Session 3: Basic Accounting, Finance and Economic Concepts and Approaches [2 HRS]Learning Outcomes
To understand the basic concepts in Accounting, Finance and Economics used in the ICT Industry.
Following are definitions of a number of terms and concepts as they are used in accounting, finance and economics. This chapter covers the most common concepts which may create some confusion if they are not well understood from the beginning. Cost: In accounting a cost is used to explain the value of a product or services. One may ask how much does it cost. In such a situation a cost reflects the value of the product or service. Opportunity Cost: To an economist a cost may not necessary reflect the monetary value one is ready to surrender but rather what the foregone value of an action is. For example, an economist uses the term opportunity cost to mean what is the foregone value of not taking a particular action. Cost of Capital: To reflect the return expected by the investor in a firm, if the firm is financed by all equity then the cost of capital is the return which the shareholders of the firm expect to receive for the risk they have taken in investing in the firm. If the firm is financed by debt and equity then the cost of capital is the expected return to both the shareholders and the debt holders. More details of the concept of cost of capital are covered in Module 2. Costing Methods and Models
In this section different costing approaches will be discussed as they relate to the ICT industry. Unit cost: This refers to the standard cost required to produce a product or provide services. Fixed and Variable Costs
• A fixed cost is that cost which does not vary with the level of activity within a specified range.
• A variable cost is that cost which varies with the level of activity within a specified range. Full costing
All cost involved in producing a product or providing services are included. It is computed by adding all cost elements, that is, adding the total per unit fixed costs plus total per unit variable costs as shown below: Full Cost = Total Fixed Costs + Total Variable Costs
Incremental costing
These are additional costs required to produce a product or provide services. The calculation of this type of costing involves adding only those costs which are additional (both the variable and fixed) and which increase as a result of increased volume of activity.
Total Incremental Cost = Total Variable Costs + Additional Cost Direct Costs
Direct costs are costs which relate directly to the cost of goods produced or the provision of services. These can be traced directly to the products or services. Such costs are direct materials for producing a product. E.g. the phone chip, phone handset, and labour used to produce a telephone. Indirect Costs
These are the costs which are not directly related to production of the good or seervice, such as utilities, administrative costs, etc. Such costs need to be apportioned. Historical Costing
The is a costing method based on historical prices. For example if you are computing depreciation the cost of the asset at the purchase time is considered a historical cost. Depreciation
This is a non-cash expense (also known as non-cash charge) that provides a source of free cash flow. Amount allocated during the period to amortize the cost of acquiring long-term assets over the useful life of the assets. To be clear, this is an accounting expense not a real expense that demands cash. The sum of depreciation expenses of prior years leads to the balance sheet item Accumulated Depreciation
Economic Vs Accounting Depreciation
Definition of depreciation can be divided into categories, economic depreciation and accounting depreciation (refer to Alexis, Henry Ergas, John Small, 1999). The basic conceptual difference between them is that economic depreciation involves a process of valuation, while accounting depreciation deals with allocation.
Economic depreciation can be defined simply as the period-by-period change in the market value of an asset. The market value of an asset is equal to the present value (see Module 3) of the income that the asset is expected to generate over the remainder of its useful life. In contrast, accounting depreciation reveals the decrease in market value of an asset over a period of time. Accounting depreciation, under historical cost accounting, means the allocation of the historical cost of a fixed asset to the periods in which services are received from the assets. It is the wear and tear which reduces the value of the asset in generating revenue. Accounting Depreciation methods
Common accounting depreciation methods are: the straight line method, which is widely used, declining balance method, sum-of the years digits, the constant percentage, the annuity and the sinking fund methods. - Straight-line method
Straight line is a simple and widely used method for computing depreciation. According to the method, an equal portion of the initial cost of an asset is allocated to each period of use. This method is most appropriate when usage of the asset is fairly uniform year to year. The computation of the periodic charge for depreciation is computed by deducting the estimated residual or salvage value from the cost of the asset and dividing the remaining depreciable cost by the years of estimated useful life. 
- Declining Balance Method
Declining balance is an accelerated depreciation method. The method charges more depreciation in the early life of the asset hence recognizing that the asset is used to generate profits less and less as it gets older. - The argument is that an asset is more efficient when it is new, hence with technological changes like in the ICT there is logic for charging more depreciation in the earlier periods. Usually as the asset gets older the repair and maintenance costs also increase.
- In the declining method the rate of depreciation is increased and applied to the declining balance (net book value) of the asset.
Example: Assume an asset is bought at a cost of $ 4,000 and has an estimated useful life of ten (10) years. The normal rate of depreciation using the declining method would be 10 percent (US $ 4,000/10 years = US $ 400 per year /US $ 4000= 10%). Using the declining method the rate would be 15 per cent which is higher than the 10%. The effect would be a depreciation expense of US $600 for the first year (an increase of $200 over the straight line method). The depreciation expense for the second year would be US$ 510 (15% on the remaining balance). The expense would decline for the subsequent years until year ten when the rate will be very small. For more depreciation methods refer to Alexis, Henry Ergas, John Small, 1999. Why Should you Bother with Depreciation Methods?
When you want to find the value of the asset one has to know which method has been used in computing depreciation. While the straight-line method distributes equally the deprecation value, other methods lead to a different depreciation expense. For example the declining balance charges more depreciation in the first years of the asset’s life and less in the final periods. This leads to higher depreciation expenses in the early years of an asset’s life and hence lower reported earnings. With the lower reported earning, the Price Earning Ratio (PE) (which many investors use as one basis of assessing the wealthyness of a firm) will be higher than it would be if straight line depreciation were used. To the regulator when two firms have used different depreciation methods the financial statements may not reflect the same status. That is why in accounting, consistency and comparability principles have to apply. It is important for the regulator to make sure that the depreciation methods used or any methods used are the same. Regulatory bodies in different countries should therefore institute regulations which make the financial statements of different firms comparable. Economic Depreciation
This is the decline in the earning power of the asset, and this is not based on the accounting calculations but rather on what it costs to replace an asset. For more terms and concepts Link to the Glossary of terms. Discussion 2
Please answer the following questions and post your response to Discussion 2 in the KEWL discussions area. Remember to respond to a classmate’s posting as well. (Read the class discussion procedures in the Course Info chapter.) - Explain the difference between Finance and Economics.
- What does cost mean to you (telecommunication regulator, operator, or consumer)?
- How do direct and indirect costs affect costing of services or products offered in the Telecommunication Industry? Give examples of direct and indirect costs for a mobile telephone service company.
Individual Assignment
Using financial statements of at least three telecommunication companies. i) Assess the methods of depreciation used
ii) Evaluate the reported profits among the firms
iii) Comment on the results | 
