ability of these assets to generate revenue. It also includes expenditures that are consistent with increasing the productive capacity of the old fixed assets. Revenue expenditures are expenditures whose purposes are exhausted in the production of revenues for that year.
A distinction is made between these two types of expenses based on the following:
- The nature and purpose of the alimony. Expense paid to obtain a fixed asset that grants the institution periodic annual services is considered capital, and it differs from the revenue expenditure from which it is intended to obtain an immediate benefit.
- The period of benefiting from the alimony, where it is used for several years if it is capital, and for one year if it is revenue.
- Periodicity and recurrence. Capital expenditures are not repeatedly spent during the normal activity cycle of the institution, while periodic expenditures are repeated.
- The nature of the institution’s activity, as an expenditure is considered capital in an institution and periodic in another institution that differs in its activity from the first.
Forms and features of capital expenditures
Capital expenditures take many forms and features, including:
- Expenditures for reform resulting in an increase in the productive power.
- Expenses of improvement and renewal that aim to bring about an amendment or change in the structure of the assets in a way that leads to an increase in their productive efficiency.
- Expenses of additions and expansion.
- Modification expenses, such as the expense of modifying a building used as a warehouse used as offices.
- Replacement expenses.
And as mentioned previously, the policy of leasing or purchasing assets, the policy of depreciation of fixed assets and the policy of sale and distribution will be explained in detail as Financial Policies.
Asset Lease or Purchase Policy
The decision to lease or buy are two financial decisions that are usually preceded by a decision to obtain an asset for the institution’s need in its operations.
We have indicated that the objective of the institution obtaining funds is to purchase assets of all kinds, but the institution can use some assets in its operations for a certain period of time without owning them, by purchasing the right to use these assets in return for payment of a fee determined in terms of quantity and time within bases to be agreed upon, and this process of usufruct is called Lease.
The leased assets are not included in the corporation’s assets, because the accounting profession requires ownership to include any of the assets within the corporation’s assets. This may have been the advantage of not including the leased asset and the obligations arising from it in the institution’s budget, one of the factors that encouraged many institutions to expand its use as borrowing outside finance (this situation continued until 1976 when accounting principles stipulated the capitalization of financial leases, where It is included under liabilities the present value of payments and within assets a similar value.
Fixed Assets Consumption Policy
Fixed assets are defined as prepaid expenses that are distributed over a number of accounting periods that are expected to benefit from the services of these assets to generate their own revenue (excluding land).
Accountants called the term consumption on the method of distributing fixed assets symmetrically to the accounting periods benefiting from their services, and the consumption of the period is charged to the calculation of profits and losses. The increase in consumption does not affect the cash, but rather increases it for tax reasons, as we will see later.
Consumption aims to balance the revenues of the period and the costs incurred by the institution (including the use of fixed assets) to achieve these revenues.
The book value of fixed assets by the extent of their depreciation over the years of its use.
Among the other advantages offered by consumption is its taxable reduction, providing the institution with a tax protection, the value of which is calculated as follows:
Consumption Tax Protection = Annual Consumption Value x Tax Rate
In means of financial policies, Consumption is defined as “The distribution of the cost of a long-term asset over its estimated useful life”.
And the consumption can also be defined as “The damage or decline in the value of fixed assets, whether that results from use, time or obsolescence.”
Depreciable assets are assets that meet the following conditions:
- The possibility of using it for more than one financial period.
- That its productive life be limited (no such condition is available on land).
- That the institution owns it for use in production, distribution of goods or services, leasing to others, or for administrative purposes.
Reasons for consumption of fixed assets
Fixed assets are depreciated for the following reasons:
- Physical Deterioration.
- Obsolescence, which may be due to the passage of time or technical developments.
- Legal and other expected limits on the use of fixed assets.
Asset Useful Life
The useful life is the expected life of a depreciable asset, or the number of units the asset is expected to produce before it is retired.
And the estimation of the useful life of depreciable assets is usually based on the experience in the useful life of similar assets in addition to the available technical information, taking into account the previously mentioned depreciation causes. The fourth international accounting principle requires the necessity of reconsidering the useful life of the fixed asset periodically and adjusting the depreciation rates for the current financial period and subsequent periods in the event of a fundamental deviation in the estimates from what was previously estimated.
When defining consumption policy as one of the financial policies, management is faced with the following problems
- Basis for calculating consumption.
- Consumption Calculation Methods.
- The effect and method of consumption used in the institution and how depreciation is used as a tax shield.
The problems related to defining the above consumption policy will be reviewed below.
1. Basics for calculating consumption
Consumption is calculated for a fixed asset based on its historical value, and some researchers have criticized the basis on which this value is based, and instead put forward the replacement value of the asset as a basis for depreciation. .
Often the residual value of fixed assets is not a normal value at the end of their useful life, but the residual value of some items may be important sometimes (scrap).
2. Consumption Calculation Methods
The consumption value is determined based on the historical value of the depreciated asset and according to the following steps:
- Determining the cost of the asset that will be depreciated, and this cost is equal to the purchase price of the asset and the subsequent expenses (transportation, transfer of ownership, installation, customs fees and trial expenses) until it is ready for operation.
- Estimating the expected productive life and determining the accounting periods that will benefit from its services.
- Estimating the expected residual value of the asset, which represents the market value of the asset after the end of the period of benefit from it.
- Determining the depreciable value equal to the difference between the cost and the residual value.
- Distribution of the depreciable value over the number of accounting periods that will benefit from the asset’s services.
Practical Example of Fixed Assets Consumption Policy
Suppose we have the following information about an asset with an organization:
- The cost of the asset = 15,000 dollars
- Its useful life = 6 years
- Its salvage value = 3000 dollars
Usinf this information we can get:
Depreciable value = 15000 – 3000 = 12000 dollars
Annual depreciation, assuming equal years of benefit from the services of this asset = 12000 ÷ 6 = 2000 dollars
And the asset cost appears in the institution’s records as follows:
|Net asset value at the end of the accounting period||13000||11000||9000||7000||5000||3000|
In the previous example, it was assumed equal benefit from different years of fixed asset services, but the practical reality does not support this because there is a discrepancy between the amount of this benefit, so there are many ways to depreciate fixed assets, including:
A. Consumption methods according to time
- The straight-line method.
- Declining Installment Method.
B. Consumption methods according to production
- Actual usage rate.
- Actual penetration rate.
The decision regarding the consumption method is up to the management of the institution, which usually makes its decisions in light of the reduction of external cash flows and the advantages and tax and financial considerations that aspire to.
In the following, we will discuss the most common methods of consumption, which are:
The straight-line depreciation method
The straight-line method is one of the simplest and most widely used depreciation methods. It is preferable to use this method when it is possible to assume that the financial periods benefit from the services of the depreciated asset. The value of the depreciated asset is distributed after excluding the expected residual value at the end of its useful life, an equal distribution over the years of its expected economic life.
The percentage depreciation is obtained by dividing the annual depreciation by the depreciable value.
The annual premium for depreciation is determined according to the following equation:
Annual Depreciation = (Asset Cost – Expected Residual Value) ÷ Estimated life of the Asset
Practical example of straight-line depreciation method
Suppose we have the following information:
The cost of the fixed asset = 220,000 dollars
Expected salvage value = 20000 dollars
Estimated years of production = 5 years
So we can get:
Annual depreciation = (220,000 – 20,000) ÷ 5 = 200,000 ÷ 5 = 40,000 dollars.
The most important advantage of this method is the ease of its calculation, and its most prominent disadvantage is the unequal benefit of the different years from the asset due to the change in its adequacy and the cost of maintaining it over time.
Declining Installment Method
This method is based on the declining installment method on the basis that the productivity of the asset is better in its first years of life than in the later periods, and accordingly, consumption expenses are more in the early years, and decrease in its later years.
The declining installment method is more realistic, because the productivity of the asset is better in the beginning, in addition to the increase in maintenance expenditures and downtime during the last years of the asset’s life.
Rapid depreciation of assets in the early years of their life brings the following advantages:
- Rapid recovery of the investment with the effect of increasing the present value of the recovered amounts.
- Reducing the risk of obsolescence of used assets.
- Reducing the risk of rising prices due to the speed of recovery, especially if there are to renew the machines.
- Reducing the negative effects of the possibility of recession and high tax rates.
- Reducing the profits achieved, and thus the profits distributed, and this means keeping more cash inside the institution.
- Suitable for newly established companies, because it reduces the external ones, as well as the case for companies in the stages of growth.
It is appropriate to point out here that the consumption methods themselves do not provide the company with cash, but what is actually taking place is its role in reducing cash outflows in the form of a reduction in taxes paid due to lower profits when depreciation increases in the early years. Rapid depreciation does not mean actual avoidance of paid taxes, but rather affects the timing of their payment.
The declining-balance method of depreciation is divided into two branches:
A. Double declining balance method
This method neglects the idea of the asset’s residual value when calculating the annual depreciation, but the depreciation calculation stops when the value of the depreciated asset reaches the equivalent of the estimated residual value.
Depreciation calculation steps:
- Determine the depreciation percentage assuming that the asset will be depreciated according to the straight line method.
- Double the percentage extracted in the first item.
- Multiply the ratio by the value of the asset, and the result is considered depreciation for the first year.
- Subtract the depreciation of the first year from the value of the asset, and multiply the remainder by the doubled depreciation ratio, and the result is the depreciation of the second year, and so on.
- Depreciation is stopped when the net asset values reach the estimated residual value.
Practical example of double declining balance method
- The cost of the original = 220,000 dollars
- The salvage value = 20,000 dollars
- Useful life = 5 years
So we get:
Annual depreciation according to the straight-line method = (220,000 – 20,000) ÷ 5 = 40,000 dollars.
Annual depreciation percentage according to the straight line = 40,000 ÷ 200,000 = 20%
Depreciation multiplier = 20% x 2 = 40%
The double depreciation ratio can be extracted directly by the following equation:
2x (1 ÷ n) = 2x (1 ÷ 5) = 40%
|Year||Depreciation percentage||Asset Balance||Depreciation||Accumulated depreciation balance|
It is noted that the depreciation of the last year is the result of the difference between the residual value (20000) and the value of the asset at the beginning of the period (28512 – 20000 = 8512) and not the result of multiplying the depreciation percentage by the value of the asset at the beginning of the period.
B. Sum of the Year Digits method
This method is based on depreciating the cost of the fixed asset (after excluding its estimated residual value) at a high rate in the first year, and it gradually decreases as its productive life progresses.
The goal of this depreciation method is the same as the goal of the previous method, which is accelerating depreciation in the early years of the productive life of the fixed asset at the expense of recent years, and some countries have allowed this method to be followed in periods of inflation and high prices.
Depreciation calculation steps:
The following steps will be built on the same assumptions as the previous example:
- Determining the sum of the years of the useful life, which was previously assumed to be (5) years and equal to:
Total years of useful life = 1 + 2 + 3 + 4 + 5 = 15
2. The annual depreciation rate is a fraction of the denominator of the total years of the useful life, and its numerator is the number of remaining years of the useful life calculated from the beginning of the financial period:
First fraction = 5/15
The second fraction = 4/15
Thus, in the end, we have the following fractions:
5/15, 4/15, 3/15, 2/15, 1/15
3. The first fraction is multiplied by the depreciable value of the asset (cost – salvage value) and the result is considered the depreciation of the first year.
4. The second fraction is multiplied by the depreciable value, and the result is considered the consumption of the second year, and so on for the rest of the years.
Practical example of Sum of the Year Digits metho
In the same last example:
The cost of the original is 220,000 dollars
The salvage value = 20,000 dollars
Useful life = 5 years
So we get:
1. Total years of useful life = 1 + 2 + 3 + 4 + 5 = 15
2. The depreciation fractions for the five years (from 1 to 5) are:
5/15, 4/15, 3/15, 2/15, 1/15
3. Depreciable asset = 220,000 -20000 = 200,000
4. depreciation of the 5 years:
|Year||Annual depreciation rate||Asset depreciable value||Annual depreciation value (=2×3)|
(Note that the total depreciation in the five years = 200,000)
C. The number of production units
The number of units that an asset can produce during its expected useful life is estimated.
If, in our previous example, we estimated the number of units expected to be produced throughout the production period of the asset as (400) thousand units, then the cost of producing the unit from the value of the asset used in production is estimated as follows:
The value of the unit produced = (Asset Cost – Salvage Value) ÷ Number of units expected to be produced
By substituting for this using the assumptions of the previous example and the number of units referred to in the previous paragraph, we get, with respect to each unit of depreciation, of the asset used in production:
Depreciation per unit produced = (220,000 – 200,000) ÷ 400,000 = 1 / 2 = 0.5 dollars
If the number of units produced per year = 100,000 units, then:
Annual consumption = 100,000 x 0.5 = 50,000 dollars.
There are cases that some institutions calculate depreciation for tax purposes in a certain way and for the purposes of financial statements in another way, where the accelerated depreciation is used for tax purposes, and the straight-line method is used for the purposes of the financial statements.
3. The effect of depreciation methods on tax, profits and cash flow
The depreciation method adopted has a temporary effect on the institution in the field of paid tax, net profits and cash flow as well, as the adoption of different depreciation methods leads to a discrepancy in the tax, profits and cash flows for one period, although the final sum of these three elements over the time period required to depreciate the asset is One, that is, the effect of depreciation is a temporary effect that is limited only to a single period of time within the life of the depreciated asset. When you follow the accelerated depreciation method, for example, depreciation increases in the early years, profits decrease, the tax burden is reduced, cash flow improves, and the situation is reversed in the last years of the life of the consumer asset.
Although the final outcome is the same for tax, profit and cash flow regardless of any consumption method followed, accelerated consumption has an advantage in favor of the institution, if we take into account the time value of money, as the consumption in the early years is high, and the profit is as a result low, as well as the tax. In other words, it can be said that accelerated depreciation leads to a delay in the payment of tax for later periods, and this means that the institution obtains an interest-free loan from income tax that will continue until it is paid in subsequent years through a higher tax.
It should be noted that some countries do not use the accelerated depreciation method, because their tax laws do not allow it.
Finally, it must be pointed out that depreciation does not constitute a source of the institution’s funds and does not constitute a use of it, because it is a distribution of the cost of the long-term asset over its estimated productive life in order to meet the period’s revenues with its expenses. Also, the cost of the asset is in fact a cash flow that has been paid in advance, but the benefit from it is not limited to the period in which the actual payment for its value occurred. So the process of distributing its value takes place on the periods benefiting from its productivity.
Disclosure of depreciation in the financial statements
Generally accepted accounting principles require disclosure of the following information:
- Depreciation method.
- The estimated productive life, or consumption rates.
- The cost of the asset and accumulated depreciation.
Sales and Distribution Policy
The institution draws up its financial policies in selling and distribution in order to reach the maximum possible extent of sales. These financial policies are usually drawn up within the following determinants:
- Sale policy, will it be done in cash or on credit?
- Financial policies of trade discount, quantity discount and expediting payment.
- The duration and conditions of the credit that can be granted.
- Financial Management Reference, MDRS Center, 2022.