S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70 Page 1 Financial Accounting Sandeep Kumar Mishra Asst Prof. Finance Astha School of management Module II Recognition of Transactions Verifiable objective evidence concept Under this concept each entry must have documentary proof so that it can beverified as and when required. An auditor has to give certificate of the accuracy of the accounts. He does so after verifying the entries on the basis of documentary proof. These documentary proofs are papers, letters, agreements, cash, memo, invoice, bills, money receipts, agreement papers, etc. Revenue and Expense recognition Capital and Revenue Expenditure All expenditure, which results in the acquisition of permanent assets, which are intended to be continually used in the business for the purpose of earning revenue, is called capital expenditure. In other words, the expenditure, which yields benefits for a long period, is termed as capital expenditure. The term capital expenditure is generally used to signify that expenditure which Increases quantity of fixed assets, Increases quantity of the fixed assets, Results in the replacement of fixed asset. The quality of fixed asset said to be increased, when expenditure results in any or some of the following events: When probable useful life of the fixed asset increases When capacity of the fixed asset increases When efficiency of the fixed asset increases When quality of its output increases beyond that originally anticipated. Example: Acquisition and purchase of fixed assets. land, building, plant and machinery, furniture and fixtures etc. Expenditure related to erection or installation of fixed assets. Expenditure on legal charges in relation to fixed assets. Etc. Cost of replacing petrol driven engine to a diesel driven engine. Expenditure incurred for increasing the sitting accommodation in a cinema hall or restaurant. Expenditure incurred for acquiring some right to carry on business. E.g., copy right, goodwill, trademark, patent rights etc. Expenditure incurred on major repairs and replacement of plant and machinery or any other fixed asset, which results in, increased efficiency. Revenue Expenditure: When the benefits of the expenditure expires within one accounting period is referred to as revenue expenditure. These are recurring in nature. Normally, the day to day expenses incurred during regular course of business are revenue expenditure. All expenses incurred by way of repairs, replacement of existing assets, which do not in any way add to their earning capacity but simply serve to maintain the original equipment in an effective working order are charged to revenue expenditure. Or simply the benefit of the expenditure expires within one accounting year; it is referred to as revenue expenditure.
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S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70 Page 1
Financial Accounting Sandeep Kumar Mishra Asst Prof. Finance Astha School of management
Module II Recognition of Transactions
Verifiable objective evidence concept Under this concept each entry must have documentary proof so that it can beverified as and when required. An auditor has to give certificate of the accuracy of the accounts. He does so after verifying the entries on the basis of documentary proof. These documentary proofs are papers, letters, agreements, cash, memo, invoice, bills, money receipts, agreement papers, etc.
Revenue and Expense recognition Capital and Revenue Expenditure All expenditure, which results in the acquisition of permanent assets, which are intended to be continually used in the business for the purpose of earning revenue, is called capital expenditure. In other words, the expenditure, which yields benefits for a long period, is termed as capital expenditure. The term capital expenditure is generally used to signify that expenditure which
Increases quantity of fixed assets, Increases quantity of the fixed assets, Results in the replacement of fixed asset.
The quality of fixed asset said to be increased, when expenditure results in any or some of the following events:
When probable useful life of the fixed asset increases When capacity of the fixed asset increases When efficiency of the fixed asset increases When quality of its output increases beyond that originally anticipated.
Example:
Acquisition and purchase of fixed assets. land, building, plant and machinery, furniture and fixtures etc.
Expenditure related to erection or installation of fixed assets. Expenditure on legal charges in relation to fixed assets. Etc. Cost of replacing petrol driven engine to a diesel driven engine. Expenditure incurred for increasing the sitting accommodation in a cinema hall or restaurant. Expenditure incurred for acquiring some right to carry on business. E.g., copy right,
goodwill, trademark, patent rights etc. Expenditure incurred on major repairs and replacement of plant and machinery or any other
fixed asset, which results in, increased efficiency. Revenue Expenditure:
When the benefits of the expenditure expires within one accounting period is referred to as revenue expenditure. These are recurring in nature. Normally, the day to day expenses incurred during regular course of business are revenue expenditure. All expenses incurred by way of repairs, replacement of existing assets, which do not in any way add to their earning capacity but simply serve to maintain the original equipment in an effective working order are charged to revenue expenditure. Or simply the benefit of the expenditure expires within one accounting year; it is referred to as revenue expenditure.
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Example: Expenses incurred in the normal course of business, administrative expenses, selling expenses,
manufacturing expenses, insurance, rent, postage, stationery, repairs to assets etc. Expenses incurred to maintain the business. Cost of stores consumed in the course of manufacturing, i.e.
oils, cotton-waste, machinery spares consumed. Cost of goods purchased for resale. Depreciation on fixed asset, interest on loans for business, loss from sale of fixed asset. Obsolesce cost.
Accounting Treatment of Capital and Revenue Expenditure All revenue expenses are taken to the debit side of the profit and loss account. All capital expenditure is shown in the assets side of the balance sheet. The expired portion of the capital expenditure is taken to the debit side of the profit and loss account. Ex: depreciation is charged to profit and loss account. Difference between Capital and Revenue Expenditure Capital Expenditure Revenue Expenditure 1. Benefit of such expenditure is available for a long period of time may be for several financial years.
Benefits of such expenditure are available for one financial year.
2. These expenses are non-recurring in nature.
These expenses are recurring in nature.
3. These expenses are incurred for the acquisition and improvement of assets.
These expenses are incurred to earn profits. Normally, the day-to-day expenses incurred during regular course of business are revenue expenditure.
4. The expired portion of such expenditure is shown in the Profit & Loss Account and the Unexpired portion is shown in the Balance sheet.
These expenses are charged to Profit and loss account.
5. Examples are Acquisition and purchase of fixed assets., land, building, plant and machinery, furniture and fixtures etc.
Examples are administrative expenses, selling expenses, manufacturing expenses, insurance, rent, postage, stationery, repairs etc.
Deferred Revenue Expenditure: A heavy expenditure of revenue nature incurred for getting benefit over a number of years is classified as deferred revenue expenditure. Generally these expenses are revenue in nature but have some features of capital expenditure. The expenses give benefits for a long period.
Example: Preliminary expenses, brokerage on issue of shares & debentures, exceptional repairs, heavy advertisements, expenses incurred in removing the business to more convenient premises.
Accounting Treatment of Deferred Revenue Expenditure. Deferred Revenue Expenditure will be taken into Profit & Loss account in part every year and thus unwritten off portion may be allowed to stand in the Balance Sheet on the assets side. This treatment is also justifiable on the ground that the benefit of such expenses likely to extend beyond the year in which it takes place and each of these years are concerned be burdened with a proportionate share of such expenses, and not the whole amount be charged off to the profit and loss account of the very year in which it had been so expended.
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Capital receipts refer to the amounts received not in the normal course of business. Money obtained from the sale of fixed assets or investments, issue of shares, debentures, money obtained by way of loans is examples of capital receipts. These are non-recurring in nature. These receipts do not affect the profitability of the concern. They can only cause increase in liabilities or decrease in assets. Revenue receipts refer to the amount received in the normal course of business. Money obtained in the course of business is revenue receipts. These receipts are recurring in nature. The profitability of the concern influenced directly by the revenue receipts. . For example, money obtained from sale of goods, interest on deposits, dividends on investments, commission received, and rent received etc.
Accounting Treatment of Capital and Revenue Receipts
Capital receipts are shown in the assets or liabilities side of Balance Sheet and Revenue Receipts in the credit side of the Trading & Profit and Loss account. Difference between Capital and Revenue Receipts Capital Receipts Revenue Receipts 1. These receipts are not frequent in the regular course of business activities. .
These receipts arise in the day to day operation of the business.
2. These receipts are non-recurring in nature.
These receipts are recurring in nature.
3. These receipts are shown in the balance sheet under assets or liabilities side.
These receipts are shown in the credit side of the profit and loss account.
4. These receipts do not affect the profitability of the firm directly.
The profitability of the concern influenced directly by the revenue receipts.
Capital Profit: Capital profit is that profit, which is not earned in the day-to-day operation of business. These profits are non-recurring in nature. Sale of fixed assets for profit, issue of shares at a premium, purchase of an existing business cause such profits, These profits are not utilized for the payment of dividend. Revenue Profit: A Revenue profit is that profit, which is earned in the day-to-day operation of business. These profits are recurring in nature and arise by matching of revenue receipts and revenue expenses. Dividend is paid out of revenue profit and not out of capital profit. Capital Loss: capital losses are those lose, which do not arise in day-to-day operation of business. These losses are non-recurring in nature. Examples of such losses are selling the fixed assets less than its book values, issue of shares at discount, redemption of debentures at premium etc. Revenue Loss: Revenue losses arise in the normal course of business. Such losses are incurred during the process of selling the goods or rendering services. It is the loss of some revenue receipts or loss incurred in the normal course of business. Accounting for Business Transactions: Preparation of Books of Original records (journal, subsidiary books, ledger, and trial balance)
CLASSIFICATION OF ACCOUNTS:
The transactions of a business entity can be classified into the following 3 categories Transactions relating to persons or individuals – Personal Accounts Transactions relating to property, assets to possessions – Real Accounts Transactions relating to income and expenditures – Nominal Accounts
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Personal Accounts: personal accounts record the dealings of a trader with persons or firms, transactions. Personal accounts can take the following forms:
1. Natural Persons: ex. Natural persons,
ACCOUNTS Personal Accounts Impersonal Accounts Natural Persons
Artificial Person
Representative Personal Accounts
Real Nominal
Ram, Sita, Harish, etc.
Bank, Club, Any Firm, Limited Company etc.
Rent prepaid, interest received in advance, prepaid insurance, outstanding salary etc.
Tangible Furniture, Plant, Machinery, Stock Cash Etc.
Intangible Goodwill, Trade Marks, Patents Etc.
Rent, Interest, Discount, Cartage etc.
Rules of Debit and Credit:
Type of the Account Personal Accounts
Debit The Receiver
Credit The Giver
Real Account What Comes in What goes out Nominal Account All loses and Expenses All gains and incomes
Recording transactions and events in the journal (Journalisation) Journal: A Journal is a book of original entry wherein transactions are first recorded. It is a book of original entry wherein transactions are recorded chronologically (i.e. in order of date). Showing date for each amounts and accounts to be debited and credited and an explanation (narration). Features of Journal:
1. It is a book of primary entry in which transactions are recorded in a chronological order. 2. It serves as a source for future reference to the accounting transactions. 3. It gives adequate explanation in the form of narration to each transaction, which describes briefly the true
nature and context of the transactions. 4. Amount of the transaction is recorded in both debit and credit column side by side. It helps in maintaining
arithmetical accuracy of the books of accounts. 5. It establishes the linkage with the ledger.
Example: Transactions of M/S Ramesh & Co.for April, 2001 are given below journalize them.
Date Transaction Amount (RS.) April1 Rajesh started business with cash 10,000
2 Paid into bank 7,000 3 Bought goods for cash 500 5 Drew cash from bank 100 13 Sold to Krishna goods on credit 150 20 Bought from shyam goods on credit 225 24 Received from Krishna
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30 Paid salary 100
Solution: GENERAL JOURNAL
Date Particulars L.F. Debit (Rs.)
Credit (Rs.)
2001 1st April
Cash A/c. Dr. To Rajesh’s Capital A/c. (being money invested in the business)
10,000 10,000
2nd April Bank Account Dr. To Cash Account (being the account paid into bank)
7000 7000
3rd April Purchases A/c. Dr. To Cash Account (being goods purchased for cash)
500 500
4th April Cash A/c. Dr. To Bank A/c. (Being the cash withdraw from the bank)
100 100
13th April Krishna A/c. Dr. To Sales A/c. (being goods sold to Krishna on credit)
150 150
20th April Purchases A/C. Dr. To Shyam A/c. (being the goods bought from shyam on credit)
225 225
24th April Cash A/c. Dr. Discount A/c. Dr. To Krishna A/c. (being cash received from Krishna and discount allowed to him)
145 5
150
28th April Shyam A/c. Dr. To Cash A/c. To Discount A/c. (being cash paid to shyam and discount allowed by him)
225 215 10
30th April Cash Account Dr. To Sales A/c. (being goods sold for cash)
800 800
30th April Rent A/c. Dr. Salary A/c. Dr. To Cash A/c. (being the amount)
50 100
150
Posting Journal entries in appropriate accounts in the general Ledger
Ledger: The ledger is the principal book of accounts where similar transactions relating to a particular account (personal, real and nominal in nature) are recorded. Ledger contains a classified summary of all transaction recorded in the Journal. Financial statements are prepared on the basis of balance in Ledger account at the end of the accounting period. Features of Ledger:
1. It is the book, which contains all the accounts. 2. The pages of the ledger are consecutively numbered and index of the page numbers of various accounts is
provided at the beginning of ledger book. 3. All the information relating to any account is available from the ledger.
Difference between Journal and Ledger Journal Ledger
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1. It is the book of original entry or primary entry.
It is the book of secondary entry.
2. Transactions are recorded sequentially or chronologically, i.e., strictly in order of dates.
Transactions are classified according to the nature and are grouped in the concerned accounts.
3. Transactions are recorded in the journal applying the rules of debit and credit.
3. Transactions are posted in the ledger systematically from the journal.
4. Ledger folio is written in L.F. column Journal Folio is written in the J.F. column. 5. Brief description of the transaction is recorded for each entry, which is called narration.
Narration is not required.
6. The process of recording financial transactions in the journal is called ‘Journalizing.
The process of recording transactions in the ledger is known as Posting.
7. In Journal there are two columns one for debit amount and another for credit amount.
In ledger there are two sides left side is debit and right side is credit side.
8. Balancing is not required in case of journal
Balancing is required for every account in the ledger
Ex: 2 for the above problem, the ledger accounts can be prepared as below: Dr. Cash Account Cr. Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 1st April,2001 To Capital 10,000 2ndApril By Bank 7000 4th April To Bank 100 3rd April By Purchases 500 24th April To Krishna 145 30th April By Shyam 215 30th April To Sales 800 30th April By Rent 50 30th April Salary 100 30th April By Balance c/d 3,180 11,045 11,045 1st May To Balance b/d 3,180
Dr. Capital Account Cr Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 1st April By Cash 10,000 30th April To Balance c/d 10,000 10,000 10,000 1st May By Balance b/d 10,000 Dr. Bank Account Cr. Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 2ndApril To Cash 7000 4th April By Cash 100 30th April By Balance
S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70 Page 7
Date Particulars J.F. Amount (Rs.)
Date Particulars J.F. Amount (Rs.)
3rdApril To Cash 500 20th April
To Shyam 225 30th April
By Balance c/d
725
725 725 1st May To Bal b/d 725 Dr. Krishna Account Cr. . Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 13th April To Sales 150 24th April By Cash 145 24th April By Discount 5 150 150
Dr. Sales Account Cr. Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 13th
April By Krishna 500
30th April
To Bal c/d 1300 30th April
By Cash 800
1300 1300 1st May By Balance
b/d 1300
Dr. Shyam Account Cr. Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 28th April To Cash 215 13th April By Purchases 225 28th April To Discount 10 225 225 Dr. Discount Allowed Account Cr. Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 24th April
To krishna 5 30th April
By Balance c/d
5
5 5 1st May To Bal b/d 5 Dr. Discount Received Account Cr. Date Particulars J.F. Amount
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Date Particulars J.F. Amount (Rs.)
Date Particulars J.F. Amount (Rs.)
30th April
To Cash 50 30th April
By Balance c/d 50
50 50 1st May To Bal b/d 50 Dr. Salary Account Cr. Date Particulars J.F. Amount
(Rs.) Date Particulars J.F. Amount
(Rs.) 30th April
To Cash 100
30th April By Balance c/d
100
100 100 1st May
To Bal b/d 100
Sub Division of Journal (Different Types of Journal) Journalizing of every transaction is a lengthy task especially when the size of a business is large. When the size of the business grows, then the main journal is split into a number of separate journal or Day Books. A separate Day Book is used for each type of transaction. They are called as special purpose subsidiary books.
Reasons for Maintaining the Subsidiary books: 1. Economy in Labour: If the transactions are recorded in the subsidiary books of accounts directly, it will
consume less time than if the transaction is recorded in the journal and then posted to the ledger. 2. More Accuracy: there will be more accuracy in the books of accounts, as entries are made in total directly
in the subsidiary books. 3. Additional information than in a simple ledger account: in subsidiary books we can also include
additional columns for recording date of payment, cheque no. Debit note number, Credit note number, payable banks name etc.
Types of Journal/Subsidiary books/Sub-divisions of Journal
1. Sales Journal: It is used to record credit sales of goods. If some asset instead of goods sold on credit cannot be recorded in the sales book. The term ‘goods’ is used to describe those things which are purchases by the business for the purpose of resale. The transactions relating to credit sale of goods after having been recorded in the sales journal are debited to individual (debtors) accounts and total sales for a period normally one month is credited to sales account.
Date Outward invoice No. Name of the customer L.F Amount(Rs.)
2. Purchase Journal: It is used to record the purchase of goods on credit basis. Purchase of goods for the purpose
of resale only can be entered in the purchase book. The transactions relating to credit purchases of goods after having been recorded in the purchases journal are credited to individual (creditors) accounts and total purchases for a period normally one month is debit of purchases account. Date Inward invoice No. Name of the supplier L.F Amount(Rs.)
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3. Purchase Returns Journal: It is used to record the transactions relating to return of such goods as were purchased on credit basis. It is also called returns outwards book. Date Debit Note No. Name of the supplier L.F Amount(Rs.)
Debit Note: it is a note made out with a carbon duplicate. The duplicate copy is for office record and the original is sent to the party to whom the goods are returned. We call it as a debit note because the party’s account is debited with the amount written in this note.
4. Sales Returns Journal: It is used to record the transactions relating to return of such goods as were sold by the firm to its customers on credit basis. It is also called as returns inward book or sales return book. Date Credit note No. Name of the customer L.F Amount(Rs.)
Credit note: a credit note is also like a debit note. It is made with a carbon duplicate-the duplicate copy being for office use. The original copy is sent to the party from which goods are received. This is called as credit note because the party’s account is credited with the amount written in this note.
5. Bills Payable Journal: the bills payables consists of all promissory notes given or bills of exchanges accepted by the business in respect of amounts owning to suppliers.
Date Name of the Drawer
Date of bill
Term Date of maturity
Payable Bank’s name
Amount (Rs.)
Remarks
2002 Sept,15
Best & Co.
15-9-2002 90 days 17-12-2002 HDFC Bank 2,00,000
6. Bills Receivable Journal: it consists of all promissory notes given or bills of exchange accepted by customers in respect of amounts due from them.
Date Acceptor Date of
bill Term Date of maturity Payable
Bank’s name Amount (Rs.)
Remarks
2002 Sept,15
Quality Dealers
15-9-2002
90 days 17-12-2002 HDFC Bank 2,00,000
7. Journal Proper: It is used for recording such transactions as occur so infrequently that they do not warrant the
setting up of special journals. For example Opening entries, adjustment entries, closing entries, correction entries, transfer entries etc. The transactions of infrequent nature which cannot be recorded in any of the special journal they will be recorded in General Journal or Journal Proper. For example loss of goods by theft or fire etc., writing off bad debts, credit purchase of sale of fixed assets, investments etc., proprietor withdraws goods from the business for his personal consumption etc. and opening entries, adjustment entries, closing entries, correction entries, transfer entries etc.
8. Cash Book: Cash Book may be defined as the record of transactions concerning cash receipts and cash payment.
Cash Book fulfils the function of book of original entry as also a ledger account. All cash received is recorded on the left hand side or the debit side of the cashbook while all cash payments are recorded on the right hand side or the credit side of the cashbook, the difference between the two totals indicating the balance of cash in hand.
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Types of Cash Book: 1. Single Column Cash Book with Cash Column only: It is just like a Cash Account. Dr. Date Receipts L.F. Amount (Rs.) Date Payments L.F. Amount(Rs.) 2. Two-Column Cash Book (Double Column Cash Book):
In this cash book, two columns are kept on both sides. One is for cash and other is for discount. There are two columns for discount account one on the debit side of cash book (discount allowed) and other is on the credit side of cash book (discount received). These two columns are not balanced.
Dr. D at e
Receipts L.F.
Discount Allowed (Rs.)
Amount (Rs.)
Date Payments L.F.
Discount Received (Rs.)
Amount (Rs.)
3. Triple Column Cash Book (Cash, Bank & Discount Columns): In three-column cash book. Bank column is
provided on both sides. All deposits into bank are written on the debit side while all withdrawals from bank are written on the credit side. The difference between the two sides reflects the balance at bank. Thus, this bank column serves the functions of a bank account in the ledger. One important feature of this cash book is that if a transaction involves both sides of the cash, one in the cash column and second in the bank column though on opposite sides. This is called a ‘Contra’ entry and the word ‘C’ is indicated against that item.
Dr. D at e
Receipts L.F. Discount Allowed (Rs.)
Amount (Rs.)
Bank (Rs.)
Date
Receipts L.F.
Discount Received (Rs.)
Amount (Rs.)
Bank (Rs.)
Triple Column Cash Book From the following transactions of M/s. J.Choudhary, write up his cash book (three column form) bringing down the balance as on May 31, 2002. Date Particulars Amount(Rs.) 1st May Balance at bank 1,50,000 2nd May Drew from bank for office use 50,000 3rd May Bought office furniture for cash 32,000 8th May Paid wages in cash 15,000 14th May Drew from bank for office use 25,000 16th May Sold goods for cash 22,000 19th May Received a cheque from B Batiwala & Co in
settlement of their account of Rs...75,000 less 5 percent
23rd May Bought goods for cash 45,000 25th May Drew cheque for self 40,000 31st May Paid Agarwal’s account Rs.40,000 by cheque
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Sol. Date May
Receipts L.F
Discount Allowed Rs.
Cash Rs.
Bank Rs.
Date
Payments
L.F.
Discount received Rs.
Cash Rs.
Bank Rs.
1st To Balance b/d
1,50,000
2nd By Cash C 50,000
2nd To Bank a/c.
C 50,000
3rd By Furniture a/c.
32,000
14th To Bank a/c.
C 25,000
8th By wages
15,000
16th To sales a/c. 22,000
14th By Cash 25,000
19th To Batiwala & Co.
3,750 71,250 23rd By Purchases
45,000
25th By drawings
40,000
31st By Agarwala
1000 39,000
31st By balance c/d
5000 67,250
Total 3750 97,000
2,21,250
Total 1000 97,000
221250
1st June
To Balance b/d
5000 67,250
Whenever a transaction relates to cash and bank both it is recorded on both sides of the cash book. For the
purpose of reference a capital letter C is put in parenthesis on both sides of the cash book. This letter stands for Contra, a Latin phrase, which stands for opposite side.
If a cheque is received and deposited on the same date, then it is directly debited to bank account. The entry is Bank a/c. Dr. To Party a/c.
If a cherub is received and deposited on different dates, then the entry on receipt of cheque is ‘debited cash and credit party’.
Cash a/c. Dr. To Party a/c.
4. Petty Cash Book: Imprest system of maintaining petty cash is the most scientific method. The essential feature of this system is that the total petty cash expenditure for a period (say, a month) is estimated at the beginning of the month and then a round sum is given to the petty cashier for making petty payments during the month. At the end of the month, the petty cashier submits the statements of expenditure made along with supporting voucher in the form of petty cash book to the main cashier. The main advantage of this imprest system of petty cash book is the small payments are not stuffed in the main cash book. They are shown separately in petty cash book.
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Accounting and Depreciation
Fixed assets are used by a business enterprise for the purpose of producing or providing goods or services. They are not held for sale in the normal course of business. They are long lived in the sense that they provide service for several future years. Therefore the amount invested in fixed assets must be equitably allocated to different period of their economic life in a systematic and rational manner. The amount to b e charged to each period is called depreciation. Hence it is a process of allocation of the cost of fixed assets to the product or process in a number of years. The process of spreading the cost of fixed asset over a number of years during which benefit is derived from the asset is known as depreciation. To conclude Depreciation is a process of allocating the depreciable amount over the useful life of the asset. Definition: 1. Depreciation is a permanent continuing and gradual shrinkage in the book value of a fixed asset. The above
definition clearly indicates Depreciation relates to book value of the asset, it has nothing to do with the market value.
2. According to International Accounting Standard Committee “Depreciation is the allocation of the depreciable amount of an asset over its estimated useful life”.
Factors in measurement of depreciation: a. Depreciable Assets: these are the assets, which have a limited useful life, and are expected to be used during more than one accounting period. These assets are held by an enterprise for use in the production and supply of goods and services and not for the purpose of sale in ordinary course of business. b. Useful life: this is the period over which the asset gives a series of future services. c. Residual Value: it is the salvage value or the scrap value or the price at which the asset can be disposed of at the end of its useful life. Causes of Depreciation: a. Physical depreciation it is caused mainly due to wear & tears which the asset is in use and also from erosion or
decay from being exposed to wind, rain, sun and other elements of nature. b. Economic factors: certain factors are also responsible to put the asset out of use even though these are in good
physical condition. These arise due to Obsolescence. As a result of technological revolutions, the asset in use may become outdated and lose a large part of its value. This fall may also be due to the changes in tastes and habits of customer, changes in the supply and location of material resources etc.
c. Time factors: certain assets have a fixed period of legal life like lease period, patent and copy right etc. In this case depreciation is a time function. By the expiration of time for which legal right to use such assets is created, the assets lose their value. This loss of value is called depreciation. Provision for consumption of these assets is called amortization rather than depreciation.
d. Depletion: Some assets are of wasting character such as mines, forests, quarries and oil wells, due to the extraction of some materials, the assets will be depleted. This case the value of mines or quarries decrease and this decrease is termed as depletion. Need for providing depreciation:
1. To know the true profit. One of the objectives of accounting is to ascertain the true income. If depreciation is ignored the loss that is occurring in respect of fixed assets is also ignored. The loss will suddenly look large when the asset becomes useless after its useful life. From another angle when goods are prodded it involves use of fixed assets. The reduction in their value should be treated as an element of cost of production of goods. There fore deprecation should be debited to Profit and Loss account in order to ascertain the true profit.
2. To show true financial position: Financial position can be studied from the balance sheet and for the preparation of the balance sheet fixed assets are required to be shown at their true value. If assets are shown in the balance sheet without any charge made for their use, then their value must have been overstated in the balance sheet and will not reflect the true financial position of the business. Therefore, for the purpose of reflecting the true financial position, it is necessary that deprecation must be deducted from the assets and then at such reduced value of these may be shown in the balance sheet.
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3. To provide for the replacement of assets: Another objective of depreciation is to create a depreciation fund out of profits for replacement of assets. The amount debited to Profit and Loss Account towards depreciation is invested in a fund. The fund is available for replacement of the asset when its useful life is over.
Characteristics/Features of Depreciation:
Depreciation is the decrease in the value of fixed assets. It is a permanent loss and the lost value due to depreciation cannot be recovered after wards. It does not result in cash outflow, so it is considered as non-cash expenses. Depreciation is always related to fixed assets and not to current assets. Depreciation is the reduction in the book value of the asset not the market value. Depreciation is the result of the use of assets, passage of time and obsolescence.
Depreciation, Depletion and Amortization: Depreciation: the term ‘depreciation’ is used when expired utility of a physical asset (building, machinery, or equipment) is to be recorded. In other words, the accounting process of converting the cost of such fixed assets to expenses is called ‘depreciation’. Depreciation has a significant effect in determining and presenting the financial poison and results of operations of a firm. Depletion: Some assets are of wasting character such as mines, forests, quarries and oil wells, due to the extraction of some materials, the assets will be depleted. This case the value of mines or quarries decrease and this decrease is termed as depletion. The accounting process of converting the cost of these natural resources (which are usually reported as a separate category of assets) to expenses is called depletion. Depletion differs from depreciation in physical shrinkage or lessening of an estimated available quantity the latter implying a reduction in the service capacity of an asset. Amortization: the term ‘Amortization’ is usually used for describing the process of writing down the long-term investments in intangibles such as leaseholds, patents, copyrights, trademarks, goodwill and heavy organization cost. In other words, the accounting process of converting such intangibles assets to expenses is called amortization. Accounting and Depreciation:
1. When provision for depreciation account is not maintained. 2. When provision for depreciation account is maintained.
1. When provision for depreciation account is not maintained: The following entries are passed to record depreciation.
a. At the time of purchase of asset: Asset a/c. Dr. To Bank
b. Entry for providing annual depreciation Depreciation a/c. Dr.
To Asset a/c. c. Entry for closing the depreciation account by transferring to P&L a/c.
P&La/c. Dr. To Depreciation a/c.
d. If the asset is sold in the middle of the accounting year the amount of depreciation is calculated from the beginning of the current accounting year up to the middle of the accounting year i.e. the time when the asset is sold and the amount is credited to asset a/c. any difference between cash and bank realized and the written down value of the asset is to be transferred to P&L a/c. (Profit / Loss on sale )
Bank a/c. Dr. (with the amount released) Depreciation a/c Dr (with the amount of depreciation calculated on the asset sold) P&L a/c. Dr (loss on sale of the asset) To Asset a/c. (With the original cost of the asset).
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2. When provision for depreciation account is maintained. a. at the time of purchase of asset: Asset a/c. Dr.
To Bank b. Entry for providing annual depreciation Depreciation a/c. Dr.
To Provision for Depreciation a/c. (will appear on the liability side of the Balance sheet c. Entry for closing the depreciation account by transferring to P&L a/c. P&L a/c. Dr. To Depreciation a/c. e. If the asset is sold in the middle of the accounting year the amount of depreciation is calculated from the
beginning of the current accounting year up to the middle of the accounting year i.e. the time when the asset is sold and the amount is credited to asset a/c. any difference between cash and bank realized and the written down value of the asset is to be transferred to P&L a/c. (Profit / Loss on sale )
Bank a/c. Dr. (disposal value of the asset) Provision for Depreciation a/c Dr. (with the amount of depreciation already accumulated on the asset sold) P&L a/c . Dr (loss on sale of the asset)
To Asset a/c. (With the original cost of the asset). To P&L a/c. (Profit on sale of the asset) Methods of providing Depreciation 1. Fixed Percentage on Original cost or Straight line or Fixed Installment Method: Under this method the amount to be written of as depreciation every year during the useful life of the asset remains same for every year. To ascertain the annual charges towards depreciation the following formula is applied. *Depreciation = Total cost of acquisition including the installation charges– scrap value Estimated life of the asset Depreciation may be expressed as a rate; the rate on cost will be calculated as under r = R X100 where r stands for depreciation rate, C R= the amount of depreciation C= acquisition cost includes the cost of installation. Advantages:
1. This method is simple, as arithmetical calculations are not at all complicated. 2. The rate or the amount of depreciation over the useful life of the assets remains uniform and same. 3. After charging depreciation for the entire life period of the asset the value of the asset reduces to zero. Limitations: 1. The amount of depreciation is same in all the years, although the usefulness of the machine to the business
is more in the beginning year than that it is in later years. 2. The unevenness of the loss in the market value of an asset over several years is also not reflected in this method. 3. The assumption that the asset will be equally useful throughout its life seems to be illogical. 4. The charge for depreciation remains constant year after year. The expenses of repairs and maintenance are
increasing, as the asset grows older. The profit and loss account thus in the later years bears more than it share of valuation.
2. Diminishing Balance method (Written down Value Method): under this method, depreciation is calculated on the written down value of the asset at a certain percentage. The amount of depreciation charged each year goes on decreasing as it is calculated on the balance of the asset carried forward from previous year. The written down value of the asset does not become zero at the end of its estimated useful life. This method can be applied only when there is some residual value of the asset. It is impossible to calculate the rate of depreciation if the residual value is assumed to be zero. The rate of depreciation under this method may be determined by the following formula: r = 1 - ns/c Where r = rate of depreciation n = useful life s = scrap value
S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70 Page 15
c= cost of acquisition including cost of installation. Advantages:
1. This method is commonly used for plant, fixtures etc. under this method, the annual charge for depreciation decreases from year to year.
2. This method is an approved method under Income Tax Act, 1961. 3. It is logical that the higher depreciation is charged in the earlier years when the machine is more efficient as
compared to later years. 4. It tends to give a fairly even charge of depreciation against revenue each year, Depreciation is generally
heavy during the first few years and is counter-balanced by repairs being light in the later years when reprise are heavy this is counter-balanced by the decreasing charge for depreciation.
Disadvantages: 1. Under this method the written down value of an asset can never be zero. 2. Calculation of proper rate of depreciation is difficult. 3. This method does not take into consideration the asset as an investment and interest is not taken into
consideration. Difference between Straight line method and Diminishing balance method. Straight line method Diminishing balance method 1. Calculation of depreciation is on original cost
1. Calculation of depreciation is on written down value.
2. Instalment of depreciation is same every year.
2. Installment of depreciation goes on diminishing every year.
3. At the expiry of working life of the asset, the balance in the asset account will reduce to zero.
3. The balance in the asset account will never reduce to Zero.
4. Suited for assets, which get depreciated more on account of expiry of time e.g. patent, lease.
4. Suitable for assets, which require heavy repairs in the later years of their working life. Plant, machinery etc.
5. Calculation of depreciation is simple. 5. Calculation of depreciation is difficult. 6. The overall charges, i.e., depreciation and repairs taken together go on increasing from year to year. In other words the amount of depreciation and repairs is relatively less during the earlier years of the life of the asset than
6. The overall charges more or less same for every year through out the life of the asset. Since depreciation goes on decreasing and the amount of repairs goes on increasing.
3. Depreciation fund method: Depreciation fund method is otherwise known as sinking fund method. This method provides funds for replacement of assets at the end of its useful life. Under this method the amount written of as depreciation is set aside and invested in readily saleable securities the security earns interest and accumulates, every year the amount of depreciation along with the interest is again invested. It is sold when the life of the asset expires; and a new asset is purchased with the amount realized to replace the old one. How much amount to be provided and invested each year can be known by referring to the sinking fund table. While providing annual depreciation here depreciation fund accounted is credited instead of asset account. Asset account appears at its original cost in the balance sheet till it is so sold/replaced. In the last year, the asset is written off by transferring it to depreciation fund account. This method is suitable when the intention is not only to provide depreciation but also to provide for its replacement as required in case of plant and machinery. Accounting Entries:
S.A. SALAKA ROLL NO 72 SECTION B REGISTRATION NUMBER 70 Page 16
Year Entry At the end of 1st year
For providing annual depreciation Depreciation a/c. Dr. To Dep. Fund a/c.
For investing the amount outside the business.
Dep. Fund investment a/c. Dr. To Bank a/c.
For transfer of depreciation a/c to P&L account.
P&L a/c. Dr. To Depreciation a/c.
2ndand subsequent years
For receiving interest on investment Bank a/c. Dr. To Depreciation fund a/c.
For providing annual depreciation Depreciation a/c. Dr. To Dep. Fund a/c.
For investing the amount of Depreciation + interest outside the business.
Dep. Fund investment a/c. Dr. To Bank a/c.
For transfer of depreciation a/c to P&L account.
P&L a/c. Dr. To Depreciation a/c.
Last year Amount realized from Sale of investments
Bank a/c. Dr. To Dep. Fund investment/c.
If sale of investment is at profit Dep. Fund investment a/c. Dr. To Depreciation fund a/c.
If sale is at loss Depreciation fund a/c. Dr. To Dep. Fund investment a/c.
Sale of old asset Bank a/c. Dr. To Asset a/c.
Depreciation fund is transferred to asset a/c. and any balance left in the asset account is transferred to profit and loss a/c.(for transfer of loss)
P&L a/c. Dr. To Asset a/c.
For transfer of profit Asset a/c. Dr. To P&L a/c.
For purchasing of the new asset. New asset a/c. Dr. To Bank.
4. Insurance Policy method: This method is quite similar to depreciation fund method /sinking fund method. But the difference is that instead of investment is made annually a fixed amount of premium is paid to the insurance company at the beginning of each year in return the insurance company pays the required amount at the expiry of the specified period to replaced the old asset. In this method an insurance policy is purchased for the value of the asset. This policy is taken up for the life of the asset and it matures at a time when the asset is to be replaced. The amount provided for depreciation is paid towards insurance premium. On the maturity of the policy, insurance company will pay the amount and the amount will be utilized for replacing the asset.
Year Entry 1st and subsequent years
Entry for depreciation P&L a/c. Dr. To Depreciation fund a/c
For the payment of premium Dep. Insurance policy a/c. Dr. To Bank a/c.
Last year For the amount received from the insurance company
Bank a/c. Dr. To Dep. insurance policy a/c.
Profit/loss on realization or any more/ less amount
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received from the insurance company is to be adjusted through Dep. Reserve a/c.
To Depreciation fund a/c.
Closing down the Dep.fund account and asset account,
Depreciation fund a/c. Dr. To old Asset a/c.
Purchase of a new asset New Asset a/c. Dr. To Bank.
5. Revaluation method: Asset is revalued at the end of the accounting year and it is compared with the value of the asset at the beginning any addition during the year is added to the asset at the beginning. Any difference between the value at the beginning and the value at the end is treated as depreciation. This method is usually used in case of assets like drums, containers, loose tools, patens, bottles etc.
6. Depletion Method: this method is used mainly in mines and quarries etc. from which a fixed quantity of output is expected to be obtained. The value of mines depend up on the quantity of output is expected to that can be extracted. When all the available deposit in the mine is extracted, its value reduces to zero. The amount of depreciation to be charged in a particular year is ascertained by multiplying the rate of depreciation with the quantity of output extracted during that particular year.
Depreciation rate = cost of mine (Asset) Quantity Quantity = no. of units of output expected to be extracted during the life of the asset. 7. Machine Hour Rate method: This is another method of charging depreciation where the life of the asset is
estimated in hours. The value of the asset minus scrap value is divided by the estimated number of hour to ascertain the machine hour rate. Under this method the life of the machine is fixed in terms of no. of hours it is expected to run. Annual depreciation to be charged is calculated as follows;
Depreciation = Cost of machine X No. of hours the machine runs in a year. Life of the machine in hours
Example: A machine was purchased for Rs.3, 00,000 having an estimated total working 24,000 hours. The scrap value is expected to be Rs.20, 000 and anticipated pattern of distribution of effective hours is as follows. Year 1-3 3,000 hours per year. 4-6 2,600 hours per year. 7-10 1,800 hours per year. Determine Annual Depreciation under Machine Hours Rate Method. Solution: Statement of Annual depreciation under machine hour’s rate method
Year Machine hours Annual Depreciation 1-3 3,000 hours per year. 3,000/24,000X(3,00,000 – 20,000) = 35,000 4-6 2,600 hours per year. ,2600/24,000X(3,00,000 – 20,000) = 30,333 7-10 1,800 hours per year 1800/24,000X(3,00,000 – 20,000) = 21,000 8. Sum of the Digits method: under this method depreciation to be provided is calculated as follows:
Amount to be written off X No. Of years the remaining life of the asset including current year._______________________ Total of all digits represented by life time of assets in years.
Ex: Machinery was purchased for Rs. 30,000 on 1st January, 03. Provide depreciation for 3 years assuming that its useful life is 3 years. Solution:
Year No. of years the remaining life of asset
Depreciation to be provided.
1st year 3 years 30,000X 3/6 = 15,000/- 2nd year 2years 30,000X 2/6 = 10,000/-
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3rd year 1 year 30,000X 1/6 = 5,000/-. Total digits 6 9. Annuity method: under this method the cost of the asset is treated as an investment and it is assumed to earn
interest at certain rate. Every year the asset account is debited with the amount of interest calculated at certain rate on the opening balance of the asset in that year, and credited with the amount of depreciation. The amount of depreciation to be provided each year is calculated by referring to the annuity table, which depends up on the rate of interest and the period over which the asset is to be written off. This method is to a great extent scientific as it treats the purchase of an asset as an investment in the business itself and charge interest on the same. But the chief defect is that the total charges of depreciation and repairs put together do not remain fairly uniform from year to year as in the diminishing balance method. This method is mainly used in the case of costly leases of long period and other assets to which additions are not usually made and as such in case of machinery this method is not found suitable. Example: A firm purchases a 5 year lease for Rs.40, 000 on 1st January, 2000. It decides to write off depreciation on the annuity method. Presuming the rate of interest to be 5% p.a. the annuity table shows that a sum of Rs. 9230/- should be written off every year. Show the lease (Asset) account for 5 years. Calculations are to be made to the nearest rupee.
Solution: Dr. Lease (Asset) A/.c. Cr. Date Particulars Amount(Rs.) Date Particulars Amount(Rs.)
1-1-2000 To Bank 40,000 31-12-2000
By Dep. 9239
31-12-2000
To Interest (5% on 40,000/)
2,000 31-12-2000
By Bal c/d. 32,761
42,000 42,000 1-1-2001 To bal b/d 32,761 31-12-
2001 By Dep. 9239
31-12-2001
To Interest (5% on 32,761/)
1638 31-12-2001
By Bal c/d. 25,160
34,399 34,399 1-1-02 To bal b/d 25,160 31-12-
2002 By Dep. 9239
31-12-02 To Interest (5% on 25,160)
1258 31-12-2002
By Bal c/d. 17,179
26,418 26,418 1-1-03 To bal b/d 17,179 31-12-
2003 By Dep. 9239
31-12-03 To Interest (5% on 17,179)
859 31-12-2003
By Bal c/d. 8799
18038 18038 1-1-04 To bal b/d 8799 31-12-
2004 By Dep. 9239
31-12-04 To Interest (5% on 8799)
440
9239 9239 Change in the method of Depreciation: sometimes the method of providing depreciation is changed either from written down value method to straight lien method or from straight lien method to written down value method. If the change in method becomes effective from current year we need not make any adjustment but simply to change the method of depreciation. But if the change in method is to be effective with retrospective effect (change in method to be effective from some past period) the following steps are to be followed. 1. First of all value of asset on the beginning date from which the method is charged is to be calculated.
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2. Depreciation is calculated under both the methods old method and changed method till the period when adjustment is to be made.
3. The differential amount of depreciation between the existing method and the new changed method is to be adjusted through asset account by giving debit or credit to P&L account.
If depreciation under changed method is less than the existing method. Asset a/c. Dr.
To P&L a/c. If depreciation to be provided under new method is more than existing method. P&L a/c. Dr.
To Asset a/c. In surplus, it should be credited to profit and loss account. Factors influencing selection of Depreciation method: Depreciation has a significant effect in determining the financial position and result of operations of an enterprise via calculating net income as well as deduction from taxable income. The quantum of depreciation to be provided in an accounting period involves the exercise of judgment by management in the light of technical, commercial, accounting and legal requirements and accordingly may need periodical review. The following factors influence the selection of a depreciation method.
1. Legal provisions 2. Financial reporting 3. Effect on managerial decisions. 4. Inflation 5. Technology. Etc.
Inventory Valuation Meaning of inventories: According to Accounting Standards (AS-2) Revised, issued by the institute of Chartered Accountants of India, Inventories are assets,
i. Held for sale in the ordinary course of business; ii. In the process of production for such sale, or iii. In the form of materials or supplies to be consumed in the production process or in the rendering of
services. Both manufacturing concern and trading concern maintain inventories. Manufacturing Concerns: Inventories of a manufacturing concern consists of raw materials, work-in progress, finished goods, spares and stores. Trading concerns: Inventories of a trading concern primarily consists of finished goods purchased for resale. Significance of Valuation of Inventory: it arises mainly because it serves two purposes.
To determine the true income To determine the true financial position.
Two Inventory Systems: There are two inventory systems. Viz. Periodic Inventory System and Perpetual Inventory System. Meaning of Periodic Inventory System: Periodic inventory system is a method of ascertain inventory by taking an actual physical count (or measure or weight) of all the inventory items on hand at a particular date on which information about inventory is required. The cost of goods sold is calculated as residual figure (which includes lost goods also) as under. . Cost of goods Sold (materials consumed) = Opening Inventory+ Purchases- Closing Inventory. Meaning of Perpetual Inventory System: Perpetual inventory system is a method of recording inventory balances after each receipt and issue in order to ensure accuracy of perpetual inventory records, physical stocks should be checked and compared with recorded balances. The discrepancies, if any should be investigated and adjusted in the accounts properly.
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Methods of Valuation of Inventories
1. FIFO method: FIFO method is known as First in first out method. Under this method the materials in the store are issued according to their order of receipts in the store. In other words the material received first is issued first. Material from the next lot is issued only after the previous lot is fully exhausted. The material in the opening stock is used first. The material in the closing stock is valued at the latest purchase price. This method is most suitable in times of falling prices, because the issue price of materials to job will be high, while the cost of replacement of material will be low. Merits: 1. The FIFO method is rational, systematic and consistent with the actual physical flow of materials. 2. Materials are issued at their purchase cost. Hence cost of the work order or job is correctly determined. 3. This method is useful when prices of material are falling. 4. The method is simple and easy to understand and operate. 5. Closing stock of material under FIFO will be valued at the most recent cost price. Demerits: 1. This method increases the possibility of clerical errors if there is very frequent fluctuation in the price. 2. Sometimes more than one prices for valuing material issues are to be adopted when materials to be issued
from different lot, even in a single requisition. 3. When prices of material rise, the issue price does not reflect the market price. And therefore the charges to
production are low, because the cost of replacing the material consumed will be higher than the price of issue.
2. LIFO Method: under this method pricing of issue of material is done in the reverse order of purchase.
The materials received last in the store is issued first and also priced at that rate. Hence this method is
known as Last in First Out method. This method is suitable at the time of rising prices because
materials issued are priced at the price of latest available consignment, which is very closely related to
the market price. Pricing the issue of materials under this method will help in fixing the competitive
selling price of the product.
Merits: 1. Materials are priced at cost price, and therefore no profit or loss will result by following this method like
FIFO method recovers the actual cost from production. 2. Production is changed at recent prices as far as possible because materials are issued from latest consignment. 3. At the time of rising prices, this method is most suitable, because materials are issued at the current market
prices, which are high, hence lowering the profit and paying less tax. Demerits:
1. Like FIFO this method may also leads to clerical error as materials are to be issued from different lots. 2. Like FIFO method comparison between one job and another will become difficult. 3. The stock of material in hand is valued at a price, which doesn’t reflect the current market price.
Consequently closing stock will be overstated or understated in the Balance Sheet. 4. Sometimes more than one price is to be adopted for pricing the material issue when it is issued form more
than one lot. 3. Average Cost method: a. Simple Average: A price which is calculated by dividing the total of the prices of materials in stock from
which the materials to be priced could be drawn by the no. of prices used in that total. For example: 1000 units purchased @ 10
2000 units purchased @ 11 3000 units purchased @ 12
Average price = 10+11+12 = 11.3 b. Weighted Average Price: “A price which is calculated by dividing the total cost of materials in stock by the
total quantity of materials in stock.” This method considers both the price and quantity in stock in the above
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example the weighted average price = 1000X10 + 2000X11 + 3000X 12 = Rs. 11.33 1000+2000+3000 This method is most suitable when there is a price fluctuation, as the actual cost can be recovered from the cost of the product.
Merits: 1. This method is a rational, systematic one. It represents the prices prevailed during the entire period,
beginning to ending or that point of time when material is issued. 2. When the prices fluctuate considerably this method is most suitable. 3. Issue prices are not to be calculated each time issues are made, issue prices are charged only when new lot of
material is purchased. 4. This method covers the cost of material from production. 5. This method maintains the issue prices as near to the market price as possible. 6. This method does not require any adjustment in stock valuation.
Demerits: 1. The major drawback of the system is that a fresh rate is to be calculated as soon as a new lot of material is
purchased which may involve tedious calculations. Hence there are chances of clerical errors. 2. Issue price of materials does not represent actual cost price of materials issued, but it represents average cost of
materials in the store. 3. This method cannot be used in job order industry where each individual order must be priced at each stage up to
completion. 4. Inflated Price Method:
There are some materials, which are subjected to natural wastage. Example: coal lost due to loading and unloading, timber lost due to seasoning. In such cases the, materials are issued at inflated price so as to recover the cost of natural wastage of materials from the production. EX: if 100 tones coals are purchased at Rs.75 per tone and if it is expected that 5 tones coals will be lost due to loading or unloading the inflated price in this case will be = 100X75 ` :- Inventory Valuation= Rs.78.95
(100-5) tones 5. Base stock method: the base stock method is based on the assumption that every organization always maintains a
minimum quantity of materials in stock. This minimum quantity is known as safety and base stock. This should be used only when an emergency arises. The base stock is created out of the first lot; hence it is always valued at the cost price of the first lot.
6. HIFO method: This method is based on the assumption that the closing stock of materials should always be valued at minimum price. Hence the materials issued are to be priced at the highest value of available consignments in the stores. This method is not suitable as this method always undervalues the closing stock, which causes creation of a secret reserve. This method is mainly used in case of cost plus contract.
7. Standard Cost method: under this method, a standard cost is set for each material and this cost is used as a basis for pricing the material issues. The use of standard cost for determining the cost of inventories requires that standards are realistic, are reviewed regularly and where necessary, revised in the light of current conditions and that there exists a proper system of pro rating significant variances between the cost of sales and inventories.
8. Specific Identification method: the specific identification method attributes specific costs to identified goods that have been bought or manufactured and are segregated for a specific purpose. According to Accounting Standard2, this method should be used for inventories of items that are not ordinarily interchangeable or for goods produced and segregated for specific projects. Lower of cost or market (LCM): different methods of inventory costing such as FIFO and LIFO determine the value of inventory in terms of historical cost. However, according to the conservatism concept, inventory should be reported on the balance sheet at the lower of its cost or its market value.
9. Material price method: market price can either be replaced price or realizable price. Replacement price is applicable in case of stock is held for use in production, while realizable price is used in case of finished product or the stock ready for sale. Under this method material issued is priced at that price at which it can be replaced. Hence cost of the material is issued at the price prevailing in the market on the date of issue. This method is ideal when quotations have to be sent, because this would reflect the latest competitive conditions. This method is also good for pricing of issue of obsolete materials, lying in the store for a long period. This method doesn’t recover the cost price of the material
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from production, because market price may be more or less than the actual cost. It makes stores ledger unnecessarily complicated.
Accounting Standard 2 (revised) has curtailed the methods available for valuation. The earlier AS-2 permitted a variety of cost formula to be adopted for inventory valuation. The revised standard permits the use of only FIFO or weighted average cost formula for determining the cost of inventories where the specific identification of cost of inventories is not possible.
