UNIT-II
DEPRECIATION
Definitions
In the AS-6 the depreciation is defined as, “Depreciation is a measure of wearing out . Consumption or other loss of value of a depreciable asset, arising from use, affluxion of time or obsolescence through technology and market changes. Depreciation is allocated so as to change a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortization of asset whose useful life is predetermined.”
As per International Accounting Standards Committees, “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life. Depreciation for the accounting period is charged to income either directly or indirectly.”
According to J.H. Burton, “Depreciation is the shrinkage in the value of an asset at a given date as compared with value at a previous date.”
From the above definition it is clear that depreciation is gradual fall in the value of the assets due to some reasons.
Characteristics of Depreciation
1. Depreciation is a gradual, permanent and continuous decrease in the utility value of a fixed asset.
2. Depreciation is a process of allocation of the cost to the period of its life and not a valuation of fixed assets.
3. Depreciation is not a substitute for repairs but it is provided for in addition to the repairs and maintenance.
4. Deprecation arises due to use of assets in productive activities.
5. Depreciation is based on cost of the asset and not on the market value of the fixed assets. 6. Deprecation is charged in respect of fixed assets.
7. Depreciation is a charge against profit.
8. Total depreciation of an asset cannot exceed its depreciable value ( cost less scrap value)
Reasons of Depreciation.
1. Wear and Tear of Assets:- Due to constant use of the tangible assets as plants and machinery, furniture and fixtures, in the business, the assets get worn and torn and they lose their value.
2. Efflux of time- On the passage of time some assets get their values down as lease hold property.
3. Obsolescence – Due to new inventions, some assets are discarded whether they are worn out or not. Such a loss due to new invention is called loss due to obsolescence.
4. Accidents:- On account of the accident as fire, earthquake, etc. the assets get their value depreciated.
5. Exhaustion;- After a long work, a machine get exhausted and it gets it Values decreased.
Significance of Depreciation
a. To present the assets at its true value in balance sheet b. To ascertain the correct profits or losses
c. To create a fund for the replacement of assets
Methods of Recording of Depreciation
a) When provision for depreciation account is maintained Under this method the following journal are passed in the books of owner:
i. When depreciation is charged on assets
Depreciation account Dr.
To Provision for Depreciation account
ii. When depreciation is transferred to P&L a/c
P&L account Dr.
To Depreciation account
iii. When asssets are sold on the expiry of useful life of the assets
Provision for depreciation account Dr. To assets account
Assets account Dr. To P&L account
v. If there is any loss on the sale of assets
P&L account Dr.
To Assets account
b) When provision for depreciation account is not maintained
Under this method the following journal are passed in the books of owner:
i. When depreciation is charged on assets
Depreciation account Dr.
To Asset account
ii. When depreciation is transferred to P&L a/c
P&L account Dr.
To Depreciation account
iii. When assets are sold at a profit on the expiry of useful life of the assets
Cash account Dr.
To assets account To P&L account
In case of loss above entry is reversed Methods of Providing Depreciation
There are various methods of allocating depreciation over the useful life of the assets. The method of providing the depreciation is selected on the basis of various factors as types of assets, nature of business, circumstances prevailing in business, etc. These methods are given below:
1. Straight Line Method or Fixed Installment Method
2. Diminishing Balance Method or Written Down Value Method 3. Annuity Method
6. Revaluation Method 7. Depletion Method
8. Machine Hour Rate Method
1. Straight Line Method or Fixed Installment Method
This method is also known as fixed installment method. In this method, depreciation is ascertained on the original cost by a fixed percentage keeping in mind the scrap value of the assets. Under this method the amount of depreciation remains uniform/fixed and the value of the asset becomes zero at the end of its life. It may also be calculated by the following formula:
Depreciation = (Original cost – Scrap value)/ Estimated life of the asset
Merits
i. This method is very simple and easy to use
ii. The value of the asset becomes zero at the end of the life of the assets as total value is divided by the life of the assets.
iii. This method is suitable to such type of assets which take physical deterioration as buildings, leasehold properties, etc.
Demerits
i. The amount of depreciation does not change while the amount of repairs and renewal increases with the passage of time.
ii. Under this method the amount of depreciation is not invested outside the firm. Therefore, there is a loss of interest.
iii. If any asset is purchased during the year , depreciation is calculated separately. iv. This method is not recognized in income tax rules.
2. Diminishing Balance Method
This method also known as written-down-value method. In this method depreciation is calculated on diminishing value but rate of depreciation remains constant. The amount of depreciation on assets decreases every year but the value of the asset do not becomes zero. Rate of depreciation can be determined with the help of cost of assets, scrap value and useful life of the assets. The formula to compute the rate of depreciation is given below.
Rate = 1-n/s/c x100
Where, N for number of years of useful life of the asset
S= for scrap value
R= for rate of depreciation
3. Annuity Method
Under this method depreciation on assets is calculated keeping into account the cost of assets along with interest thereon. In other words, if a firm purchases a plant of Rs.50, 000 and it only provides depreciation of Rs.10, 000 every year, after five years it will collect fund of Rs.50, 000 to replace the new plant. In this case one point is ignored that interest means if this firm invested this amount of Rs.50, 000 in some other form of securities on the place of buying assets. It would get return some interest along with the principal amount of Rs.50000. In this method the amount of depreciation is determined by adding the depreciation and interest thereon. The amount of depreciation is computed with the help of annuity table. Under this method the following journal entries are passed for depreciation and interest thereon.
1. When depreciation is charged on Assets
Depreciation Account Dr.
To Assets Account
2. When interest on cost of assets is calculated and showed
Assets Account Dr.
In Interest Account 3. When interest is transferred to P&L A/c
Interest Account Dr.
To P.& L Account
4. Depreciation Fund Method or Sinking Fund Method
This method is designed in such a way so that the accumulated amount may be readily available to replace the assets on the expiry of the useful life of the assets. Under this method a sinking fund is created with the amount of depreciation on assets. An equivalent amount of the depreciation is invested in some government or marketable securities each year and the amount of interest on these securities is also reinvested in same securities. On the expiry of the economic life of the assets, these securities are sold in the market and from the amount realized, the old assets are replaced. If there is any profit or loss from the sale of these securities, that is transferred to the profit and loss account. To adopt this method the following journal entries are passed.
1. At the end of first year, when depreciation (which is calculated with the help of sinking fund table) is charged and transferred to sinking fund or depreciation fund account.
Depreciation Account Dr.
To Sinking Fund Account
To Depreciation Account
Alternatively in the place of above two entries, the following one entry may be passed P & L. Account Dr.
To Sinking Fund Account
3. When at the end of 1st. Year, an equivalent amount to the depreciation is invested in some securities
Sinking Fund Investment Account Dr. To Cash/Bank Account
4. At the end of second year when interest on the first year’s sinking fund investment is received
Bank Account Dr.
To Sinking Fund Account 5. When depreciation on assets is charged
P & L. Account Dr.
To Sinking Fund Account
6. When annual installment of depreciation along with the interest received on previous year’s investment is invested in some securities
Sinking Fund Investment Account Dr. To Bank Account
For the subsequent years the same pattern is adopted.
7. On the expiry of the economic life of the assets, if S.F. investments are sold at profit
Bank Account Dr.
To Sinking Fund Investment Account To Sinking Fund Account (profit on sale) If there is loss on sale of investment
Bank Account Dr.
Sinking Fund Account Dr.
To Sinking Fund Investment A/c 8. When old assets are sold
Bank Account Dr.
To Assets Account
9. When the balance of sinking fund account is transferred to assets account
Sinking Fund Account Dr.
To Assets Account
` 10. The balance of assets account (if any) transferred to P& L account
To Assets Account
Or
Assets Account Dr.
To P & L Account (Profit)
5. Insurance Policy Method
The method is similar to the sinking fund method. Under this method to replace the assets. An insurance policy is taken by the firm. Amount of premium is paid by the annual amount of depreciation while under the sinking fund method; some securities were bought by the firm. The amount of premium with interest accumulates with the insurance company. On the expiry of the useful life of the assets the insurance policy matures. On maturity the amount is made a available by the insurance company which is used for the purchase of new assets. Thus this method provides more safety and liquidity to the funds. Under this method the following journal entries are passed.
1. When depreciation is charged –
P&L. Account Dr.
To Depreciation Fund Account 2. When amount of premium is paid
Depreciation Fund Policy Account Dr.
To Bank Account
3. When amount of policy is received from insurance company on maturity
Bank Account Dr.
To Depreciation Fund Policy Account
4. There may be profit or loss on the policy that is transferred to the depreciation fund account. Then following entry is passed for profit.
Depreciation Fund Policy Account Dr. To Depreciation Fund Account
For
Loss-Depreciation Fund Account Dr.
To Depreciation Fund Policy Account 5. When new assets are
acquired-Assets Account Dr.
To Bank Account
6. Revaluatioon or Appraisal Method
periods is called depreciation or appreciation of that period. Generally, this method is used in the case of live-stock, copyrights and parents.
7. Depletion Method
It is also known as production method. This method is useful for natural assets as coal mines, oil wells, etc. These are taken for excavation for a definite period on the contact basis. In this case the depreciation is computed on the basis of production. First the total production of the contract period is estimated. then total depreciable cost is divided by the total production and multiplied by annual output to determine the annual amount of depreciation. In the form of formula
Annual Depreciation = Annual Output/Total Estimated Output
8. Machine Hour Rate Method
When depreciation is calculated on the basis of working hours of the machine or plant. This method is used. The original cost of plant or machinery is divided by the total number of working hours of the machine or plant to find the machine hour rate. To compute the depreciation of a year the machine hour s of the machine/plant in a year. This procedure may be explain in the following formula
Machine Hour Rate = Original Cost of Machine/Total Working Hours of the Machine During its Life
Annual Depreciation = Machine Hour Rate x Working Hours in a year.
INVENTORY VALUATION
In America the word ‘ Inventory’ is used for the unsold or unused goods in store and in England
the word ‘ Stock’ is used for the unsold and unused goods in stock. But in India both the terms ‘
Stock’ and ‘Inventory’ are used for the unsold and unused goods in stock. There is no difference
in these two terms. For the accuracy of the balance sheet and profit and loss account, the
proper valuation of inventory is required. It is the second largest item after fixed assets in the
balance sheet. Therefore more and more significance is given to the inventory control and
inventory valuation.
Definition of Inventory
As per Accounting standard ( AS-2) of ICAI , inventories mean the tangible property held for
a) Sale in the ordinary course of business
b) The processes of production for such sale; or
c) Production process in the rendering of services
a) Finished goods in stock
b) Work-in – progress in stock
c) Raw materials for production in stock
d) Loose tools and spare parts for production
However , AS-2 excludes the following items for the term inventory:
a) Work-in-progress arising under construction contracts
b) Financial instruments
c) Biological assets related to agricultural activities and agricultural produce at the point of
harvest.
Objectives of Inventory valuation
a) Determination of accurate Income
b) Determination of Financial Position
Systems of Stock Keeping
There are two systems of stock keeping
a)
Periodic Inventory System
: Under this system of inventory, value and quantity of the
inventory is dternined at the end of a particular period. Counting of stock is done as per
the nature of the stock.
b)
Perpetual Inventory System
: Under this system of inventory, different registers are
maintained for different stocks as finished goods, work-in-progress and materials.
Balance of inventory can be determined at any time desired. Therefore, it is also called
automatic inventory system.
PRICING ISSUES OF MATERIAL
Materials issued from stores should be valued at the rate they are carried in stock. Materials
are valued at cost and entry in the stores ledger is made with every receipt. Different lot of
materials may be received at different prices. Hence, when issues are made from stock, it may
happen that materials from more than one lot may have to be issued. Which price will be
applicable in such case? Actual cost or average price, market price or notional price? Various
methods for pricing materials issued from stores are classified in the following manner:
A. Cost price methods :
i) Specific price
iv) Highest in, first out (HIFO)
v) Base stock price.
B. Average price methods:
i) Simple average
ii) Weighted average
iii) Periodic simple average
iv) Periodic weighted average
v) Moving simple average
vi) Moving weighted average
C. Current price methods :
i) Replacement price
ii) Next in, first out (NIFO)
D. Notional price methods :
i) Standard price
ii) Inflated price
iii) Re-use price
A.(I) Specific Price Method
Specific price method is applicable to materials purchased for a particular job, order or process,
and are identified when received either in stores or in the shop floor directly. Such materials
are usually nonstandard and the actual cost is charged to the job or order or process
concerned. No question of difference arises out of such pricing.
A.(II) First In, First Out (FIFO)
This method assumes that materials are used in the order in which they are received in stores.
Hence, the price of the first lot is charged to all issues till the stock lasts. In other words, the
issues are priced in the chronological order of receipts. As a result, closing stock will be
valued at latest purchase price.
Advantages :
a) Simple method to understand and operate.
b) Material cost represents actual cost which should be charged to product or process.
c ) Stock value is closer to current price.
Disadvantages:
a) In fluctuating price and too many purchases and issues, this method will involve more
calculations.
c ) If price changes frequently, comparison of one job with the other will not serve useful
purpose. Similar jobs will have different costs because of price change.
d) Adjustment for rejection and returns become complicated.
A.(III) Last In, First Out (LIFO)
This method assumes that the last receipt of stock is issued first. The method has advantage
under inflationary condition of the market. Using the same data of the earlier illustration, the
issue prices and closing stock valuation of the material will be as follows :
Advantages:
a) Issues are charged at current price, which is more appropriate.
b) Profit is realistic.
c ) Since issues are charged at actual cost, no adjustment for profit or loss is necessary.
Disadvantages:
a) Stock-value does not represent current market price.
b) Unfair comparison of job cost when price changes too frequently.
c ) Like FIFO, this method also involves too many calculations, if frequent price changes
occur and purchases are made in small lots.
However, the method is useful for materials used,
less frequently and under inflationary condition.
A.(IV) Highest In, First Out (HIFO)
Under this method, issues are valued at the highest price i.e. costliest items are issued first,
and inventory is kept at lowest possible price. Thus, a secret reserve is created by undervaluing
stock. This method is complicated to administer, if there are numerous purchases within short
period.
A (V) BASE STOCK METHOD
This method assumes that a minimum stock is always carried at original cost. The issues are
priced using one of the conventional methods, i.e. FIFO or LIFO, at actual cost. In the given
The advantages and disadvantages of FIFO and LIFO methods will apply to this method also.
This method is suitable in tanning, smelting, oil refineries, etc. using basic raw materials like
hides, nonferrous metals and crude oil for their products.
B(I) Simple Average
Advantages:
a) Easy to operate.
b) Gives reasonably accurate results, if prices do not fluctuate, and purchase quantities
are similar.
Disadvantages:
a) Under fluctuating prices and purchase of different quantities at each time, this method
gives incorrect results.
b) Verification of closing stock becomes difficult.
c ) Value of closing stock may indicate absurd figure, in case of violent price changes.
The method can be applied when materials are received in uniform quantities and purchase
prices do not fluctuate significantly.
B.(II) Weighted Average Method
Unlike the simple average method, this method gives due importance on quantities received
also. Issue prices are calculated at the average cost price of materials in hand, i.e. by dividing
value of materials in stock by the quantities in stock. Weighted average rate is calculated each
time a fresh lot is received. Average price remains the same till the next issue is received. Thus,
issue prices are derived at the time of receipt, not at the time of issues. In the given
Advantages:
a) Easy to calculate and operate.
b) When prices fluctuate considerably, it smooths out the fluctuations.
c ) Closing stock value is acceptable.
Disadvantages:
a) Since issues are not valued at actual cost, profit or loss may occur.
b) Issues and closing stock are not at current cost.
This method is suitable where wide fluctuation of prices occur, as it evens out prices over the
accounting period.
B.(III) Periodic Simple Average
Under this method, simple average price is calculated periodically, say, monthly or quarterly,
and not at each receipt or issue. Similarly, issues for the period is totalled and valued at the end
of the period. Receipts are maintained on perpetual inventory basis to ensure adequate control
of stock.
Advantages
and
disadvantages
a) Very simple to operate.
b) Issues can be valued only at the end of the period. Hence, it could be useful where
process costing is applicable.
B.(IV) Periodic Weighted Average Method
Periodic weighted average rate is calculated at the end of each period, say, a month,
with reference to the purchases made during the same period, and shall be applicable to the
total issues made during the period. Records are however maintained on perpetual inventory
system as shown in the previous example.
B.(V) Moving Simple Average
This is calculated by dividing the total of the periodic simple average prices of a given period,
including the period of issue by the number of periods. The moving average method may be
used to even out price fluctuation. The effect of using the average prices of a number
of periods is that in conditions of rising prices, a price is used which is lower than the
corresponding periodic simple average price, as will be evident from the following example.
Month
Periodic
5-monthly Moving Periodic 5-Monthly
Moving
simple
moving
simple
simple
moving
simple
average
total
average
average
total
average
price
B.(VI) Moving Weighted Average Method
This method is similar to the previous method with the difference that instead of simple
average, weighted average prices of monthly average is adopted. This system renders more
accurate results for considering quantity as well as prices for arriving at weighted average.
C(I) Replacement Price
Under this method, issues are valued at the replacement price prevailing in the market on the
date of issue. The system presupposes that material identical to that which is being replaced or
revalued could be purchased.
Advantages:
a) It is easy to operate, as no calculation is involved for ascertaining issue prices.
b) The issues are priced at current market price.
Disadvantages:
a) Not easy to get market price daily.
c ) Valuation of closing stock will not be at current market price. This method is not applicable
in case of material of daily use.
C(III) Next In, First Out (NIFO)
Under this method, issues are valued at the price expected for the next purchase i.e. price of
the material which has been ordered but not yet received. The problem will arise, if the price
ruling at the time of supply differs from the purchase order price. However, this method
attempts to value issues at nearest to current market price.
D.(I) Standard Price
It is a predetermined price fixed on the basis of a specification of all the factors affecting the
price of material in a future period. It is normally a part of the process of standard cost
system. Under this method, standard prices in respect of each type of material is fixed and all
the issues are valued at standard price. The difference between the standard and actual prices
results in material price variance. Such variance can be calculated at the point of purchase i.e.
on receipt of materials or at the point of consumption or issues to production. In the former
method, the stores ledger is maintained at standard price, while the same is maintained
at actual price, when the latter method is adopted.
Advantages:
a) It reveals the efficiency of purchase department.
b) It is easy to operate as only one standard rate prevails for the period, say, a year.
c ) Comparison between jobs or processes can be useful.
d) Reduces clerical cost.
Disadvantages:
a) It is difficult to determine standard price during fluctuating market conditions.
b) Issues are not made at actual or current cost, which should be charged to products.
c ) Adjustment is required for closing stock valuation at the year end.
d) The trend of actual prices will not be available from the stores ledger.
D.(II) Inflated Price
Under this method, price of materials is inflated by including all costs incurred till they are
used. That is, apart from the invoice price, which includes the cost, insurance, freight and taxes
les
s discounts, other related expenses like cost of receiving, inspection storing and
carrying, handling of materials and losses arising out of evaporation and breaking bulk, etc.,
which are otherwise charged to production overheads, are also added to determine material
price for issues. This is not a separate method of pricing, but a principle, which can be
adopted with any of the methods described earlier.
D.(III) Reuse Price
or excess material is applied for an alternate use. The reuse price will naturally be lower than
actual price. However, the price should be more than its scrap value.
PRICING OF RETURNS, TRANSFERS, SHORTAGE AND EXCESS MATERIALS
A. Returns from Production to Stores
Material Return Note shall be prepared by the production department returning materials to
store with full description, code No. and quantity returned. If the price at which the material
was issued to production department is known, then same price will be applied. If not, latest
issue price will be applicable.
B. Returns to Suppliers
Sometimes materials are accepted after inspection, and yet are not usable by
production department due to some defects which could not be detected at the time of
inspection. These materials, after inspection by the suppliers, are returned to them. Such
materials shall be valued at invoice price at which they were supplied originally.
C. Transfer Inter-department
Excess material of one job may be used by another job, if required, instead of returning the
materials to stores and again requisitioning for other job. Similarly, excess material of one
production department can be conveniently transferred to a neighbouring production
department, if required by the latter, instead of returning to the stores. This saves double
handling with associated loss. In both cases a Material Transfer Note shall be prepared by the
transferor department indicating transfer from job/production department to the transferee
job/department with description, code no. and quantity transferred, and receipted by the
transferee department One copy of the MTR shall be sent to stores while the original copy will
be sent to costing department for pricing at the same rate at which the material was
issued to the transferor. department as per material requisition note.
D. Shortage and excess found during Physical Verification
The shortage or excess found during physical verification shall be entered in the issue column
on the basis of stock verification adjustment note, and shall be valued at the last issue price
depending on the method i.e. FIFO, LIFO, Wtd. average, etc. followed by the unit. Excess
quantity should be shown as deduction from issues, and not as receipt.
VALUATION OF CLOSING STOCK FOR BALANCE SHEET
